Positive Accounting Theory

ACCOUNTING THEORY AND PRACTICE

FAR 600

Positive Accounting Theory

By:Prof Madya Dr Roshayani Arshad

Faculty of AccountancyUiTM

04/08/23

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LEARNING OBJECTIVES

At the end of this lesson, students should be able to:Contracting theory Agency theoryPolitical processes

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POSITIVE ACCOUNTING

THEORY

04/08/23Copyright@2005 by Rohana Othman. All rights reserved.

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Copyright@2005 by Rohana Othman. All rights reserved.

ECONOMIC CONSEQUENCES

Economic consequences is a concept that asserts that, despite the implications of

efficient securities market theory, accounting policy choice can affect firm

value.(Scott, W.R., 2003, p.259)

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Despite implications of efficient market theory, accounting policy choice have economic consequences for various constituencies of financial statement users

Standard setting bodies includes different constituencies in their board in order to reach a consensus between accounting and political demands.

THE RISE OF ECONOMIC CONSEQUENCES

Economic consequences as defined by Zeff (1978) the impact of accounting reports on the decision-making behavior of business,

government and creditors. (Scott, 2003, p.261)

Third party interventions complicate the setting of accounting standards because they try to influence or influenced the accounting the standard setting bodies

Example: attempt by several US corporations to implement replacement cost accounting during the period of high inflation (1947-1948)

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THE RISE OF ECONOMIC CONSEQUENCES

Since there is no theory that clearly prescribes what accounting policies should be used other than a vague requirement tradeoff between relevance and reliability is necessary

This opens the door for various other constituencies to argue for their preferred accounting policies

Hence standards setting requires both the accounting theory domain as well as the political domain

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PHILOSOPHY OF PAT A science to predict unobservable phenomena

and seeks to explain observed accounting phenomena by searching for the reasons events occur

‘The objective of (positive) accounting theory is to explain and predict accounting practice … Explanation means providing reasons for observed practice. For example, positive accounting theory seeks to explain why firms continue to use historical coat accounting and why certain firms switch between a number of accounting techniques. Prediction of accounting practice means that the theory predicts unobserved phenomena. (Watts & Zimmerman, 1986, p.2)

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PHILOSOPHY OF PAT

Economic focus

i.e., focus on the costs and benefits of the alternative

accounting methods, regulations & accounting std setting

process & the effects of reported FS on share prices.

More scientific in methodology i.e., empirically

explaining & predicting what occurs.

Central idea is to develop hypotheses about factors

that influence the world of accounting practices and

to test the validity of these hypotheses empirically.

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NATURE OF NORMATIVE THEORY & ITS LIMITATIONS

Prescribes what should occur or the best way to account

Limitations Normative presupposes PAT (Jensen, 1983)

Normative not based on identified, empirical observations & methods (Watts & Zimmerman , 1986)

‘Valid prescription requires specification of both an objective and an objective function.’ (p.7)

Normative produces irrefutable prescriptions (Popper, 1968)

‘No amount of empirical testing can prove a theory to be correct – i.e. tests of a theory against real-world data - but a theory should be refutable or capable of falsification.’ 04/08/23

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04/08/23

Copyright@2004 by

Rohana Oth

man. All

Rights

Reserved.

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SCOPE OF PAT

Capital Market Research (CMR)

Efficient market hypothesis (EMH)

Capital Asset Pricing Model (CAPM)

Positive Accounting Theory

Accounting Policy Choice (APC)

Opportunistic reasons

Efficiency reasons

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Copyright@2004 by

Rohana Oth

man. All

Rights

Reserved.

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SCOPE OF PAT PAT attempts to understand & predicts

firm’s APC PAT asserts that firms need APC to minimize

contracting costs PAT implies it is more efficient for firm to

have a set of accounting policies (GAAP) from which management can choose

However, this flexibility in APC opens the door to opportunistic management behavior

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Copyright@2004 by

Rohana Oth

man. All

Rights

Reserved.

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SCOPE OF PAT Efficiency assume that internal control systems limit

opportunism and motivate managers to choose

accounting policies that minimize contracting costs.

Sweeney (1994) found that managers change

accounting policies only when it was cost effective &

Dechow (1994) further confirmed Sweeneys’ findings.

Both the above studies confirmed that managers

choose accounting policies more for efficiency reasons

rather than opportunistic reasons.

