Chapter 7 Positive Accounting Theory Q & A PDF

Preview

Summary

7 Positive Accounting Theory ...

Description

Chapter 7 Positive Accounting Theory Solutions 7.1 What is the difference between a positive and normative theory of financial accounting, and is one better than the other? LO 7.1 7.1 A positive theory of financial accounting would seek to explain and/or predict particular financial reporting practices (or perhaps how different users will react to particular accounting disclosures) whereas a normative theory of financial accounting would seek to prescribe particular approaches to or methods of financial accounting with these prescriptions being based on particular perspectives about the role of financial accounting, and the needs and expertise of financial statement readers. Because normative theories serve a different role to positive theories, it is not appropriate to say one is better than the other. Indeed, rather than seeing them as competing, they can actually be used in a complementary manner. For example, positive research and positive theories might provide valuable insights into how different categories of financial statement readers react to particular forms of accounting disclosures. These insights can then be used by other people who are seeking to make prescriptions about the types of disclosures that reporting entities should make. 7.2 Early positive research investigated evidence of share price changes as a result of the disclosure of accounting information. However, such research did not explain why particular accounting methods were selected in the first place. How did Positive Accounting Theory fill this void? LO 7.2 7.2 Early research considering share price reactions to accounting information relied on various assumptions about the efficiency of the capital market and assumed that capital market participants could ‘undo’ the effects of organisations using different accounting methods. It also assumed the absence of transaction costs. Accepting these assumptions, and to the extent that the selection of accounting method did not affect taxation, then the choice of accounting method would have limited implications for the firm and hence managers should be indifferent when choosing between alternative accounting methods. However, evidence indicates that managers are not indifferent. The development of agency theory suggested that where there is a delegation of decision making within an organisation there can be inefficiencies because agents will not necessarily work in the interests of the organisation, but rather will work in their own interests. However, the principals will anticipate the opportunistic actions of the agents and will reduce their payments accordingly (that is, the principals will price protect). To minimise the agency costs, and to align the interests of principles and agents, numerous contractual arrangements will be put in place. Accepting the perspectives provided by Agency Theory, Watts and Zimmerman (1978) showed how accounting-based contractual arrangements can act to minimise the transaction costs that might arise within an organisation. The choice of one method of accounting in preference to another was deemed to be important in maximising the value of an organisation. For the reason that there are many uncertainties when investing or lending funds to an organisation, managers will agree to provide investors and lenders with financial statements.

This reduced risk associated with being able to monitor the performance of the entity will be expected to reduce the costs associated with attracting funds to the entity. Since some methods of accounting are able to better reflect the performance of an entity, managers will select some methods in preference to others (the efficiency perspective). This will have direct implications for the cost of attracting funds into the organisations. Further, accepting that managers might not always work in the interests of the owners, it is common to find accounting-based bonus plans. Again, some methods of accounting might be more relevant in some organisations than alternative methods of accounting and again, PAT provides an explanation for why certain accounting methods might be selected in preference to others. 7.3 What does it mean to say that an organisation can be represented as a ‘nexus of contracts’? LO 7.6 7.3 Organisations can be described in a multitude of ways. One description is that organisations are effectively a ‘nexus of contracts’. Such descriptions are often used within the agency theory literature, with the contracts being put in place with the intention of ensuring that all parties, acting in their own self-interest, are at the same time motivated towards maximising the value of the organisation. The view of the firm as a nexus of contracts is consistent with Smith and Watts’ (1983, p. 3) definition of a corporation. They define the corporation as: … a set of contracts among various parties who have a claim to a common output. These parties include stockholders, bondholders, managers, employees, suppliers and customers. The bounds of the corporation are defined by the set of rights under the contracts. The corporation has an indefinite life and the set of contracts which comprise the corporation evolves over time. Agency theory does not assume that individuals will ever act other than in selfinterest, and the key to a well-functioning organisation is to put in place mechanisms (contracts) that ensure that actions that benefit the individual also benefit the organisation. The firm will have many contracts negotiated with various individuals and parties – hence the reference to a ‘nexus of contracts’ – and these contracts will aim to reduce the many conflicts of interests and related uncertainties that might otherwise arise. The establishment of the firm, with all the related contractual mechanisms, is seen as an alternative and efficient way to produce or supply goods and services relative to individuals dealing with ‘the market’ by way of a series of separate transactions. 7.4 Explain the management bonus hypothesis and the debt hypothesis of Positive Accounting Theory. LO 7.7, 7.11 7.4 Managers are often rewarded in terms of accounting-based bonus plans. Such plans are introduced to align the interests of the managers of the firm with those of the owners. The establishment of management bonus plans can be explained from an efficiency perspective. The management bonus plan hypothesis predicts that managers who are rewarded in terms of accounting numbers are more likely to select accounting methods that increase income to the extent that this will lead to an increase in the size of the bonus. This is an opportunistic perspective. (The efficiency perspective relates to the initial establishment of the bonus scheme

