Flashcards
Week 7 AT
Flashcards do conjunto (50)
- 1PATPositive Accounting Theory
- 2Positive compared to normative theoriesA positive theory seeks to explain and predict particular phenomena
Positive Accounting Theory (PAT), which we explore in this lecture, is one example of a positive theory of accounting. - 3Positive compared to normative theoriesNormative theories prescribe how a particular practice should be undertaken
the prescription might depart from existing practice - 4Positive Accounting Theory definedPAT ‘… is concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method … but it says nothing as to which method a firm should use.’ (Watts and Zimmerman 1986, p. 7)
- 5Positive accounting theory defined (cont.)Focuses on relationships between various individuals and how accounting is used to assist in the functioning of these relationships
Examples of relationships
owners and managers
managers and the firm’s debt providers - 6PAT ASSUMESASSUMES 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
Economists use the term “utility” rather than self-interest. - 7Origins of PAT—capital markets researchtarted 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
Development of Efficient Markets Hypothesis (EMH) by Fama and others
capital markets react in an efficient and unbiased manner to publicly available information - 8Origins of PAT—capital markets research PT 2Ball and Brown (1968) paper was crucial to the acceptance of the positive research paradigm
investigated stock market reaction to accounting earnings announcements
sought to explain market reactions
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 - 9PAT addresses the issue of: Literature unable to explain why particular accounting methods selected. Information is costless and there are no transaction costs in the CAPM frameworks, Hence if accounting methods do not affect taxes, they do not affect firm value. In that situation there is no basis for predicting and explaining accounting choice. Accounting is irrelevan
- 10Firms can be characterised as a nexus of contractsbetween consumers of products and the suppliers of factors of production
- 11Firms exist because they reduce contracting costsfirms provide an efficient means of organising economic activity
One contract per action in business, firms reduce these - 12PAT—Agency theoryAgency theory explained why the selection of particular accounting methods might matter
Focused on the relationships between principals and agents
Information asymmetries create much uncertainty
assumptions of self-interest and wealth maximisation - 13Agency relationshipDefined 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’ - 14Controlling Incentive Problems through ContractsContracts (implicit and explicit) define the organisational architecture, ie, The decisions rights, performance evaluation and reward systems.
This architecture provides an important set of constraints and incentives that help resolve incentive problems. - 15Contracts are not costless to negotiate, write, administer or enforce.A primary factor that limits the ability of contracts to solve incentive conflicts is costly information.
- 16Price protectionIn 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 - 17Well designed contractsALIGN the interests of managers with LONG-TERM firm value
Agents will therefore have incentives to enter contracts which appear to limit actions detrimental to agents - 18The agency problemThe agency problem relates to issues associated with motivating one party (the agent) to work in the best interests of another party (the principal)
Leads to agency costs - 19Agency costsMonitoring costs
costs of monitoring agents’ behaviour e.g. auditing financial statements
Bonding costs
costs involved in agents bonding their behaviour to expectations of principal e.g. preparing financial statements
Residual loss
too costly to remove all opportunistic behaviour
Accounting information used to reduce agency costs - 20Key hypothesesThree 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 - 21What is earnings management?Earnings management is a form of creative accounting relating only to reported earnings.
Earnings management is using accounting methods that ensure that the profit and loss statement presents the preparer’s desired level of reported profit/loss - 22Three techniques that firms may use to manage their reported earnings.Manipulate accruals
shift revenues and expense between periods)
Timing of transactions
delay or accelerate asset sales)
Change accounting policies
e.g. early adopt an income increasing new standard - 23Bonus plan hypothesisManagers of firms with bonus plans are more likely to use accounting methods that increase current period reported income
- 24‘Take a Bath’ or ‘Big Bath’ What do these terms Mean?“The term “big bath” refers to where if a firm must report a loss it might include an unusually large amount of charges as at this point it has nothing to lose”. (Healy, 1985)
- 25Debt hypothesisThe higher the firm’s debt/equity (or debt/assets) ratio, the more likely managers use accounting methods that increase income (or assets)
the higher the debt/equity ratio (or debt/assets), the closer the firm is to the constraints in debt covenants
covenant violation results in costs of technical default - 26What happens when a debt covenant is violated?A debt covenant violation represents a breach of contract. Lender’s response to the breach of contract usually depends on the severity of the breach as well as the terms of the debt agreement.
