Financial Accounting Theory

FINANCIAL ACCOUNTING THEORY
Craig Deegan
CHAPTER 7
Positive Accounting Theory
Slides written by Craig Deegan

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd
PPTs to accompany Deegan, Financial Accounting Theory 4e
7-1
Learning objectives
7.1
Understand how a positive theory differs from a normative

theory.
7.2
Be aware of the origins of Positive Accounting Theory (PAT).
7.3
Understand that PAT uses insights from agency theory and

why agency theory is of relevance to financial accounting
practices.
7.4
Be aware of the central assumptions of PAT.
7.5
Be aware of the meaning and nature of agency costs.
7.6
Understand why an organisation can usefully be referred to

as a nexus of contracts.
7.7
Understand the perceived role of accounting in minimising the

transaction costs of an organisation.
continued

7-2
Learning objectives (cont.)

7.8
Be aware that accounting policy choices made by

management will be influenced by both efficiency
considerations as well as opportunistic motivations.
7.9
Be able to identify the reasons for the existence of creative

accounting.
7.10
Be able to explain the meaning of political costs and how

accounting can be used to reduce the costs associated with
various political processes.
7.11
Understand the role of accounting-based management

compensation schemes and debt covenants in reducing
potential conflicts (agency costs) within an organisation.
7.12
Understand how particular accounting-based agreements

with parties such as debtholders and managers can provide
incentives for managers to manipulate accounting numbers.
continued

7-3
Learning objectives (cont.)

7.13 Be aware of what constitutes conservative accounting
procedures and why conservative accounting procedures
provide efficient mechanisms for minimising the contracting
costs within an organisation.
7.14 Understand the relevance of PAT to current debates about
how assets and liabilities should be measured.
7.15 Be able to identify some of the criticisms of PAT.

7-4
Positive theories compared to

normative theories
A positive theory seeks to explain and predict
particular phenomena
Positive Accounting Theory (PAT), which we explore in this
lecture, is one example of a positive theory of accounting.
Other examples are covered in the next lecture (when we
consider theories such as Legitimacy Theory and
institutional theories which are positive theories that can be
applied to explain the practice of accounting)
By contrast, normative theories (which were

considered in Chapters 5 and 6) prescribe how a
particular practice should be undertaken
the prescription might depart from existing practice
7-5
Positive Accounting Theory

defined
PAT is concerned with explaining accounting
practice. It is designed to explain and predict which
firms will and which firms will not use a particular
method but it says nothing as to which method a
firm should use. (Watts and Zimmerman 1986, p. 7)
Again, positive theories do not prescribe what should
occur they focus on explaining or predicting what
does occur
continued
7-6
Positive Accounting Theory defined

(cont.)
PAT focuses on relationships between various
individuals and explains how accounting is used to
assist in the functioning of these relationships
Examples of relationships
between owners and managers
between managers and the firms debt providers

7-7
Assumptions underlying PAT

All individuals action is driven by self-interest and
individuals will act in an opportunistic manner to the
extent that the actions will increase their wealth
does not incorporate notions of loyalty or morality

7-8
Origins of PAT
Started coming to prominence in mid-1960s
paradigm shift from normative theories
PAT became the dominant research paradigm in

1970s and 1980s
shift resulted from US reports on business education, and
improved computing facilities enabling large-scale statistical
analysis something common in positive research

7-9
Origins of PATcapital
markets research
Development of Efficient Markets Hypothesis (EMH)
by Fama and others provided an environment suitable
for PAT research
capital markets react in an efficient and unbiased manner to
publicly available information
Ball and Brown (1968) paper was crucial to the

acceptance of the positive research paradigm
investigated stock market reaction to accounting earnings
announcements
sought to explain market reactions
continued
7-10
Origins of PATcapital markets

research (cont.)
Price of a security based on beliefs about present value of future
cash flows
Ball and Brown found that earnings announcements impacted
share prices
evidence that historical cost information is useful to the market
But the literature was unable to explain why particular accounting

methods were selected if the market was efficient as commonly
assumed by researchers, and could understand how different
accounting methods affect accounting numbers, then why does it
matter what accounting method was selected? PAT addresses
this issue
7-11
Firms and contracts

Firms can be characterised as a nexus of contracts
between consumers of products and the suppliers of factors of
production
Firms exist because they reduce contracting costs,

firms provide an efficient means of organising economic
activity
[consider the alternative, an individual organising the
production of a good: acquiring the raw materials organising
various people to make the good]
Contracts include all types of agreements between two

or more parties (not necessarily written contracts)
7-12
Origins of PATagency theory

