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ACCOUNTING THEORY AND PRACTICE FAR 600

Positive Accounting Theory


By: Prof Madya Dr Roshayani Arshad Faculty of Accountancy UiTM

4/3/2013

LEARNING OBJECTIVES
At

the end of this lesson, students should be able to:


Contracting theory

Agency theory
Political processes

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POSITIVE ACCOUNTING
THEORY

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To explain the reason for observed practice

Why the economic consequences exist?

Concept of PAT

Which accounting policy firm will choose when some policies available To predict the actions of the firm What will the firm react to new acct standards? 4
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ECONOMIC CONSEQUENCES
Economic consequences is a concept that asserts that, despite the implications of efficient securities market theory, accounting policy choice can affect firm value.
(Scott, W.R., 2003, p.259)

Despite implications of efficient market theory, accounting policy choice have economic consequences for various constituencies of financial statement users

Standard setting bodies includes different constituencies in their board in order to reach a consensus between 5 accounting and political demands.
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THE RISE OF ECONOMIC CONSEQUENCES

Economic consequences as defined by Zeff (1978) the impact of accounting reports on the decision-making behavior of business, government and creditors.
p.261) (Scott, 2003,

Third party interventions complicate the setting of accounting standards because they try to influence or influenced the accounting the standard setting bodies Example: attempt by several US corporations to implement replacement cost accounting during the period of high inflation (1947-1948)
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THE RISE OF ECONOMIC CONSEQUENCES


Since

there is no theory that clearly prescribes what accounting policies should be used other than a vague requirement tradeoff between relevance and reliability is necessary This opens the door for various other constituencies to argue for their preferred accounting policies Hence standards setting requires both the accounting theory domain as well as the political domain
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PHILOSOPHY OF PAT
A

science to predict unobservable phenomena and seeks to explain observed accounting phenomena by searching for the reasons events occur
The objective of (positive) accounting theory is to explain and predict accounting practice Explanation means providing reasons for observed practice. For example, positive accounting theory seeks to explain why firms continue to use historical coat accounting and why certain firms switch between a number of accounting techniques. Prediction of accounting practice means that the theory predicts unobserved phenomena. (Watts &
Zimmerman, 1986, p.2) 8

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PHILOSOPHY OF PAT
Economic focus
i.e., focus on the costs and benefits of the alternative accounting methods, regulations & accounting std setting process & the effects of reported FS on share prices.

More scientific in methodology i.e., empirically explaining & predicting what occurs. Central idea is to develop hypotheses about factors that influence the world of accounting practices and to test the validity of these hypotheses empirically.
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NATURE OF NORMATIVE THEORY & ITS LIMITATIONS


Prescribes

what should occur or the best way to

account
Limitations

Normative presupposes PAT (Jensen, 1983)

Normative not based on identified, empirical observations & methods (Watts & Zimmerman , 1986)

Valid prescription requires specification of both an objective and an objective function. (p.7)

Normative produces irrefutable prescriptions (Popper, 1968)

No amount of empirical testing can prove a theory to be correct i.e. tests of a theory against real-world data - but a theory 10 should be refutable or capable of falsification.
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SCOPE OF PAT
Positive Accounting Theory

Capital Market Research (CMR)

Accounting Policy Choice (APC)

Efficient market hypothesis (EMH) Capital Asset Pricing Model (CAPM)

Opportunistic reasons Efficiency reasons

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SCOPE OF PAT
PAT PAT

attempts to understand & predicts firms APC

asserts that firms need APC to minimize contracting costs


implies it is more efficient for firm to have a set of accounting policies (GAAP) from which management can choose this flexibility in APC opens the door Cop to yrig ht@ opportunistic management behavior 2004
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PAT

However,

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SCOPE OF PAT

Efficiency assume that internal control systems limit

opportunism and motivate managers to choose accounting


policies that minimize contracting costs.

Sweeney (1994) found that managers change accounting

policies only when it was cost effective & Dechow (1994)


further confirmed Sweeneys findings.

Both the above studies confirmed that managers choose

accounting policies more for efficiency reasons rather


opportunistic reasons.

