Positive Accounting Theory (PAT)

affects peoples behavior Accounting

People affect accounting 2

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. Principal knows agent has access to superior information Principal incurs monitoring costs to attempt to make sure agent acts in appropriate ways a. Budget constraints, auditing b. Profit sharing, stock options and similar incentive plans to align agents self-interest with principals 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

Asymmetric Information Moral hazard

Monitoring costs

Owner-Manager Relationship

Why wont 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 firms profits May be effort averse (lazy)

There are efficient markets for both

Capital Managerial Labor

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

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, Contd

The Jones Model

TAjt = j + 1jREVjt + 2jPPEjt + jt 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 s 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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