Agency theory was crucial to the development of
PAT
Agency theory explained why the selection of
particular accounting methods might matter
Focused on the relationships between principals and
agents
e.g. between shareholders (principals) and managers
(agents)
Information asymmetries create much uncertainty

transaction costs and information costs exist

7-13
Agency relationship
The agency relationship is a central focus of agency
theory
Defined by Jensen and Meckling (1976)
a contract under which one or more (principals) engage
another person (the agent) to perform some service on their
behalf which involves delegating some decision-making
authority to the agent
Agency theory key assumptions from the economics

literature, such as:
assumptions of self-interest and wealth maximisation
7-14
Price protection
In the absence of contractual mechanisms to restrict
agents potentially opportunistic behaviour, the
principal will pay the agent a lower salary
compensates principals for adverse actions
Agents will therefore have incentives to enter

contracts which appear to limit actions detrimental to
agents

7-15
The agency problem

At the core of the analysis is the agency problem
The agency problem relates to issues associated
with motivating one party (the agent) to work in the
best interests of another party (the principal)
Agency problems arise because of inefficiencies
and information asymmetries
The agency problem leads to agency costs

7-16
Agency costs
Monitoring costs
costs of monitoring agents behaviour
e.g. auditing financial statements
Bonding costs
costs involved in agents bonding their behaviour to
expectations of principals
e.g. preparing financial statements
Residual loss
too costly to remove all opportunistic behaviour

7-17
Role of accounting in
contracts
Accounting information is used to address the
agency problem and to reduce agency costs
Accounting is used as a monitoring and bonding
mechanism to control the efforts of self-interested
agents (managers)

7-18
Key hypotheses
Three key hypotheses frequently used in PAT
literature to explain, and predict support or
opposition to, an accounting method
bonus plan hypothesis
debt hypothesis
political cost hypothesis
Research assumes managers will act

opportunistically when selecting methods

7-19
Bonus plan hypothesis

Managers of firms with bonus plans are more likely
to use accounting methods that increase current
period reported income
also called management compensation hypothesis
action increases the present value of bonuses paid to
management

7-20
Debt hypothesis
The higher the firms debt/equity ratio, the more likely
managers use accounting methods that increase
income
also called debt/equity hypothesis
the higher the debt/equity ratio, the closer the firm is to the
constraints in debt covenants
covenant violation results in costs of technical default

7-21
Political cost hypothesis

Large firms rather than small firms are more likely to
use accounting choices that reduce reported profits
size is a proxy variable for political attention
reduction of reported income is hypothesised to reduce the
possibility that people will argue that the organisation is
exploiting other parties

7-22
Two perspectives adopted by

PAT research
Efficiency perspective
Opportunistic perspective

7-23
Efficiency perspective
Researchers explain how contracting mechanisms
minimise agency costs of the firm
Known as ex ante perspective
mechanisms put in place up front to minimise future agency
and contracting costs
Managers select accounting methods which most

efficiently reflect underlying firm performance
PAT theorists argue that regulation forcing firms to
use a particular accounting method imposes
unwarranted costs and introduces inefficiencies

7-24
Opportunistic perspective
Seeks to explain managers actions once contracts
are already in place
That is, particular accounting methods might initially
be selected for efficiency reasons, but once they
have been negotiated/agreed, then managers will
aim to utilise accounting choices in a way that best
serves their own interest
Not possible to write complete contracts, so
managers are assumed to opportunistically act to
maximise own wealth
Known as ex post perspective
considers opportunistic actions after the fact
7-25
Owner/manager contracting
Assuming self-interest, owners expect managers
(agent) to undertake activities not always in the interest
of owners (principal)
Managers have access to information not always
available to principals
information asymmetry
further increases managers ability to undertake activities
beneficial to themselves
Costs of divergent behaviour are agency costs

continued
7-26
Owner/manager contracting (cont.)