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SCOPE OF PAT

PAT developed in two stages


First-stage literature did not explain accounting practice. The

earlier of the two stages involved research into accounting and


the behaviour of capital markets

Second-stage literature sought to explain and predict

accounting practices across firms

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THE DIFFERENCE BETWEEN NORMATIVE


THEORY AND POSITIVE THEORY
Normative theory: what they should do What is a good normative theory: it is judged by its logical consistency with underlying assumptions of how rational individuals should behave Positive theory: to predict which acct policy firms will choose

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THE RELATION BETWEEN NORMATIVE


THEORY AND POSITIVE

Both are valuable to theory development and testing

Positive theory helps to keep the normative research


on track by empirical testing

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STRENGTH OF PAT
Perceived that theory should be able to generate hypotheses capable of falsification through empirical testing Deemed desirable that theory aim was to explain and predict accounting practices rather than supply prescriptions Necessary to rationalize existing accounting principles, which normative theory didnt attempt to do PAT attempt to model connection between accounting, firms, & markets & analyze problems within an economic network
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WHY PAT?

What was? What is? What ought to be? A theory that is consistent with the existence of economic consequences explain or predict real world phenomenon and are tested empirically

Based on scientific methodology using economic based empirical literature


Enable theories to be refuted, to explain & predict, to rationalize accounting principles and to model connection between accounting, firms & markets Attempt to understand why accounting policies matter 18 and predict which accounting policies firms will choose
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PAT HYPOTHESES

Predictions made by PAT largely organized around 3 hypotheses formulated by Watts & Zimmerman (1996), all other things being equal: The Bonus Plan Hypothesis

Choose accounting policy that shift reported earnings from future periods to the current period Firm with prospect of violating accounting-based debt covenants (e.g. going below the agreed specified level of debt equity ratio) would shift reported earnings from future periods to current periods Choose accounting policy that defer reported earnings from current to future periods.

The Debt Covenant Hypothesis

The Political Cost Hypothesis

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PAT HYPOTHESES
Managers

of firms with bonus plan predicted to

choose less conservative accounting policy & oppose accounting standards that may lower reported net income than managers of firms without such plan

Managers

of firms with high debt-to-equity ratio of large firms

Choose less conservative accounting policy & oppose new standards that may lower reported net income. Choose more conservative accounting policies & less likely to oppose new standards that may lower reported net income.

Managers

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POSITIVE THEORIES

Experiences or facts of the real world explaining reasons for current practice predicting how accounting information is used in economic decision-making

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NATURE OF POSITIVE THEORIES


Provide

description of what accounting is inferential & objective

Descriptive, Objective

of PAT is to explain & predict accounting practice science to predict unobserved phenomena & verifiable

Observable Derived

inductively from specific set of observation (logic), semantic & pragmatic


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Analytic

NATURE OF POSITIVE THEORIES


Based on scientific empirical methodology, relating or testing accounting hypothesis to experience or facts of real world e.g., efficient market hypothesis Focus on

Accounting policy choice Capital market research Efficient capital market A firm is a nexus of contracts Accounting is important in contract enforcement Accounting information is an economic good Managers, investors, lenders & others are assumed to be rational & evaluative utility maximizer Discretion to choose accounting policies that maximize their utility and value of firm
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Assumptions

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CRITICISMS ON PAT

Positive theory are not value free

VALUE FREE IS NOT ALTERED OR


INFLUENCED BY VALUE JUDGMENT

Value judgment of the rightness or wrongness or usefulness of something base on persona; view.

The theories use large-scale statistical research,

remote from practitioners and their concerns


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DIFFERENCE BETWEEN NORMATIVE & POSITIVE ACCOUNTING THEORIES


Normative Prescriptive

Prescribed how people should behave

Positive Descriptive, explanatory or predictive


Describe how people behave Explain why people behave in a certain manner Predict what people have done or will do

Suggestion:

can coexist & complement each


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other
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CONTRACTING THEORY
Firm is a legal nexus (connection) of contractual relationships amongst suppliers and consumers of factors of production

Rationale for the firm:


it costs less to transact (or contract) through central organization than to do so individually firm is an efficient means of organizing economic activity because they reduce contracting costs Hence firm exists to reduce transaction costs

PAT-APC focuses on two main types of agency contracts to explain accounting practices:
Management contracts (shareholders & managers)
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Debt contracts (lenders & managers who is acting on behalf of the shareholders)
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AGENCY THEORY
Developed to explain & predict the actions of agents (e.g. managers) & principals (e.g. shareholders or lenders). Assumption: no a priori reason to believe that agent will act in the best interest of the principal Jensen & Meckling (1976) describe an agency relationship arises when there is a contract under which one party (the principal) engages another party (the agent) to perform some service on the principals behalf.