and the opportunistic perspective relates to the subsequent efforts to manipulate profits and hence, the bonus.) The debt hypothesis (also called the debt/equity hypothesis) predicts that firms with higher debt/equity or debt/assets ratios are more likely to adopt accounting methods which increase income (and assets and residual equity) than firms with lower ratios. This prediction is made on the basis of an assumption that firms will have entered into debt contracts with external lenders (with the purpose of reducing agency costs and hence explained from an efficiency perspective) and these debt contracts will rely upon accounting numbers. The incentive to adopt income increasing methods will increase the closer the firm comes to breaching the accounting-based debt covenant. While debt contracts will initially be entered into in an endeavour to reduce the costs of borrowing (the efficiency perspective), the view that management will subsequently choose ‘favourable’ methods to loosen the restrictions imposed by debt-related contractual covenants is considered to represent an opportunistic perspective. 7.5 Explain why a decision made in London by members of the International Accounting Standards Board and incorporated within an accounting standard could influence the business operating strategies employed by a manager in Melbourne, Australia. LO 7.8 7.5 Drawing on the material provided in Chapter 7 we know that numbers generated through the application of accounting standards and other generally accepted accounting procedures will be used in various contractual arrangements that have been negotiated by the organisation with various other parties. For example, there will be accounting-based debt agreements negotiated with lenders and there will be accounting-based management bonus plans negotiated with managers. When the IASB releases a new accounting standard this has a high probability of impacting some of the accounting numbers that are used within the various contractual arrangements that the organisation has negotiated with different parties. This might in turn have implications for the transactions that the organisation might subsequently elect to enter. For example, when the IASB’s accounting standard on intangible assets was used for the first time in many countries (for example, in Australia and the European Union from 2005) it meant that many intangible assets that were previously recognised as assets within the statement of financial position (balance sheet) were no longer eligible for capitalisation. Rather, they were required to be expensed as incurred. This would conceivably have caused a reduction in the acquisition of such assets, particularly for organisations that were close to breaching accounting-based debt contracts, such as debt to equity ratios. As a general principle we can argue that if an organisation has negotiated various contracts with various parties, and those contracts – with related cash flows – rely upon accounting numbers, then when new accounting standards are released there will be potential cash flow consequences. To alleviate potentially negative cash flow consequences managers might elect to alter the operating strategies, and therefore transactions, that the organisation enters. Therefore the release of a new accounting standard by the IASB can have implications for how an organisation in Melbourne conducts its operations.

7.6 If a manager is paid a percentage of profits, does this generate a motive to manipulate profits? Would this be anticipated by principals and, if so, how would principals react to this expectation? LO 7.8, 7.11 7.6 It is predicted by Positive Accounting Theory (PAT) that on an ex ante basis (that is, upfront) mechanisms will be put in place that align the interests of the managers (agents) with those of the owners (as principals). As the evidence provided in the chapter indicates, such mechanisms will include offering management a bonus which is tied to reported profits. Assuming self-interest, such mechanisms will lead to a reduction in agency costs (they will encourage the self-interested manager to work harder) and hence can be explained from an efficiency perspective. However, maintaining the assumption of self-interest, it is assumed that once a profit-sharing bonus scheme is put in place then management will seek to undertake actions to increase the size of the bonus and hence their own financial rewards. One way is to work harder, but another way is to manipulate reported profits by selecting accounting methods that lead to an increase in reported profits (the opportunistic perspective). Within PAT it is assumed that principals expect managers to be opportunistic and unless managers can demonstrate that they have not been opportunistic principals will assume that they have been and accordingly, the principal will pay the managers a lower salary (this is called ‘price protection’). The lower salary compensates the principals for the expected opportunistic behaviour of the agents. To reduce this ability to be opportunistic (with consequent implications for increasing the managers’ bonuses) contractual agreements will be put in place up front to reduce the ability of the managers to manipulate accounting profits (but this ability can never be fully removed). Such agreements may include a clause which restricts the choice management has when selecting between alternative accounting methods or it may include a requirement that the financial statements be audited by an independent third party who will attest to whether appropriate accounting methods have been selected by the manager. 7.7 What is an agency relationship and what is an agency cost? How can agency costs be reduced? LO 7.3 7.7 An agency relationship occurs when decision-making authority is delegated from one party (the principal) to another party (the agent). Jensen and Meckling (1976, p.308) define the agency relationship as: 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

