Positive Accounting Theory

1. Positive Accounting Theory

2. Class Announcements • Assignment #6 due February 20th; available on-line • Research Paper Part #2 due February 13th (today) • Assignment #5 available for pick up on Friday (14th) from SCHW 396 until 2:00pm • Midterm is February 17th (in-class) • Business Banquet - April 2nd – 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia • Additional Office Hours: • Friday (14th) 10:00am to 2:00pm

3. Midterm • Worth – 25% • When –Monday (17th) • Coverage – • Conceptual Framework (CICA 1000); Accrual Accounting; • Efficient Markets (Chapter 4); • Information Perspective (Chapter 5); • Measurement Perspective (Chapter 6); • Positive Accounting Theory (Chapter 8); • Format: • short answer with multiple parts; • choice of 3 out of 4; • no quantitative problems

4. Class Objectives • Viewing the firm as a series of contracts • Contracts between agents and principles define the relationship and expectations • Defining a rationale person • Hypotheses of Positive Accounting Theory (PAT)

5. Positive Accounting Theory (PAT) • The term positive refers to a theory that attempts to make good predictions of real world events • “Positive accounting theory is concerned with predicting such actions as the choice of accounting policies by firm managers and how managers will respond to proposed new accounting standards.” p. 304 • Accounting policy choice is part of the overall process of corporate governance.

6. Positive Accounting Theory • Positive: the objective is to understand and predict managerial accounting policy choice across different firms. • Normative: the objective is to tell managers what they should or ought to do.

7. Positive Accounting Theory • “Firms organize themselves in the most efficient manner so as to maximize their prospects for survival” p. 304 • depends on factors such as legal & institutional environment, technology, degree of competition, etc. firm can be viewed as nexus of contracts • Firm is a nexus of contracts • A firm will want to minimize the various contracting costs associated with these contracts • Many of these contracts involve accounting information • PAT argues that the firm’s accounting policies are selected to reduce contracting costs – efficient contracting • Managers require flexibility in accounting policies to allow adoption to new or unforeseen circumstances

8. Positive Accounting Theory • Flexibility to choose from a set of accounting policies opens up the possibility of opportunistic behavior. • PAT assumes • managers are rational (self interested, risk adverse, effort adverse) • will choose accounting policies in their own best interests (not necessarily profit maximization) – opportunistic • will choose accounting policies to attain corporate governance objectives of the firm – efficient contracting

9. Positive Accounting Theory: Distinguishing Versions (opportunistic vs. efficient) • Difficulty in distinguishing between versions (p. 316-318): • Mian & Smith (1990) • Consolidated financial statements • Christie & Zimmerman (1994) • Takeover targets • Dichev & Skinner (2002) • Debt covenants • Dechow (1994) • Net income more highly associated with share returns than cash flows • Guay (1999) • Limit firm risk using derivatives • Evidence from empirical research of both

10. Positive Accounting Theory: Accounting Implications-Managing Earnings • Ways to manage earnings: • Changing accounting policies • Managing discretionary accruals • Timing of adoption of new accounting standards • Changing real variables-R&D, advertising, repairs & maintenance • SPEs (Enron), capitalize operating expenses (WorldCom)

11. Positive Accounting Theory: Accounting Policies • The optimal set of accounting polices for the firm represents a compromise: • A) Tightly prescribing accounting policies beforehand will minimize opportunistic accounting policy choices by mangers but incur cost of lack of accounting flexibility to meeting changing circumstances • B) Allowing managers to choose from a broad array of accounting polices will reduce costs of accounting inflexibility but expose the firm to the cost of opportunistic manager behavior.

12. Positive Accounting Theory: Hypotheses • The predictions made by PAT are largely organized around three hypothesis: (in opportunistic form) • 1) Bonus plan hypothesis – select accounting policies to move earnings to current period for remuneration • 2) Debt covenant hypothesis - select accounting policies to move earnings to current period to reduce possibility of technical default • 3) Political cost hypothesis - select accounting policies to move earnings to future period

13. Positive Accounting Theory: Empirical Investigation • 1) Bonus plan hypothesis – Healy (1985), managers do choose accounting policy to maximize earnings • 2) Debt covenant hypothesis – Dichev & Skinner (2002), managers choose accounting polices to maintain covenant ratios; managers work harder to avoid first covenant violation • 3) Political cost hypothesis – Jones (1991), firms choose accounting policy consistent with improving their case of import protection • Overall – the three PAT hypothesis may predict manager reaction.

14. Class Objectives - Revisited • Viewing the firm as a series of contracts • Contracts between agents and principles define the relationship and expectations • Defining a rationale person • Hypotheses of Positive Accounting Theory (PAT)