Financial Accounting Theory
Chapter 8 – Summary The Positive Theory of Accounting
In the text, Scott defines Positive accounting theory (PAT) as: “concerned with predicting such actions as the choices of accounting policies by firms and how firms will respond to proposed new accounting standards.” (263) PAT uses theory to predict the choices that management will make regarding their choice of accounting policies. This theory is introduced as a way to merge efficient securities markets with economic consequences. PAT takes the view that firms will conduct themselves in the way that maximizes their own best interests. Managers do not always do what is best for ...view middle of the document...
8.2 The Three Hypotheses of Positive Accounting Theory
Positive accounting theory is organized around three hypotheses:
➢ the bonus plan hypothesis
➢ the debt covenant hypothesis
➢ the political cost hypothesis
The bonus plan hypothesis dictates that managers will use accounting policies that are likely to shift reported earnings from future periods to the current period. This is to maximize their personal compensation as by reporting a high net income, their utility will be maximized through bonuses and incentives.
The debt covenant hypothesis states that the closer a firm is to compromising their debt covenants, the more likely management is to use accounting policies that shift reported earnings from future periods to the current period. This is because higher net earnings will reduce the probability of technical default on the debts.
The political cost hypothesis states that the greater the political costs to the firm, the more likely management is to use accounting policies to defer reported earnings from current periods to future periods. This hypothesis brings politics into the choice of accounting policies. Highly profitable firms attract media and consumer attention. This attention can create an increase in taxes and other regulations.
These three hypotheses form the cornerstone of Positive Accounting Theory. They all lead to empirically verifiable predictions.
8.3 Empirical PAT Research
Positive accounting theory has created a large amount of empirical research. Lev’s research helped us understand why firms choose the accounting polices they do, why some managers would object to the change in policies, and why investors react the way that they do to changes in net income. Healy discovered that managers in organizations with bonus incentive plans often adopted accrual policies to maximize their expected bonuses. Sweeney studied first-time debt covenant violators, and found that the violators made significantly more voluntary income-increasing accounting policies prior to their default. Firms were also able to manipulate net income with the timing of their adoption of new accounting standards.
Jones investigated the tendency for firms to reduce their reported net income during import relief investigations. These firms have to prove to the government that their income has deteriorated as a result of foreign competition, and deserve assistance such as tariff protection or trade legislation. There is a financial motivation for these organizations to reduce their net income to qualify for relief. Jones also investigated whether firms used discretionary accruals to lower reported earnings. She concluded that there was a tendency for organizations to manipulate accounting policies relating to accruals.
8.4 Distinguishing the Opportunistic and Efficient Contracting Versions
Positive accounting theory can be classified as opportunistic and efficient versions. The three hypotheses of...