From the Agency Theory perspective, the ‘contract’ itself does not need to be written. Because it is assumed that all individuals will act in their own selfinterest, there will be costs (agency costs) associated with appointing agents to make decisions on behalf of the principals. Agency costs can be defined as costs that arise as a result of the agency relationship and relate to the costs that arise as a result of the process of delegating decision making to others. Pursuant to Agency Theory it is argued that various contractual arrangements will be put in place to minimise anticipated agency costs and hence to increase the value of the organisation. For example, to minimise the agency costs relating

to appointing a manager, contractual arrangements might be put in place to provide the manager with a share of profits. That way, the manager will be motivated to make decisions that lead to an increase in profits and, all things being equal, this will also be in the interests of the owners. An organisation is considered to represent a nexus of contracts between many self-interested individuals and the reason for having the various contracts is to reduce the agency costs that the organisation might otherwise encounter and consequently to maximise the expected value of the organisation. 7.8 Explain the political cost hypothesis of Positive Accounting Theory. LO 7.10 7.8 Political costs are those costs that particular groups external to the firm may be able to impose on the firm as a result of various actions. For example, the costs associated with the community lobbying the government to decrease the subsidy support for an organisation, the costs associated with labour unions taking actions to increase the wages of their members or the costs associated with consumer boycotts associated with the firm’s products. The political cost hypothesis predicts that those organisations under political scrutiny (usually assumed to be larger firms) will undertake actions to minimise the possibility of adverse cash flows associated with the scrutiny. For example, if a company is being scrutinised in a particular period because of its perceived monopoly powers and those external parties undertaking the scrutiny claim that these monopoly powers enable it to generate excessive profits, then in such periods the entity may elect to adopt accounting methods which reduce its reported profits, and hence, its susceptibility to actions to reduce the wealth of the organisation (perhaps, in the form of increased taxes). Watts and Zimmerman provide the following explanation of the political cost hypothesis: The political cost hypothesis predicts that large firms rather than small firms are more likely to use accounting choices that reduce reported profits. Size is a proxy variable for political attention. Underlying this hypothesis is the assumption that it is costly for individuals to become informed about whether accounting profits really represent monopoly profits and to ‘contract’ with others in the political process to enact laws and regulations that enhance their welfare. Thus rational individuals are less than fully informed. The political process is no different from the market process in that respect. Given the cost of information and monitoring, managers have incentive to exercise discretion over accounting profits and the parties in the political process settle for a rational amount of ex post opportunism (1990, p.139)

As reflected in the above quote, the political cost hypothesis assumes that various parties will simply react to the quantum of reported profits and will not necessarily focus on which accounting methods were used to generate these profits. 7.9 Why is accounting important in political processes? LO 7.10 7.9 Accounting is important in political processes because of the emphasis society tends to place on accounting numbers. We constantly hear about the financial performance of various companies, with the financial press often running stories about the profits (often ‘record profits’) or losses of various companies. Profits are portrayed as a form of benchmark measure of firm performance. Throughout society, various contractual arrangements are directly linked to

accounting numbers. For example, when companies borrow funds they typically agree to various accounting-based debt covenants, the breaching of which will cause the organisation to be in ‘technical default’ – something that attracts negative publicity. Also, senior managers’ salaries – which often attract extensive negative media attention if they are deemed to be excessive – are often tied to accounting numbers. Politicians, consumer groups, trade unions, environmental groups and others often use accounting numbers (such as profits) as a basis for various arguments that the company is not paying enough to its workers, is exploiting consumers by charging high prices, or is not investing enough in cleaner production processes. Because accounting numbers are used as a justification for various claims made in favour of, or in opposition to, corporate activities, we can see that accounting does play an important part in various political processes. 7.10 As part of efforts to develop a revised Conceptual Framework for Financial Reporting, the IASB is currently investigating alternative approaches for measuring the assets and liabilities of reporting entities. In relation to asset measurement it appears that fair value is a favoured option of the IASB. In this regard, would researchers who embrace the view that accounting plays a vital role in reducing the contracting costs of an organisation favour the adoption of fair value in all situations? Carefully explain your answer. LO 7.14 7.10 It is generally accepted that accounting numbers play an important role in reducing conflicts of interest within an organisation. It has generally been argued in the literature that potential conflicts of interest between agents and principals are better managed when conservative accounting methods are used as this restricts the ability of the managers (agents) to opportunistically use income and net asset increasing accounting methods. The use of fair value to measure assets – which would not be considered to be a conservative approach to accounting – provides managers with a greater ability to use professional judgement relative to more conservative measures, such as historical cost. Historical cost accounting numbers are less able to be manipulated by management and are more readily verified than information based on current values. Conservative accounting methods are considered to provide relatively greater efficiency from a contracting perspective. In Chapter 6 we learned that the two fundamental qualitative characteristics of useful financial information, according to the IASB Conceptual Framework for Financial Reporting (a normative framework of accounting), are relevance and representational faithfulness. While equity investors (owners) and debtholders will be interested in receiving information that is relevant for valuing the firm (for example, fair values), they will also recognise that management has an incentive to opportunistically introduce bias to this information. From a contracting perspective, there will be a trade-off away from relevance in favour of verifiability (which is tied to ‘representational faithfulness’). Historical cost information tends to be more verifiable (and representationally faithful) than ...