In the absence of controls to reduce opportunistic
behaviour, agents (managers) expected to undertake
activities disadvantageous to the value of the firm
Principals price this into the amounts they are
prepared to pay the manager
Managers may contract themselves not to consume
perks so will receive higher salary
known as bonding

7-27
Methods of rewarding
managers
Fixed basissalary independent of performance
manager may not take great risks as does not share in
potential gains
Salary plus remuneration is, in part, tied to firm

performance
known as bonus schemes

7-28
Bonus schemes
Remuneration can be tied to:
profits of the firm
sales of the firm
return on assets
All based on output from the accounting system

May also be rewarded in line with market price of the
firms shares

7-29
Accounting-based bonus
plans
Any changes in accounting methods will affect the
bonuses paid
may occur as a result of a new accounting standard in place
Contracts in some circumstances may be based on

the old method in place so changes will not affect
bonuses
Contracts relying on accounting numbers may rely
on floating GAAP
7-30
Incentives to manipulate
accounting
numbers
The decision to reward managers on the basis of
accounting profits might initially be introduced for
efficiency reasons (it motivates them to work in a way
that also benefits the principals), but it may
subsequently induce them to manipulate accounting
numbers (the opportunistic perspective)
a change in accounting numbers will affect their rewards
Bonuses based on profits cause short-term rather than

long-term focus
may affect investment in positive NPV projects if returns not
expected to be consistent
7-31
Incentives to manipulate
accounting numbersevidence
Healy (1985) found:
managers adopt accounting methods to maximise bonus if

contract rewarded managers after a pre-specified level of
earnings reached
if income not expected to reach pre-specified minimum,
managers shift earnings to future period (take a bath)
Lewellen, Loderer and Martin (1987) found:

US managers approaching retirement are less likely to
undertake R&D expenditure if rewards based on accountingbased performance measures
short-term focus
7-32
Use of conservative accounting methods

in management bonus schemes
Conservative accounting methods, which would include
historical cost, tends to delay the recognition of income,
accelerate the recognition of expenses, and lead to lower
asset and higher liability recognition
Asset and income recognition based on assessments of
fair value would not be considered a conservative
accounting approach
Potential conflicts of interest between agents and
principals are better managed when conservative
accounting methods are used as they restrict the ability
of managers to opportunistically use income and net
asset increasing accounting methods
7-33
Market-based bonus schemes

Apart from accounting-based bonus schemes,
managers are also often provided with capital marketbased bonuses
May be more appropriate to remunerate managers in
terms of market value of firms securities (shares)
where accounting earnings fluctuate greatly
e.g. mining, or high technology R&D firms
or where managers are approaching retirement
Methods include:
cash bonus based on share price increases
shares
options to buy shares
continued
7-34
Market-based bonus schemes (cont.)

Providing managers with shares, or share options
creates incentives for managers to increase the
value of the firm aligns their interests with those of
the owners (principals)
But, problems include:
share price also affected by factors beyond the control of
managers (e.g. general market movements)
only senior managers likely to have a significant impact on
share value
continued
7-35
Market-based bonus schemes (cont.)

But remember, regardless of how managers are rewarded there is
always a maintained assumption within PAT that managers (and
everybody else) will be opportunistic
Consider results of Bartov and Mohanram (2004):
In presence of deteriorating profitability managers are likely to adopt
income increasing accounting methods to increase share prices and
therefore the value of their share options. They would then exercise their
share options thereby acquiring the shares, and fairly quickly sell the
shares before reported profits ultimately decline and the value of the
shares fall
Aboody and Kasnik (2000):

if managers know that share options were to be granted to them they will
disclose bad news so as to reduce share prices and therefore the likely
future exercise price of the share options. This would mean that when they
ultimately exercise the granted options, thereby buying the underlying
shares, they will pay less and therefore make greater financial gain

7-36
Choice of accounting versus

market-based bonus schemes
Managers bonuses are more likely to be based on
accounting earnings where:
share returns relatively more sensitive to general market
movements
earnings have a high association with firm-specific
movement in the firms share values
earnings have a less positive association with market-wide
movements in equity values

7-37
Debt contractingagency
costs
of
debt
Moving our attention to the relationship with

debtholders, in the absence of safeguards to protect
debtholders (creditors), managers are predicted to
adopt strategies to disadvantage the debtholders
Agency costs of debt created by managers include

excessive dividend payments, which leave fewer assets to
service debt
the organisation may take on additional debt, with new
debtholders competing with original debtholders for repayment
(claim dilution)
investment in high-risk projects may not be beneficial to debt
holders as they have a fixed claim (asset substitution)
underinvestment
7-38
Use of debt contracts