04/08/23

Copyright@2004 by

Rohana Oth

man. All

Rights

Reserved.

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SCOPE OF PAT PAT developed in two stages

First-stage literature did not explain accounting

practice. The earlier of the two stages involved

research into accounting and the behaviour of capital

markets

Second-stage literature sought to explain and predict

accounting practices across firms

THE DIFFERENCE BETWEEN NORMATIVE THEORY AND POSITIVE THEORY

Normative theory: what they should do What is a good normative theory: it is judged by its logical consistency with

underlying assumptions of how rational individuals should behave

Positive theory: to predict which acct policy firms will choose

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THE RELATION BETWEEN NORMATIVE THEORY AND POSITIVE

Both are valuable to theory development and

testing

Positive theory helps to keep the normative

research on track by empirical testing

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STRENGTH OF PAT

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WHY PAT? What was? What is? What ought to be?

A theory that is consistent with the existence of economic consequences

explain or predict real world phenomenon and are tested empirically

Based on scientific methodology using economic based empirical literature

Enable theories to be refuted, to explain & predict, to rationalize accounting principles and to model connection between accounting, firms & markets

Attempt to understand why accounting policies matter and predict which accounting policies firms will choose

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PAT HYPOTHESES Predictions made by PAT largely organized around

3 hypotheses formulated by Watts & Zimmerman (1996), all other things being equal:The Bonus Plan Hypothesis

Choose accounting policy that shift reported earnings from future periods to the current period

The Debt Covenant Hypothesis Firm with prospect of violating accounting-based debt

covenants (e.g. going below the agreed specified level of debt equity ratio) would shift reported earnings from future periods to current periods

The Political Cost Hypothesis Choose accounting policy that defer reported earnings from

current to future periods.

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PAT HYPOTHESES

Managers of firms with bonus plan predicted to choose less conservative accounting policy & oppose

accounting standards that may lower reported net income than managers of firms without such plan

Managers of firms with high debt-to-equity ratio Choose less conservative accounting policy & oppose new

standards that may lower reported net income.

Managers of large firms Choose more conservative accounting policies & less likely

to oppose new standards that may lower reported net income.

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POSITIVE THEORIES

‘Experiences’ or ‘facts’ of the real world

explaining reasons for current practice

predicting how accounting information is used in economic decision-making

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NATURE OF POSITIVE THEORIES

Provide description of what accounting is Descriptive, inferential & objective Objective of PAT is to explain & predict

accounting practice A science to predict unobserved phenomena Observable & verifiable Derived inductively from specific set of

observation Analytic (logic), semantic & pragmatic

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NATURE OF POSITIVE THEORIES Based on scientific empirical methodology,

relating or testing accounting hypothesis to experience or facts of real world e.g., efficient market hypothesis

Focus on Accounting policy choice Capital market research

Assumptions Efficient capital market A firm is a nexus of contracts Accounting is important in contract enforcement Accounting information is an economic good Managers, investors, lenders & others are assumed to

be rational & evaluative utility maximizer Discretion to choose accounting policies that maximize

their utility and value of firm 04/08/23

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CRITICISMS ON PAT

Positive theory are not value free

VALUE FREE IS NOT ALTERED OR INFLUENCED

BY VALUE JUDGMENT

Value judgment of the rightness or

wrongness or usefulness of something base

on persona; view.

The theories use large-scale statistical

research, remote from practitioners and their

concerns

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DIFFERENCE BETWEEN NORMATIVE & POSITIVE ACCOUNTING THEORIES

Normative Prescriptive

Prescribed how people should behave

Positive Descriptive, explanatory or predictive

Describe how people behave Explain why people behave in a certain

mannerPredict what people have done or will do

Suggestion: can coexist & complement each other

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CONTRACTING THEORY

Firm is a legal nexus (connection) of contractual relationships

amongst suppliers and consumers of factors of production

Rationale for the firm:

‘it costs less to transact (or contract) through central

organization than to do so individually’

‘firm is an efficient means of organizing economic activity

because they reduce contracting costs’

Hence firm exists to reduce transaction costs

PAT-APC focuses on two main types of agency contracts to

explain accounting practices:

Management contracts (shareholders & managers)

Debt contracts (lenders & managers who is acting on behalf of the

shareholders)04/08/23

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AGENCY THEORY

Developed to explain & predict the actions of agents (e.g. managers) & principals (e.g. shareholders or lenders).