The lender has a range of alternative responses, including the following
Require penalty payment
Increase interest rate
Demand immediate repayment of the loan
Increase collateral
Terminate debt agreement - 27Two perspectives adopted by PAT researchEfficiency perspective
opportunistic perspective - 28Efficiency perspectiveResearchers explain how contracting mechanisms minimise agency costs of the firm
Known as ex ante perspective
mechanisms put in place up front to minimise future agency and contracting costs
Managers select accounting methods which most efficiently reflect underlying firm performance - 29Opportunistic perspectiveSeeks to explain managers’ actions once contracts are already in place
That is, particular accounting methods might initially be selected for efficiency reasons, but once they have been negotiated/agreed, then managers will aim to utilise accounting choices in a way that best serves their own interest
Not possible to write complete contracts, so managers are assumed to opportunistically act to maximise own wealth
Known as ex post perspective - 30Owner/manager contractingAssuming self-interest, owners expect managers (agent) to undertake activities not always in the interest of owners (principal)
Managers have access to information not always available to principals
information asymmetry - 31Owner/manager contracting (cont.)In the absence of controls to reduce opportunistic behaviour, agents (managers) expected to undertake activities disadvantageous to the value of the firm
Principals price this into the amounts they are prepared to pay the manager
Managers may contract themselves not to consume perks so will receive higher salary - 32Methods of rewarding managersFixed basis — salary independent of performance
manager may not take great risks as does not share in potential gains
known as bonus schemes
Remuneration can be tied to
profits of the firm
sales of the firm
return on assets
Accuting based plans (next card) - 33Accounting-based bonus plansAny changes in accounting methods will affect the bonuses paid
may occur as a result of a new accounting standard in place
Contracts in some circumstances may be based on the old method in place so changes will not affect bonuses
Contracts relying on accounting numbers may rely on ‘floating’ GAAP - 34Incentives to manipulate accounting numbersThe decision to reward managers on the basis of accounting profits might initially be introduced for efficiency reasons (it motivates them to work in a way that also benefits the principals), but it may subsequently induce them to manipulate accounting numbers (the opportunistic perspective)
Bonuses based on profits cause short-term rather than long-term focus - 35Incentives to manipulate accounting numbers—evidenceHealy (1985) found
managers adopt accounting methods to maximise their bonus if their contract rewarded managers after a pre-specified level of earnings reached, losses? take a bath
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 - 36Use of conservative accounting methods in management bonus schemesConservative accounting methods, which would include historical cost
tend to delay the recognition of income,
accelerate the recognition of expenses, and
lead to lower asset and higher liability recognition
Asset and income recognition based on assessments of fair value would NOT be considered a ‘conservative’ accounting approach - 37Potential conflicts of interest between agents and principalsare better managed when conservative accounting methods are used as they RESTRICT the ability of managers to opportunistically use income and net asset increasing accounting methods
- 38Market-based bonus schemesApart from accounting-based bonus schemes, managers are also often provided with capital market-based bonuses
May be more appropriate to remunerate managers in terms of market value (shares) where accounting earnings fluctuate greatly
Methods include
cash bonus based on share price increases
shares
options to shares - 39Market-based bonus schemes pt 2Providing managers with shares, or share options creates incentives for managers to increase the value of the firm – aligns their interests with those of the owners (principals)
Problems include
share price also affected by factors beyond the control of managers (e.g. general market movements)
only senior managers likely to have a significant impact on share value - 40Choice of accounting versus market-based bonus schemesMore likely to be based on accounting earnings where
share returns relatively more sensitive to general market movements - 41Debt contractingMoving our attention to the relationship with debtholders, in the absence of safeguards to protect debtholders (creditors), managers are predicted to adopt strategies to disadvantage the debtholders
- 42Agency costs of debt includeexcessive dividend payments, which leave fewer assets to service debt
the organisation may take on additional debt, with new debtholders competing with original debtholders for repayment
investment in high-risk projects may not be beneficial to debt holders as they have a fixed claim (asset substitution)
underinvestment - 43Use of debt contractsIn the absence of safeguards to protect the interests of debtholders from strategies such as those on the previous slide, it is assumed the debtholders will require the firm to pay higher costs of interest to compensate for the risks
That is, they will ‘price protect’
Hence, it is efficient to enter into contracts that restrict the ability of managers to adversely affect the wealth of debtholders - 44Australian debt contractsIn 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 (think about ABC Learning)
Prior charges covenants typically included in term loan agreements of larger firms
Prior charges covenants defined as a percentage of total tangible assets - 45The role of conservative accounting methods in reducing the agency costs of debtAs with management bonus schemes, it is believed that the use of conservative accounting methods are relatively more effective in reducing agency costs of debt
Zhang (2008) suggests that from an efficiency perspective, managers might agree to adopt conservative accounting methods because it allows them to attract debt at a lower price - 46role of conserv cntAs Zhang (2008) argues, the more binding covenants will provide an earlier warning of default risk, and will thereby reduce the risk exposure of the lending party (for example, a bank)
The reason for this is that, because management will have less ability to circumvent restrictive covenants
The earlier the lender can take action to safeguard its funds, the lower the risk to the lender - 47Debt contracts—manager’s incentive to manipulateEx 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 - 48Role of external auditorsAuditors 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
the firm has borrowed funds, and accounting-based covenants are in place to protect the investment of debtholders - 49Political costsPolitical costs are costs resulting from political attention from government, lobby groups etc.
- 50Relevance of PAT-based research to current efforts of IASB to promote use of fair valuesHistorical cost accounting is a conservative approach to accounting when compared to fair value accounting
Conservative accounting methods, such as historical costs, reduce the ability of managers to manipulate accounting numbers compared to fair value accounting
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- Bachelors Degree Accounting Theory FlashCards sobre Week 7 AT, criado por Nicholas Rossi em 27-05-2016.
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