Professional Documents
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LEARNING OBJECTIVES
At
Agency theory
Political processes
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POSITIVE ACCOUNTING
THEORY
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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
Copyright@2005 by Rohana Othman. All rights reserved. 4/3/2013
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.
Copyright@2005 by Rohana Othman. All rights reserved. 4/3/2013
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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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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Copyright@2005 by Rohana Othman. All rights reserved. 4/3/2013
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.
Copyright@2005 by Rohana Othman. All rights reserved.
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account
Limitations
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)
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.
Copyright@2005 by Rohana Othman. All rights reserved. 4/3/2013
SCOPE OF PAT
Positive Accounting Theory
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SCOPE OF PAT
PAT PAT
PAT
However,
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SCOPE OF PAT
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SCOPE OF PAT
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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
Copyright@2005 by Rohana Othman. All rights reserved.
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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
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.
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PAT HYPOTHESES
Managers
choose less conservative accounting policy & oppose accounting standards that may lower reported net income than managers of firms without such plan
Managers
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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Descriptive, Objective
of PAT is to explain & predict accounting practice science to predict unobserved phenomena & verifiable
Observable Derived
Analytic
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
Value judgment of the rightness or wrongness or usefulness of something base on persona; view.
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Describe how people behave Explain why people behave in a certain manner Predict what people have done or will do
Suggestion:
other
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CONTRACTING THEORY
Firm is a legal nexus (connection) of contractual relationships amongst suppliers and consumers of factors of production
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
Copyright@2005 by Rohana Othman. All rights reserved.
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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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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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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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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
Copyright@2005 by Rohana Othman. All rights reserved. 4/3/2013
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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
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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