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Chapter 7 - Positive Theory Positive Accounting Theory Philosophy of PAT Million Friedman championed positive theories in economics.

He stated that: (part 3 Empirical Research in Accounts of Accounting theory from Jayne Godfrey) The ultimate goal of positive science (i.e. INDUCTIVE) is The development of a theory or hypothesis; that yields valid and meaningful Predictions about phenomena not yet observed. Consistent with Friedmans view, Watts and Zimmerman asserts that: 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 cost accounting and why certain firms switch between a numbers of accounting techniques. Prediction of accounting practice means that the theory predicts unobserved phenomena.

Unobserved phenomena are not necessarily future phenomena; they include phenomena that have occurred, but on which systematic evidence has not been collected. For example Predicting the reaction of firms to a proposed accounting standard and an explanation of why firms would lobby for and against such a standard, even though the standard has already been released. Testing these theories provides evidence that can be used to predict the impact of accounting regulations before they are implemented. PAT has an economic focus and seeks to answer such questions what is the effect of reported financial statements on share price, for example?

For the above issue, PAT is based on assumption about the behavior of individuals: that is Manager, investors, lender and other individuals are rational, evaluative utility maximize (REM). Chapter 7 - Positive Theory Positive Accounting Theory This theory attempts: 1. to explain managers choices of accounting methods in terms of self-interest, 2. the relationships between stakeholders and, 3. how financial accounting can be used to minimize cost by aligning competing interests. Returning our fouces, PAT foucses on the relationship between the various individuals involved in providing resources to an organization and how accounting is used to assist in the functioning of these relationship PAT, as developed by Watts and Zimmerman and others, is based on the central economic-based assumption that all individuals action is derived by self-interest and that individuals will act in an opportunistic manner to the extent that the actions will increase their wealth. Given an assumption that self-interest drives all individual actions, PAT predicts that organization will seek to put in place mechanisms that aligns the interests of the manages of the firm (agent) with the interests of the owners of the firm (the principal). EMH Efficient market hypothesis The genesis of positive accounting theory is the Efficient Market Hypothesis (EMH). According to Fama, the EMH is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information. The perspective taken is that security prices reflect the

information content of publicly available information and this information is not restricted to accounting disclosures. The capital market is considered to be highly competitive, and as a result, newly released public information is expected to be quickly impound into share prices. Chapter 7 - Positive Theory Positive Accounting Theory EMH Efficient market hypothesis (contd) A. The Efficient capital market vs. the accounting method If accounting results are released by an organization, and these results were already anticipated by the market (e.g. interim announcement), then the expectation is that the prices of security will not react to the release of the accounting results. Consistent with traditional finance theory, the price of a security is determined on the basis of belief about The Present Value of Future Cash Flows pertaining to that security and when these belief changes (as a result ot particular information becoming available) the expectation is that the securitys price will also change. Because share prices are expected to reflect information from various sources (as the information relates to predicting future cashflow), that was a view that Management cannot manipulate share prices by changing accounting methods in an opportunistic manner. Page 207 B. The choices of manager under the efficient capital market Because there are many sources of data used by the capital market, if managers make less than truthful disclosures, which are not corroborated or contradicts other available information, then, assuming that the market is efficient, the market will question the integrity of the managers. Consequently the market will tend to pay less attention to subsequent accounting disclosures made by such managers. While supportive of EMH, the literature was unable to explain why particular accounting methods might have been

selected in the first place. For example, if an entity elected to switch its inventory cost flow assumptions and this led to an increase in reported income, then the market was assumed to be able to see through this change, and to the extent that there were no apparent cash flow implications, there would be no share price reaction. Hence, if the particular accounting method had no direct taxation implications, there was an inability to explain why one method of accounting was selected in preference to another. Page 210 Chapter 7 - Positive Theory Positive Accounting Theory Agency Theory A key to explaining managers choice of particular accounting method came from Agency theory. Agency theory provided a necessary explanation of why the selection of particular accounting methods might matter, and focused on the relationships between principals and agents, a relationship which, due to various information asymmetries, created much uncertainty. Agency theory accepted that transaction costs and information costs exist. Relying upon traditional economic literature (i.e. maximize own wealth), Jensen and Meckling considered the relationship and conflicts between agents and principals and how efficient markets and various contractual mechanisms can assist in minimizing the cost to the firm of these potential conflicts. (Page 211) It is assumed within Agency Theory that principles will assume that the agent will be driven by self-interest, and therefore the principle will anticipate that the manager, unless restricted from doing otherwise, will undertake self-serving activities that could be

detrimental to the economic welfare of the principle. (Page 211) In the absence of any contractual mechanism to restrict the agents potentially opportunistic behavior, the principle will pay the agent a lower salary in anticipation of the opportunistic actions. The agents are therefore assumed to have an incentive to enter into contractual arrangements that appear to be able to reduce their ability to undertake actions detrimental to the interests of the principals. That is, if it is assumed that managers would prefer higher salaries, then there will be an incentive for them to agree to enter into contractual arrangement that minimize their ability to undertake activities that might be detrimental to the interests of the owners. Chapter 7 - Positive Theory Positive Accounting Theory Contracting theory Agency Theory does not assume that individual will ever act other than in self-interest, and the key to a well functioning organization is to put in place mechanism (Contracting theory) that ensure that actions that benefit the individual also benefit the organization. By the mid to late 1970s, theory had therefore been developed that proposed Markets were efficient and that Contractual arrangements were used as a basis for controlling the efforts of self-interested agents. It is also emphasis that efficiently written contracts, with many being tied to the output of the accounting system, were a crucial component of an efficient corporate governance structure. PAT development and Accounting method In 1990 Watts The accounting Review identified three key hypothesis that had become frequently used in the PAT literature to Explain and Predict whether an organization would support or

