Financial Accounting Theory

Positive Accounting Theory and Earnings Management

This week’s lecture
 Recap
 Agency and Positive Accounting Theory
 PAT Hypotheses
 Earnings Management and PAT
 Jones (1991)
 Earnings Management and Impression
Management
Recap
 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 found that earnings announcements
impacted share prices
– evidence that historical cost information is useful to the market
– price of a security based on beliefs about present value of future
cash flows
 literature unable to explain why particular accounting
methods selected
 PAT emerged trying to fill this gap
Positive Accounting Theory
 PAT is an accounting theory that is rooted in agency
theory
– Developed by Watts and Zimmerman (1978)
– Presented three testable hypotheses
– Aims to explain accounting practice
 To predict which firms will use which method and which firms will
not
– Focuses on relationships between key individuals in firms and
what role accounting plays in that relationship
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’
– Firm as a nexus of contracts
 relies upon traditional economics literature
– assumptions of self-interest and wealth maximisation
Agency Theory

From Gray, Owen and

Maunders (1987)
Agency Theory (2)
 Each party seen as ‘individuals’ who are all utility maximisers
– in the absence of contractual mechanisms to restrict agents’
potentially opportunistic behaviour the principal will pay the agent
a lower salary
 Contracts are written between parties to outline nature of
relationship (as bonding or monitoring mechanisms)
– agents will therefore have incentives to enter contracts which
appear to limit actions detrimental to agents
– Motivation to ‘game’ the contract to ensure personal utility is
maximised
– Creates tension and conflicts
Agency theory (3)
 accounting information used to reduce agency costs
 Costs associated with agency
– 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
Scenario A
Your bosses have set you a target of earnings per share growth of 10% -
should you achieve this target, you will receive £1,000,000 bonus this
year.

Your earnings figure is ever so slightly on the lower side. You know that
you bought some items on credit the day before balance sheet day, but you
haven’t received the invoice yet. If you defer the recognition of this
expense to next year, you will be able to achieve the earnings per share
growth target. Would you do it?
Scenario B
Your bosses have set you a target of earnings per share growth of 10% -
should you achieve this target, you will receive £1,000,000 bonus this
year.

The company is considering embarking on a new research and

development exercise. By doing so this year, expenses will decrease as
research costs are charged against earnings; and this will mean you will
not get your bonus. You can delay the R&D exercise if you want to.
Would you?
Scenario C
Your company has a loan with XYZ bank, and the interest
rate on the loan is stated as follows:
If the Debt to Equity Ratio is 0.4 or below, the interest rate is 1.8%
If the Debt to Equity Ratio is above 0.4, the interest rate is 3.6%