Assumption: no ‘ a priori’ reason to believe that agent will act in the best interest of the principal

Jensen & Meckling (1976) describe an agency relationship arises when there is a contract under which one party (the principal) engages another party (the agent) to perform some service on the principal’s behalf.

Under the contract the principal delegates some decision-making authority to the agent

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AGENCY THEORY – PROBLEM

No reason to believe that the agent will always

act in the principal’s best interests.

Agency problem is the problem of inducing an

agent to behave as if he or she were

maximizing the principal welfare, resulting in

agency cost

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AGENCY THEORY - COSTS Agency costs are costs that arises from

agency relationships (because of the separation of ownership from control of an entity)

Three types of agency costs identified are: Monitoring costs Bonding costs Residual loss

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AGENCY THEORY - MONITORING COSTS

Costs of monitoring the agent’s behavior Expenditure by principal to measure,

observe & control agent’s behavior Examples: mandatory audit costs, cost to

establish management compensation plan, & budget restrictions among others

Price protection is the way the principal protects against agency costs by paying according to the level of costs expected.

Price protection is borne by agents

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AGENCY THEORY - BONDING COSTS

Costs of establishing & complying with mechanisms (bonding agent’s interest with the principal’s interest)

Borne by agents - Price protection resulted in agents ultimately having to bear monitoring costs associated with contracts

Examples: frequent quarterly financial statements

Costs to managers includes: time & effort, constraints, & income forgone

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AGENCY THEORY – RESIDUAL LOSS

Residual loss occur when the net value of the agents’ output is less, when they make decisions that are not entirely in the principal’s interest (deadweight loss)

When the agent make decisions that do not keep the best interest of the principal, it results in residual loss

Strong form efficient market provide information on incentives & opportunities that will trigger the agent to act contrary to the interest of a principal

The agent would then use information to set their remuneration level i.e., the principal will remunerate the agent to the point that the principal expects the agent to likely become contrary to the interest of the principal

Principal is price protected04/08/23

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AGENCY THEORY – SETTLING UP Settling up means the principal review the

remuneration package given to the agent base on the principle that the remuneration level has to tally with the agent’s effort.

If the agent is deemed to have acted more in favor of the interest of the principal the it is likely that the remuneration will be revised upwards

In contrary, remuneration will revise downwards if the agent is deemed to have acted more in contrary to the interest of the principal

If the contract is to be continued then it should start with the remuneration decided upon at the settling up

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AGENCY THEORY – RESIDUAL OPPORTUNISM

Residual opportunism – cost borne by agent

due loss of reputation & potential loss of long-

term returns to them

With incomplete price protection & settling up,

residual loss is borne partly by agent & partly

by principal

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AGENCY COSTS Monitoring costs

Cost of monitoring agents behaviour and expenditure by principal to measure, observe and control the agent’s behaviour.

Examples: audit costs, operating rules, budget restrictions Bonding costs

Costs of establishing and complying with these mechanism (bond’s agents interest to match principal’s interest).

These costs are borne by agents Examples: frequent (weekly, quarterly, semi-annually)

reporting to shareholders Residual costs

Also known as deadweight loss is when the net value of the agent’s output is less than if the agent’s interest were completely aligned to the principal

Not reduced by monitoring or binding costs However, under strong-form efficient market, it is assumed that

the firm can be price protected in the form of agent’s remuneration

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AGENCY PROBLEM AND COST Agent problem and cost arise from the opportunistic

behaviour of management Opportunistic tendencies increase with decrease

proportionate share (ownership) which increases residual loss.

Shareholders are prepared to bear agency costs as long as marginal benefits to shareholders exceed marginal cost

Price protection of shareholders could be in two forms: Share price adjustments to reflect opportunistic behaviour Share price exclude monitoring and binding cost Limitation of price protection is that share price is not

always available due to thin trading and when manager’s efforts can be directly related to earnings performance

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SUMMARY

A number of conflicting theories have developed

A theory generally consists of three parts

There are several criteria for judging a theory Persuasiveness of evidence

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SUMMARY

Many different approaches to theory formulation in accounting

All methods of theory formulation have strength and weaknesses

Accounting practitioners should use theories they find most persuasive

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Positive Accounting Theory

Documents

shift reported

accounting

economic consequences

accounting

agency costs

accounting

agency theory

accounting