In the absence of safeguards to protect the interests
of debtholders from strategies such as those on the
previous slide, it is assumed the debtholders will
require the firm to pay higher costs of interest to
compensate for the risks
That is, they will price protect
If firms contract not to pay excess dividends, take on
high levels of debt, invest in risky projects, or underinvest then they can attract debt at lower cost
Hence, it is efficient to enter into contracts that restrict
the ability of managers to adversely affect the wealth
of debtholders
7-39
Evidence from Australian debt

contracts
In relation to Australian debt contracts, Cotter (1998)
found:
leverage covenants frequently used in bank loan contracts
leverage most frequently measured as the ratio of total
liabilities to total tangible assets
prior charges covenants typically included in term loan
agreements of larger firms
prior charges covenants defined as a percentage of total
tangible assets
continued
7-40
Australian debt contracts (cont.)

debt to assets, interest coverage and current ratio clauses
frequently in use
interest coverage required to be between 1 and 4
times
current ratio clauses required current assets be
between 1 and 2 times the size of current liabilities
continued
7-41
Australian debt contracts (cont.)

Mather and Peirson (2006) provide evidence of a
change in the use of covenants relative to earlier
periods. Their findings include:
a reduction in the use of debt/asset restrictions;
greater variety of debt convents being used;
more common covenants include minimum interest
coverage; minimum dividend coverage; minimum current
ratio; minimum required net worth;
use of rolling GAAP more common which introduces risks
for the borrower;
mean number of covenants in public debt contracts less
than private debt contracts explained from an efficiency
perspective
7-42
The role of conservative accounting methods

in reducing the agency costs of debt
As with management bonus schemes, it is believed that the use
of conservative accounting methods are relatively more
effective in reducing agency costs of debt
Zhang (2008) suggests that from an efficiency perspective,
managers might agree to adopt conservative accounting
methods because it allows them to attract debt at a lower price
The use of conservative accounting procedures means that
debt covenants restricting the amount of debt relative to assets
(or debt to equity), or the amount of times profits must cover
interest (known as an interest coverage clause), will tend to be
more restrictive or binding compared to those organisations
that do not adopt conservative accounting methods.
continued
7-43
The role of conservative accounting methods in

reducing the agency costs of debt (cont)
As Zhang (2008) argues, the more binding covenants will
provide an earlier warning of default risk, and will thereby
reduce the risk exposure of the lending party (for example,
a bank)
The reason for this is that, because management will have
less ability to circumvent restrictive covenants (for example,
by undertaking asset revaluations), such covenants will
create a technical default of a loan agreement earlier than if
management has the scope to loosen the restrictions
The earlier the lender can take action to safeguard its
funds, the lower the risk to the lender

7-44
Debt contractsmanagers
incentive to manipulate
Ex post, the incentive to manipulate accounting numbers
increases as the accounting-based debt covenants approach
violation
Managers found to manipulate accounting accruals in the
years before and the year after violation of a debt agreement
Too costly to stipulate all acceptable accounting methods in
contract so managers always have some discretionary ability
But as we have learned, contracts that require the use of
conservative accounting methods reduce the ability of
managers to opportunistically manipulate accounting numbers

7-45
Role of external auditors

Auditors arbitrate on the reasonableness of the
accounting method chosen
Demand for financial statement auditing when:
management is rewarded on the basis of numbers
generated by the accounting system
the firm has borrowed funds, and accounting-based
covenants are in place to protect the investment of
debtholders

7-46
Political costs
We have already indicated that financial accounting numbers
are important with respect to debt contracting and
management compensation contracting. Financial accounting
also plays a key role in the political process
Political costs are costs resulting from political attention from
government, lobby groups etc.
Commonly directed at larger firms
indication of market power
May result in increased taxes, increased wage claims,

product boycotts etc.
Firms likely to adopt accounting methods to reduce profits to
lower political scrutiny
7-47
Political actions of individuals

Limited expected pay-off results from the actions of
individuals
Results in formation of interest groups
Information costs shared, ability to investigate
government and business action increases
Given self-interest, representatives of interest groups
predicted to maximise own welfare as constituents
have limited motivation or means to be fully informed
7-48
Actions of politicians
Politicians know that highly profitable companies
could be unpopular with members of their
constituency
Politicians (who are assumed to be driven by selfinterest like everybody else) could win votes by
taking actions against the companies
argue that it is in public interest even though in own interest
May rely on reported profits to justify actions

provides incentives for firms to reduce reported profits
7-49
Example of how politicians use accounting

numbers as a means of justifying actions
against an organisation
As reported in the Hobart Mercury on 9 March 2013, the Australian

