Topic 5 -PAT and CMR - Positive Accounting Theory (PAT) Capital Market Research key terms important PDF

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Positive Accounting Theory (PAT)
Capital Market Research

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Topic 5:

Theoretical perspectives on accounting policy choice: PAT and CMR (Chapters 7 & 10) Topic 1 recap: In Topic 1 Introduction to accounting theories, theories can be classified into positive and normative theories • Positive theories: pg: 10 & 270 Theories that seek to explain and predict particular phenomena (descriptive Theory)  Theory about accounting policy choice • E.g PAT (this topic), legitimacy theory, stakeholder theory, and institutional theory (Topic 9) • Normative theories: pg 11 prescribe how a particular practice should be undertaken (prescriptive Theory) • e.g. the Framework in Topic 3, Public Interest Theory to explain accounting regulation in Topic 2, accounting standards used in accounting practice (Topics 4-7)

PART A – Chapter 7 Positive Accounting Theory (PAT) - pg272 ‘… 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). Again, positive theories do not prescribe what should occur – they focus on explaining or predicting what does occur  PAT focuses on relationships between various individuals and explains how accounting is used to assist in the functioning of these relationships o Examples of relationships  between owners and managers  between managers and the firm’s debt providers

Central economics based assumption - 273 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 o does not incorporate notions of loyalty or morality (No incorporated in any theories o PAT predicts that organisations will put in place mechanisms that will align the interests of the shareholders(owners) and the managers of the firm

Agency Relationship - 273 Many Relationships involve the delegation of decision making from one party the principle (the owner/shareholder) to another party the agent (the manager) – Known as Agency Relationship. - Agency Theory: A theory explaining the relationship between the principle and the agent and the delegation of powers from the principle to the agent. This can cause issues with loos of efficiency and subsequently agency costs. - agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth.    

Can lead to loss of efficiency and consequent costs Mangers may not work as hard as the owner would – could result in under-performance in the business. Any loss of profits or under-performing areas is considered to be a cost (agency cost) as it is the result of delegation of tasks Agency problems arise because of inefficiencies and information asymmetries: The agency problem leads to ‘agency costs’ including o Monitoring costs: costs of monitoring the behaviour of others such as the agent. PAT and Agency theory referrers to the costs taken by the principle to monitor the agent. e.g. auditing financial statements o

Bonding costs: costs borne by the agent to refrain from undertaking certain activities involved in agents bonding their behaviour to expectations of principals e.g. preparing financial statements

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Residual loss: PAT assumes that not all opportunistic behaviour can be controlled by contractual agreements. There will always be a residual cost of employing an agent. These will occur even with Monitor and Bonding costs

Origin and Development of PAT - 274  

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Started coming to prominence in mid-1960s o paradigm shift from normative theories PAT became the dominant research paradigm in 1970s and 1980s o shift resulted from US reports on business education, and improved computing facilities enabling large-scale statistical analysis – something common in positive research Watts: Hypothesis forming and testing were viewed as essential for good research o Hypothesis- a proposition typically derived from theory which can be tested for causality or association using empirical data

Role of Efficient Markets Hypothesis: 276 (further explained later) • • •

1960s Development of Efficient Markets Hypothesis (EMH) by Fama and others provided an environment suitable for PAT research EMH is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information Efficient market defined as a market that adjusts rapidly to fully impound information into share prices when the information is released. Therefore: stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.

Share price Reaction to Unexpected earning announcements Ball and Brown proposed that if the earnings announcements were useful to the capital market or if there was new of unexpected information the markets would react and adjust to the new information. - Abnormal Markets: In capital market research abnormal returns are the realised (actual) rate of return, less the expected rate of return.