oppose a particular accounting method. These hypotheses as follow: 1. The bonus plan hypothesis 2. The debt / equity hypothesis; and 3. The political cost hypothesis The bonus plan hypothesis assumes that managers with bouns plan as more likely to use accounting methods that increase current period reported income. It predicts that if a manager is rewarded in terms of a measure of performance such as accounting profits, the manager will attempts to increase profits.. The debt/ equity hypothesis predicts that the higher the firms debt/equity ratio, the more likely managers use accounting methods that increase income. Managers exercising discretion by choosing income increasing accounting method, relaz debt constraints and reduce the costs of technical default. Chapter 7 - Positive Theory Positive Accounting Theory Opportunistic and efficiency perspectives Within the efficiency perspective, researchers explain how various contracting mechanisms can be put in place to minimize the agency costs of the firm, that is, the costs associated with assigning decision making authority to the agent. The efficiency perspective is often referred to as an ex ante perspective. Ex-ante means before the fact as it considers what mechanisms are put in place up front, with the objective of minimizing future agency and contracting costs. The opportunistic perspective of PAT, takes as given the negotiated contractual arrangements of the firm and seeks to explain and predict certain opportunistic behaviors that will

subsequently occur. Initially, the particular contractual arrangements might have been negotiated because they were considered to be most efficient in aligning the interests of the various individuals within the firm. However, it is not possible or efficient to write complete contracts that provide guidance on all accounting methods to be used in all circumstances hence there will always be some scope for managers to opportunistic. The opportunistic perspective is often referred to as an ex post perspective- ex post meaning after the fact because it considers opportunistic action that could be undertaken once various contractual arrangements have been put in place. As noted previously, it is assumed to be too costly to stipulate in advance all accounting rules to be used in all circumstances. Hence, PAT proposes that there will be always be scope for agents to opportunistically select particular accounting methods in preference to others.

Chapter 7 - Positive Theory Positive Accounting Theory How PAT attempt to explain in part the revaluation of assets under AASB116? It is the choice of accounting method between cost model and revaluation model. Given that AASB 116 (IAS 16) allows entities a choice between the cost model and the revaluation model, it is of interest to consider what may motivate entities to choose between the two measurement models. Cost-benefit basis - cost incurred to provide relevant information In most arguments relating to the choice between the two models, there are the general propositions that a Current Price, namely a

fair value, will provide more relevant information than a past price, namely the original cost, while the costs associated with continuously determining the present price reduce the incentive, on a cost-benefit basis, to move to current values. Certainly, the requirement under AASB 116 to continuously adjust the carrying amounts of assets measured at fair value so that they are not materially different from current fair values provides a cost dis-incentive to management to adopt the revaluation model. The bonus plan hypothesis Another factor that entities have to consider when choosing their measurement bases for class of property, plant and equipment is the effect of the model on the income statement. Where assets are measured on a fair value basis, the depreciation each year would be expected to be higher as the depreciable amount is higher. Besides the effect of depreciation, there will be an effect on disposal of the assets. When an asset is measured at fair value, there is expected to be an immaterial amount of profit/loss on sale, as the recorded amount of the asset at time of sale should be close to that of the market price at time of sale. For an asset measured at cost, any gain on sale will be reported in the income statement the income is recognized upon disposal of assets which is determined by the management decision. Chapter 7 - Positive Theory Positive Accounting Theory Apart from increased relevance and reliability argument, what are the incentive for management to use revaluation model? The Debt / Assets hypothesis The effect of adopting the revaluation model is to increase the entitys assets and equities. Hence, entities which need to report higher amounts in these areas would consider adoption of the revaluation model.

For example, entities which have debt covenants generally have constraints relating to their debt-asset ratio e.g. the debt-asset ratio must not exceed 50%. Hence, for an entity with increasing debt, adoption of the revaluation model for a class of assets which is increasing in value will ease pressure on the debt-asset ratio by increasing the asset base of the entity, providing, of course, that the debt covenant allows revaluations to be taken into account in measuring assets. The political cost hypothesis The incentives for entities to adopt fair value measures, then, tend to be entity-specific because of pressures placed on the entities relating to external circumstances. For example: an entitys reported profit figure may be under scrutiny from a specific source, such as a trade union seeking reasons to support claims for higher pay, or regulators looking at monopoly control within an industry. Conclusion Where there are pressures to report lower profits, adoption of the revaluation model provides scope of higher depreciation charges with increases in the value of non-current assts not affecting the income statement. With lower reported profit and a higher asset/equity base, any judgment made by reviewing ratio such as rate of return on assets or equity will result in the entity being seen in a less favorable light. (Company Accounting Ken Leo, John Hoggett Page 189 and 190)