Positive Accounting

Theory (PAT)

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 affects people’s behavior
Accounting

People affect accounting

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 Agency Theory
Moral Hazard

Principal Agent

Adverse Selection

 Agency theory has been used to demonstrate:

 Why it may be mutually beneficial to both parties
to have an audit
 Why firms may lobby for certain accounting
regulations
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 Agency Theory Basics
Principal
Definition A party who delegates others to
perform some service on his or her
behalf. The principal often contracts
with an agent to safeguard and
enlarge a pool of assets which the
principal owns and with which the
agent is entrusted.
Asymmetric Principal knows agent has access to
Information superior information
Moral hazard Principal incurs monitoring costs to
attempt to make sure agent acts in
appropriate ways
Monitoring costs a. Budget constraints, auditing
b. Profit sharing, stock options and
similar incentive plans to align agent’s
self-interest with principal’s interests
Agent
A party engaged as a steward to
perform some service on the behalf of
others, often involving safeguarding
assets belonging to them. The
principals delegate decision making
authority to the agent
Agent has access to superior
information
Agent may be able to act in ways
unfavorable to or not approved by the
principal – shirking, fraud, etc.
Agents also benefit from monitoring
activities like an audit since such
devices permit them to demonstrate
effective performance and charge
more for their services
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 Owner-Manager
Relationship
 Why won’t a fixed salary motivate hard work?

 So, how would you motivate the work?

 Give manager a share of the payoff

 Bonus based on net income
 Ownership interest through options
 Combination?

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 Positive Accounting Theory
 Specific application of Agency Theory

 Studies managers’ accounting policy choices,

as part of the overall process of corporate
governance
 That is, accounting policies are chosen
strategically
 Positive (descriptive) rather than normative.
 Tries to understand and predict managers’
accounting policy choices

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 ASSUMPTIONS OF PAT

 Firm is a nexus of contracts

 Managers are rational economic decision
makers
 Act to maximize their own utility, which may
not include the firm’s profits
 May be effort averse (lazy)
 There are efficient markets for both
 Capital
 Managerial Labor
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 Hypotheses of PAT
 Bonus Plan Hypothesis
 Management chooses policies to shift earnings to improve
their bonus
 Current earnings can go up or down
 Debt Covenant Hypothesis
 Policies chosen to shift future earnings to avoid violation of
debt contracts
 Political Cost Hypothesis
 Defer earnings from current to future to minimize political
“heat”
 Compliance Hypothesis
 Shift earnings to ensure that you meet regulator
requirements

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 Versions of PAT

 Opportunistic Version
 Managers choose accounting policies for
their own benefit

 Efficient Contracting Version

 Managers choose accounting policies to
attain corporate governance objectives of
the firm

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 Distinguishing Opportunistic vs.
Efficiency Versions of PAT
 Per Scott Text: significant evidence in
favor of efficiency version of PAT

 This implies that the inherent conflict

between investor and manager interests is
reasonably controlled

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 Earnings Managment

 Ways to Do It
 Changing accounting policies
 Managing discretionary accruals
 Timing of adoption of new accounting
standards
 Changing real variables--R&D, advertising,
repairs & maintenance
 Structured transactions like SPEs
 Fraud like Worldcom capitalizing operating
expenses
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 Managing Earnings Through
Discretionary Accruals

 NI = CFO ± Net Accruals

= CFO ± Net Non-Discretionary
Accruals ± Net Discretionary
Accruals
 Examples of Discretionary Accruals
 Allowance for doubtful accounts
 Provision for reorganization

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 Estimating Discretionary
Accruals, Cont’d
 The Jones Model
 TAjt = αj + β1jΔREVjt + ß2jPPEjt + εjt
 This is the simplified version of the model.
 TA is total accruals or
Net Income – Cash Flows

 Discretionary accruals = Earnings Management

 actual total accruals – predicted total accruals
 The ßs are coefficients to be estimated. No
relation to firm beta.
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 Implications For Financial
Accounting
 Net income matters
 Why?
 Why would managers object to some new
GAAP pronouncements?

 The agency relationship is a contract

 Contracts are rigid

 Implies accounting policy choice and changes
to accounting policy matter

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 Implications For Financial
Accounting
 To maintain market share, net income should
be correlated with manager effort
 Historical cost accounting?
 Fair value accounting?

 Fundamental problem of current financial

accounting theory
 Most useful net income for investors is not
necessarily the most highly correlated with
manager effort

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