Positive Accounting Theory PAT

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Positive Accounting Theory (PAT) Agency Theory

• Ch. 8 9 Scott, Accounting Theory

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Recall From Efficient Securities Market Theory

• Beaver (1973) argued that accounting policy
  choices do not affect firms security prices, if
  no cash flow effects and if chosen policies are
  fully disclosed
• This argument implies that accounting policies do
  not matter
• Positive accounting theory

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affects peoples behavior
Accounting
People affect accounting
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Economic Consequences

• What does this term mean?
• The impact of accounting reports on the
  decision-making behavior of business, government,
  and creditors.
• Best way to understand the concept is through
  examples

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Economic ConsequencesExamples

• Expensing employee stock options
• APB 25 (1972)
• Exposure draft (1993)
• FASB 123 (1995)
• FASB 123R (2004)
• Oil Gas Accounting Controversy
• Required successful efforts method (FASB 9,
  1975)
• Full cost method restored as option (FAS19, 1977)

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Positive Accounting 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 but not
  necessarily firms profits
• May be effort averse (lazy)
• There are efficient markets for both
• Capital
• Managerial Labor

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The 3 Hypotheses of PAT

• Bonus Plan Hypothesis
• Management chooses policies to shift future
  earnings to current period (more rewards from
  managerial incentive contracts)
• Debt Covenant Hypothesis
• Policies chosen to shift future earnings to
  present to avoid violation of debt contracts
• Political Cost Hypothesis
• Defer earnings from current to future to minimize
  political heat

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Managing Reported Earnings

• Ways to Do It
• Changing accounting policies
• Managing discretionary accruals
• Timing of adoption of new accounting standards
• Changing real variables--RD, advertising,
  repairs maintenance
• Structured transactions like SPEs
• Fraud like Worldcom capitalizing operating
  expenses

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2 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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Managing Reported Earnings Through Discretionary
Accruals

• NI OCF Net Accruals
  OCF 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 aj ß1j?REVjt ß2jPPEjt ejt
• Estimate by least-squares regression
• Discretionary accruals actual - predicted
• The ßs are coefficients to be estimated. No
  relation to a shares beta

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Distinguishing Opportunistic v. 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
• How this is done is subject of Chapter 9

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Presentation OAP9

• This article discusses how conservatism may be
  desirable for contracting reasons
• In Chapter 9 we get into the theoretical
  (analytic) models that are used to study
  contracting
• Principal-Agent Theory

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Principal-Agent Theory
Asymmetric Information
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Timeline for Agency Example page 269
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EMH and Managers

• Corporate managers dont seem to really believe
  in EMH
• Structured transactions
• Lobbying efforts with standard setters
• Earnings management to meet perceived investor
  preferences

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Classic Prisoners Dilemma
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Conflict Resolution

• Example 9.1, p. 301

• Game Theory
• Agency Theory

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Relationship to Single-Person Decision Theory

• Projects states of nature
• Random mechanism
• Agency theory
• Thinking opponent replaces states of nature
• Opponent strategy not probabilistic
• Rational manager has own interests at stake

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Principal Agent Theory

• 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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Principal-Agent Theory
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Owner-Manager Agency Relationship

• Since fixed salary may not motivate hard work
• Give manager a share s(x) of the payoff x
• Net income
• Ownership interest through options
• Combination?

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Contracting between Manager Owner

• Holmströms Agency Model
• Basing managers compensation on 2 variables is
  better than on 1 variable, unless the 2 variables
  are perfectly correlated
• This implies that net income is in competition
  with share price performance for market share

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Bondholder-Manager Agency Relationship

• Similar issues for lending contracts
• Information asymmetry
• Manager might do things to make repayment of debt
  less likely
• Solution
• Contracts to limit management discretion
• Benefit to manager/company lower borrowing cost

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4 Principles of Contract Design

• 1. The Informativeness Principle
• 2. The Incentive-Intensity Principle
• Optimal level depends on
• Incremental profits created by additional effort
• Precision with which desired activities can be
  assessed
• Agents risk tolerance
• Agents responsiveness to incentives

Milgrom, Paul, and Roberts, John, Economics,
Organization and Management 1992, London
Prentice-Hall
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4 Principles of Contract Design

• 3. The Monitoring Intensity Principle
• 4. The Equal Compensation Principle
• (for multi-tasking)
• From Milgrom and Roberts (1992) as described
  athttp//en.wikipedia.org/wiki/Principal-agent_pr
  oblemOverview

Milgrom, Paul, and Roberts, John, Economics,
Organization and Management 1992, London
Prentice-Hall
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Implications For Financial Accounting

• Net income matters
• 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, Concl.

• To maintain market share, net income should be
  highly correlated with manager effort
• Historical cost accounting?
• Fundamental problem of financial accounting
  theory
• Most useful net income for investors is not
  necessarily the most highly correlated with
  manager effort

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Multi-Period Considerations

• Manager reputation and resulting value of manager
  on managerial labor market motivates effort
• Net income provides information to market about
  manager value
• Is agency contract still needed?
• Answer Yes

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Reconciliation of Securities Market Efficiency
and Economic Consequences

• Because of rigid compensation and debt contracts,
  accounting policies matter to managers
• This argument does not depend on securities
  market efficiency