Greens political party used the size of bank assets and profits as the
basis for levying additional taxes on banks. The article stated:
The Greens want a levy of 0.2 per cent on all bank assets above $100 billion in
return for Federal Government guarantees, which the independent
Parliamentary Budget Office has costed as raising $11 billion over the next four
years.
At a time when there's pressures on the budget, and the government is
looking around for ways of raising revenue, especially in light of the failed
mining tax, who can afford to pay it the most?" Australian Greens Mr Bandt
said yesterday.
"If we don't stand up to the big banks and the big miners, then the Labor Party
is going to come after the rest of us, like they have with single parents, and like
they are threatening with the forthcoming budget."
As we can see, profits are used to justify the proposed action. Lower
reported profits would provide less ammunition for the politicians

7-50
Relevance of PAT-based research to current

efforts of IASB to promote use of fair values
As already indicated in this lecture, conservative
accounting methods lead to:
relatively lower revenue recognition
faster expense recognition
higher liability recognition
lower asset recognition
Historical cost accounting is a conservative approach to

accounting when compared to fair value accounting
Conservative accounting methods, such as historical
costs, reduce the ability of managers to manipulate
accounting numbers compared to fair value accounting
continued
7-51
Relevance of PAT-based research to current efforts

of IASB to promote use of fair values (cont)
Do the ongoing efforts of the IASB to embrace fair values
make sense from an efficient contracting perspective?
Because conservative accounting methods reduce the
possibility that management will undertake opportunistic
earnings management, organisations that use conservative
accounting methods might be able to attract debt and
equity capital at a lower cost because of perceptions about
lower risk
Applying this reasoning, numerous researchers argue that
the IASB and FASB should take note of the advantages
inherent in conservative accounting procedures before
finalising any judgements about accounting measurement
continued
7-52
Relevance of PAT-based research to current efforts

of IASB to promote the use of fair values (cont)
Whilst information about fair values will be useful to
various financial stakeholders in terms of assisting them to
make informed investment/resource allocation decisions,
more conservative accounting methods also provide
benefits in terms of controlling potentially divergent
behaviour of individuals involved in various contractual
arrangements.
There is a clear-trade-off between the advantages of
having relevant information about current values and the
contracting benefits that more conservative accounting
benefits provide

7-53
Criticisms of PAT
Does not provide prescription
PAT is not value-free as it asserts assumption that all
action is driven by self-interest
Argued to be too negative and simplistic a
perspective of humankind
Issues have not shown great development
In undertaking large-scale empirical research,
researchers ignore organisational-specific
relationships

7-54
Diagrammatic summary of PAT

7-55

Financial Accounting Theory

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FINANCIAL ACCOUNTING THEORY

Slides written by Craig Deegan

Understand how a positive theory differs from a normative

Be aware of the origins of Positive Accounting Theory (PAT).

Understand that PAT uses insights from agency theory and

Be aware of the central assumptions of PAT.

Be aware of the meaning and nature of agency costs.

Understand why an organisation can usefully be referred to

Understand the perceived role of accounting in minimising the

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Learning objectives (cont.)

Be aware that accounting policy choices made by

Be able to identify the reasons for the existence of creative

Be able to explain the meaning of political costs and how

Understand the role of accounting-based management

Understand how particular accounting-based agreements

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Learning objectives (cont.)

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Positive theories compared to

By contrast, normative theories (which were

Positive Accounting Theory

Positive Accounting Theory defined

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Assumptions underlying PAT

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

PAT became the dominant research paradigm in

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Ball and Brown (1968) paper was crucial to the

Origins of PATcapital markets

But the literature was unable to explain why particular accounting

Firms and contracts

Firms exist because they reduce contracting costs,

Contracts include all types of agreements between two

Origins of PATagency theory

Information asymmetries create much uncertainty

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Agency theory key assumptions from the economics

Agents will therefore have incentives to enter

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

The agency problem

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Research assumes managers will act

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Bonus plan hypothesis

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Political cost hypothesis

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Two perspectives adopted by

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Managers select accounting methods which most

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Costs of divergent behaviour are agency costs

Owner/manager contracting (cont.)

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Salary plus remuneration is, in part, tied to firm

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

All based on output from the accounting system

Copyright 2014 McGraw-Hill Education (Australia) Pty Ltd

Contracts in some circumstances may be based on