Key hypotheses - 283 • Three key hypotheses frequently used in PAT literature to explain, and predict support or opposition to, an accounting method. Research assumes managers will act opportunistically when selecting methods. Used to provide an explanation to why an accounting method of a firm Bonus Plan Hypothesis -286 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. • Managers of firms with bonus plans are more likely to use accounting methods that increase current period reported income – A firm would choose an accounting policy that will increase the firm’s profits if their bonus is linked to the amount of profit. – also called management compensation hypothesis – action increases the present value of bonuses paid to management Debt Hypothesis -285 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. •

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Developed from positive accounting theory, it proposes that organisations close to breaching accounting based convents such as a debt to equity ratios. The firm will select accounting methods that leads to an increase profits and assets Debt financing: Borrowings from bank – Lending agreement may be imposing which includes a debt covenants. If breached – serious consequences arise The higher the firm’s debt/equity ratio, the more likely managers use accounting methods that increase income or revaluations of assets – also called debt/equity hypothesis – the higher the debt/equity ratio, the closer the firm is to the constraints in debt covenants – covenant violation results in costs of technical default

Political Cost Hypothesis – 286 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. Proposes that firms subjected external cost due to political scrutiny, that will drive the firm to adopting accounting methods to reduce reported income.  An external cost such as change of legislations or regulation  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 – reduction of reported income is hypothesised to reduce the possibility that people will argue that the organisation is exploiting other parties

Two perspectives adopted by PAT research – 287 Efficiency perspective    

Researchers explain how contracting mechanisms minimise agency costs of the firm Known as ex-ante perspective o mechanisms put in place up front to minimise future agency and contracting costs Managers select accounting methods which most efficiently reflect underlying firm performance PAT theorists argue that regulation forcing firms to use a particular accounting method imposes unwarranted costs and introduces inefficiencies

Opportunistic perspective    

Seeks to explain managers’ actions once contracts are already in place Known as ex-post perspective 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 o considers opportunistic actions after the fact

****************Overview of PAT – rewrite – pg 324*******

Role of accounting in contracts - 281 • •

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Firms can be characterised as a nexus of contracts – between consumers of products and the suppliers of factors of production Firms exist because they reduce contracting costs, – firms provide an efficient means of organising economic activity – [consider the alternative, an individual organising the production of a good: acquiring the raw materials organising various people to make the good] Contracts include all types of agreements between two or more parties (not necessarily written contracts)

Owner/manager contracting - 291 • •

Accounting information used to reduce agency costs Used as monitoring and bonding mechanisms to control the efforts of self-interested agents

If the Manager owned the firm, they would bear the costs associated with the his or hers Perquisite Consumption Perquisite consumption: Personal benefits, including direct benefits, such as the use of a firm car or expense account for personal business, and indirect benefits, such as up-to-date office decoration. Therefore, it is considered that managers will provide themselves with more benefits that would be unreasonable in the eyes of the principle • •

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Assuming 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: where some individuals have access to information that others do not have access to – further increases managers’ ability to undertake activities beneficial to themselves Costs of divergent behaviour are agency costs In the absence of controls to reduce opportunistic behaviour, agents (managers) expected to undertake activities disadvantageous to the value of the firm – Price Protect: An Individual or organisation price protects when it requires a higher rate of return to compensate the higher risk of investment 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 – known as bonding

Methods of rewarding managers • •

Fixed basis—salary independent of performance – manager may not take great risks as does not share in potential gains Salary plus remuneration is, in part, tied to firm performance – known as bonus schemes

Bonus Schemes - 292 

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Remuneration can be tied to: o profits of the firm o sales of the firm o return on assets All based on output from the accounting system May also be rewarded in line with market price of the firm’s shares

Accounting-based bonus plans -292 • • •

Any 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

Incentives to manipulate accounting numbers - 294 •

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The 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) – a change in accounting numbers will affect their rewards Bonuses based on profits cause short-term rather than long-term focus – may affect investment in positive NPV projects if returns not expected to be consistent evidence: Healy (1985) found: – managers adopt accounting methods to maximise bonus if contract rewarded managers after a pre-specified level of earnings reached – if income not expected to reach pre-specified minimum, managers shift earnings to future period (‘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 – short-term focus