Your debt-equity ratio is currently at 0.41. If you decide that

the provision for doubtful debts is reduced to 5% of sales
instead of 8% of sales, then earnings will increase and your
debt-equity ratio is 0.39. Would you?
Scenario D
You are the accountant of a utility company, and this year your company
has made a profit of £4.8bn, an increase of 3.2% from last year. However,
the following issue has continued to make the news this winter period.
You have some aging coal plants you
could write off as an expense instead of
continuing to depreciate them, which
would mean that your profit would be
negative relative to last year: that is, you
would still make a profit, but it will not be
an increase from last year. Would you?
PAT’s three hypotheses
 PAT builds upon agency theory and uses them to develop
three hypotheses
– The Bonus Plan hypothesis
 Managers with bonus plans are more likely to use accounting methods that
increase the potential of their bonus
– The Debt Covenant Plan hypothesis
 Managers with debt covenants in place are more likely to use accounting
methods that reduce the risk of violating the debt covenants
– The Political Cost hypothesis
 Firms that are more politically sensitive (large firms) are more likely to use
accounting methods that reduce income to avoid scrutiny
Bonus Plan Hypothesis
 rewarding managers on the basis of accounting profits may
induce them to manipulate 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
 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’)
Bonus Plan Hypothesis (2)
 Lewellen, Loderer and Martin (1987) found:
– US managers approaching retirement are less likely to undertake R&D
expenditure if rewards based on accounting-based performance measures
– short-term focus
 CEOs may consider R&D investments as less desirable than other
investments in terms of the impact on short term stock prices because
current stock prices do not fully reflect the future benefits of R&D
spending (Lev and Sougiannis, 1996)
 Subsequent work focused on looking at impact of different
components of pay e.g. salary, share options, bonus payments
Debt contracting
 agency costs of debt include:
– excessive dividend payments, which leave fewer assets to service
debt
– the organisation may take on additional debt
– investment in high-risk projects may not be beneficial to debt
holders as they have a fixed claim
 in the absence of safeguards to protect the interests of
debtholders, it is assumed they will require the firm to pay
higher costs of interest to compensate
– if firms contract not to pay excess dividends, take on high levels of
debt or invest in risky projects, then they can attract debt at lower
cost
– managers might agree to adopt conservative accounting methods
such as reduce or restrict asset revaluation
Evidence on 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 debt to assets, interest coverage and current ratio clauses
frequently in use
– interest coverage required to be between 1 1/2 and 4 times
– current ratio clauses required current assets be between 1 and 2
times the size of current liabilities
Evidence on debt contracts (2)
 In more recent research Mather and Peirson (2006) found:
- significant reduction in the use of debt to asset constraints
- Use of greater variety of covenants such as minimum interest coverage,
dividend coverage, current ratio
– ex post, the incentive to manipulate numbers increases as the constraints
approach violation
– managers found to manipulate accounting accruals in the years before and
the year after violation of a debt agreement
 External auditors also play a role:
– 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
 when the firm has borrowed funds, and accounting-based covenants
are in place to protect the investment of debtholders
Political costs
 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
Evidence of political cost
hypothesis
 Jones (1991) found that firms more sensitive to import
relief manage earnings downwards during import relief
investigations
 Han and Wang (1998) found that firms standing to benefit
from oil price increases during the First Gulf War managed
earnings downwards to reduce political sensitivity
 Firm size often used as a measure of ‘political cost’
– Not the best or most accurate proxy; limited work on the use of
other measures as proxy for size
PAT and Standard Setting
 Recall the standard setting process:
PAT and Standard Setting (2)
 Watts and Zimmerman (1978) propose that
understanding positive accounting theory allows
us to understand how managers attempt to
influence the standard setting process, through
lobbying.
 Uses PAT to help predict matters that are
important to managers
 Argues that managers will lobby for accounting
standards that meet their personal agendas
Earnings management
 Earnings management refers to practices by managers who
attempt to manipulate accounting numbers within the
scope allowed by GAAP
 There are various motivations behind earnings
management practices
– Income smoothing, allowing for better predictability
– Meeting performance targets – both analyst forecasts and personal
performance targets
– Cost-saving: avoiding debt covenants or lowering income tax
Earnings management and PAT
 PAT predicts that managers would use accounting methods
that would benefit themselves most
 Earnings management is effectively the process by which
managers would implement the above strategy
– example: Manager X would like to maximise his bonus, which is a
function of earnings. In order to do so, he would have to find a
way to boost his earnings – in which case, he would apply
accounting methods that meant the earnings figure would be
bigger. This can be done by shifting accruals from one period to
the next, for example
Jones (1991)
 Looked at accounting behaviour of managers during
import relief investigations
 Import relief: government intervention in particular
industries, where restrictions can be placed upon import
activity to help boost domestic businesses’ revenue
– Companies need to apply for import relief, and an investigation is
carried out by a government agency to evaluate the need for import
relief
 Jones (1991) argued that during import relief
investigations, managers had incentives to manage
earnings
Jones (1991) II
 The theoretical motivations that underlie the paper are:
– Agency theory: firms are seen as a nexus of contracts, and there is
an implicit contract between the firm and the regulator
– Positive accounting theory (PAT): managers facing potential
political ‘costs’ have incentives to manage earnings downwards
 Setting of the study particularly unique to the US
 Different from other studies looking at earnings
management because of the unique nature of the settings
– Slightly different incentive effects
– Users of financial statements less ‘sophisticated’
Jones (1991) III
 Assumes that earnings management is done using accruals
– Predicts accruals based on current year’s accruals and uses error
term to define abnormal accruals, which are considered to be
evidence of earnings management
– Split into periods, looked at how accruals behaved around the time
of the import relief investigation
 Found evidence that accounting numbers were used as
performance measures for import relief investigations
 Found evidence that accruals were significantly lower in
periods surrounding the import relief investigations,
relative to periods outside of the import relief investigation
Jones (1991) IV
 Reflections on the Jones (1991) paper
– Small sample size (23 firms over 5 years)
– Good overview and explanation of methods used and
the logic behind the construction of the model
– Captures a unique setting / event
 To what extent are findings generalisable? How important is
generalisability
Earnings management vs
impression management
 Another way management may try to influence how
decisions are being made by managers is via impression
management
 Impression management refers to managerial attempts to
manage the interpretation of financial reports, by way of
selecting information to display that may distort its
meaning
(Godfrey et al, 2003)
Visuals and Impression
Management (II)
 Impression management is largely designed to be self-
serving : managers paint themselves in a positive light
(Neu, 1991), or to manage the repercussions of bad news
(Garcia-Osma and Guillamon-Saurin, 2011)
 It can also be argued, however, that managers use
impression management as a means of ‘signalling’ – that
is, because their performance cannot be observed directly.
 An impact of impression management is that it may
mislead investors who may erroneously believe that the
company is doing better than it is
Visuals and Impression
Management (III)
 Examples of impression management practices:
– Graphs
 Modifying axis / scale of graphs depending on whether performance
is good or bad
– Size of images
 Using different sizes of images / graphs / visuals to send different
messages to the reader
– Use of images / colours to communicate particular ideals
 Use of green to suggest environmental friendliness
 Images of women to communicate gender equality