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Positive Accounting
Theory (PAT)
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People affect accounting
affects peoples behavior
Accounting
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Agency Theory
Principal Agent
Adverse Selection
Moral Hazard
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 Agent
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.
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
Asymmetric
Information
Principal knows agent has access to
superior information
Agent has access to superior
information
Moral hazard Principal incurs monitoring costs to
attempt to make sure agent acts in
appropriate ways
Agent may be able to act in ways
unfavorable to or not approved by the
principal shirking, fraud, etc.
Monitoring costs a. Budget constraints, auditing
b. Profit sharing, stock options and
similar incentive plans to align agents
self-interest with principals interests
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 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
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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, Contd
The Jones Model
TA
jt
=
j
+
1j
REV
jt
+
2j
PPE
jt
+
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