Use of conservative accounting methods in management bonus schemes – 295 •

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Conservative accounting methods, which would include historical cost, tends 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 Potential conflicts of interest between agents and principals are 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

Market-based bonus schemes - 296 • •

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Apart from accounting-based bonus schemes, managers are also often provided with capital marketbased bonuses May be more appropriate to remunerate managers in terms of market value of firm’s securities (shares) where accounting earnings fluctuate greatly – e.g. mining, or high technology R&D firms – or where managers are approaching retirement Methods include: – cash bonus based on share price increases – shares – options to buy shares Providing 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) But, 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 regardless of how managers are rewarded there is always a maintained assumption within PAT that managers (and everybody else) will be opportunistic

Debt Contracts - 302 • •

the relationship with debtholders, in the absence of safeguards to protect debtholders (creditors), managers are predicted to adopt strategies to disadvantage the debtholders Agency costs of debt created by managers include – excessive 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 (claim dilution) – investment in high-risk projects may not be beneficial to debt holders as they have a fixed claim (asset substitution) – underinvestment

Use of debt contracts •

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In 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’ If firms contract not to pay excess dividends, take on high levels of debt, invest in risky projects, or under-invest then they can attract debt at lower cost Hence, it is efficient to enter into contracts that restrict the ability of managers to adversely affect the wealth of debtholders

Political costs • • • • •

Financial accounting also plays a key role in the political process Political costs are costs resulting from political attention from government, lobby groups etc. Commonly directed at larger firms – indication of market power May result in increased taxes, increased wage claims, product boycotts etc. Firms likely to adopt accounting methods to reduce profits to lower political scrutiny

Political actions of individuals • • • •

Limited expected ‘pay-off’ results from the actions of individuals Results in formation of interest groups Information costs shared, ability to investigate government and business action increases Given self-interest, representatives of interest groups predicted to maximise own welfare as constituents have limited motivation or means to be fully informed

Actions of politicians • •

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Politicians know that highly profitable companies could be unpopular with members of their constituency Politicians (who are assumed to be driven by self-interest like everybody else) could win votes by taking actions against the companies – argue that it is in public interest even though in own interest May rely on reported profits to justify actions – provides incentives for firms to reduce reported profits

Evaluation of PAT • •

PAT fills the gap in explaining motivators for accounting policy choice Relaxing assumptions about market efficiency • Some assumptions about market efficiency have been challenged recently • Market reactions to information often found to be longer than would be anticipated from an ‘efficient market’. Also market found to sometimes ‘under-react’ to particular announcements • Created new areas for research—for example what factors influence ‘earnings drift’

Criticisms of PAT • • • • •

does not provide prescription is not value-free as it asserts assumption that all action is driven by self-interest is argued to be too negative and simplistic a perspective of humankind has not shown great development Is undertaking large-scale empirical research, and arguably ignore organisational-specific relationships (researchers’ philosophical conflicts, i.e. scientific versus interpretive; normative versus positivistic; qualitative versus quantitative research)

See Topic 1 for details about evaluating a theory

PART B – Chapter 10 Capital Market Research - 500 Investigates how the disclosure of particular information influences the aggregate trading activities by individuals participating within capital markets. capital markets react in an efficient and unbiased manner to publicly available information • The use of accounting information by investors is therefore of central importance to the accounting profession, in particular, the issue of whether accounting information is used by investors in their decision making processes • capital markets research explores the market’s (investors in aggregate) reaction to various releases of information – including accounting information – and therefore capital markets research should be of interest to the accounting profession • • • •

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Information about earnings and its components is the primary purpose of financial reporting (objective of GPFR) Explores the role of accounting and other financial information in equity markets Involves examining statistical relations between financial information and share prices Reactions of inv...