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

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PPTs t/a Financial Accounting Theory 2e by Deegan 7-1
Origins of PAT
• Started coming to prominence in mid-1960s
– paradigm shift from normative theories
• dominant research paradigm in 1970s and 1980s
– shift resulted from US reports on business education, and
improved computing facilities enabling large-scale
statistical analysis

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PPTs t/a Financial Accounting Theory 2e by Deegan 7-2
Origins of PAT—capital markets research
• Development of Efficient Markets Hypothesis
(EMH) by Fama and others
– 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

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PPTs t/a Financial Accounting Theory 2e by Deegan 7-3
Origins of PAT—capital 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
• Literature unable to explain why particular
accounting methods selected

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PPTs t/a Financial Accounting Theory 2e by Deegan 7-4
Origins of PAT—Agency theory
• Explained why the selection of particular
accounting methods might matter
• Focused on the relationships between principals
and agents
– e.g. shareholders and managers
• Information asymmetries create much uncertainty
– transaction costs and information costs exist

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Agency relationship
• 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’
• Relies on traditional economics literature
– assumptions of self-interest and wealth maximisation

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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

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PPTs t/a Financial Accounting Theory 2e by Deegan 7-7
Role of accounting in contracts
• Accounting information used to reduce agency
costs
• Used as monitoring and bonding mechanisms to
control the efforts of self-interested agents

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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

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