Under the contract the principal delegates some decision-making authority to the agent
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4/3/2013

AGENCY THEORY PROBLEM

No reason to believe that the agent will always act in the principals best interests. Agency problem is the problem of inducing an agent to behave as if he or she were maximizing the principal welfare, resulting in agency cost

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AGENCY THEORY - COSTS


Agency costs are costs that arises from agency relationships (because of the separation of ownership from control of an entity) Three types of agency costs identified are:

Monitoring costs Bonding costs Residual loss

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AGENCY THEORY - MONITORING COSTS


Costs

of monitoring the agents behavior Expenditure by principal to measure, observe & control agents behavior Examples: mandatory audit costs, cost to establish management compensation plan, & budget restrictions among others Price protection is the way the principal protects against agency costs by paying according to the level of costs expected. Price protection is borne by agents
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AGENCY THEORY - BONDING COSTS


Costs

of establishing & complying with mechanisms (bonding agents interest with the principals interest) Borne by agents - Price protection resulted in agents ultimately having to bear monitoring costs associated with contracts Examples: frequent quarterly financial statements Costs to managers includes: time & effort, constraints, & income forgone
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AGENCY THEORY RESIDUAL LOSS


Residual loss occur when the net value of the agents output is less, when they make decisions that are not entirely in the principals interest (deadweight loss) When the agent make decisions that do not keep the best interest of the principal, it results in residual loss Strong form efficient market provide information on incentives & opportunities that will trigger the agent to act contrary to the interest of a principal The agent would then use information to set their remuneration level i.e., the principal will remunerate the agent to the point that the principal expects the agent to likely become contrary to the interest of the principal 32 Principal is price protected

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AGENCY THEORY SETTLING UP

Settling up means the principal review the remuneration package given to the agent base on the principle that the remuneration level has to tally with the agents effort. If the agent is deemed to have acted more in favor of the interest of the principal the it is likely that the remuneration will be revised upwards In contrary, remuneration will revise downwards if the agent is deemed to have acted more in contrary to the interest of the principal If the contract is to be continued then it should start with 33 the remuneration decided upon at the settling up
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AGENCY THEORY RESIDUAL OPPORTUNISM

Residual opportunism cost borne by agent due loss

of reputation & potential loss of long-term returns to


them

With incomplete price protection & settling up,

residual loss is borne partly by agent & partly by


principal

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AGENCY COSTS

Monitoring costs

Cost of monitoring agents behaviour and expenditure by principal to measure, observe and control the agents behaviour. Examples: audit costs, operating rules, budget restrictions Costs of establishing and complying with these mechanism (bonds agents interest to match principals interest). These costs are borne by agents Examples: frequent (weekly, quarterly, semi-annually) reporting to shareholders Also known as deadweight loss is when the net value of the agents output is less than if the agents interest were completely aligned to the principal Not reduced by monitoring or binding costs However, under strong-form efficient market, it is assumed that the firm can be price protected in the form of agents remuneration 35
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Bonding costs

Residual costs

AGENCY PROBLEM AND COST


Agent problem and cost arise from the opportunistic behaviour of management Opportunistic tendencies increase with decrease proportionate share (ownership) which increases residual loss. Shareholders are prepared to bear agency costs as long as marginal benefits to shareholders exceed marginal cost Price protection of shareholders could be in two forms:

Share price adjustments to reflect opportunistic behaviour Share price exclude monitoring and binding cost Limitation of price protection is that share price is not always available due to thin trading and when managers efforts can be directly related to earnings performance
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SUMMARY
A number of conflicting theories have developed A theory generally consists of three parts There are several criteria for judging a theory Persuasiveness of evidence

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SUMMARY
Many different approaches to theory formulation in accounting All methods of theory formulation have strength and weaknesses Accounting practitioners should use theories they find most persuasive

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4/3/2013

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