9.403 Chapter 8 Summary Feb.

27, 02

Financial Accounting Theory

Chapter 8 – Summary The Positive Theory of Accounting

8.1 Outline

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 shareholders, but what will be the
most beneficial to their organization. The choices that an organization makes are
dependant on what industry they are in, and the factors within that industry.

An organization can be portrayed by the contracts it enters into. A firm’s

contracts with employees, suppliers, lenders, and shareholders are central to its
operations. The organization is inclined to keep these contract costs as low as
possible. PAT emphasizes that an organization’s choice of accounting policies is
motivated by keeping contract costs down. PAT does not propose that
organizations completely identify what accounting policies they will use. Such
specification is costly to commit to, and does not give management the
opportunity to respond to unforeseen circumstances.

Managers have flexibility to choose from a set of accounting policies, and

these options let them choose the policies that are the most beneficial to them.
The most favourable accounting policies are a balance of minimal costs, and
flexibility to give management the option of changing policies in response to
9.403 Chapter 8 Summary Feb. 27, 02

changes in their external environment. The ultimate objective of PAT is to

comprehend and forecast accounting policy choice across different firms, and
different industries.

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.
9.403 Chapter 8 Summary Feb. 27, 02

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

of PAT

Positive accounting theory can be classified as opportunistic and efficient

versions. The three hypotheses of PAT are presented in opportunistic form.
Managers choose accounting policies to maximize their own expected utility
relative to their bonus plan, debt covenants, and political costs. Management
chooses accounting policies that minimize their contract costs. These policies
9.403 Chapter 8 Summary Feb. 27, 02

can also be chosen on an efficiency criterion. Quite often, these two theories
make similar forecasts. It is difficult to determine whether opportunism or
efficiency is driving the policy changes.

Research has addressed this problem. Christie and Zimmerman

investigated the frequency of firms that faced takeover, to use income-increasing
accounting policies to maximize reported net income and financial position. They
found that these policy changes were not used to avoid possible takeover, and
that were not as opportunistic as originally thought.

Sweeney discovered that managers would change accounting policies in

response to debt covenant problems, only when it was cost-effective. In another
study, Sweeney found that firms that would benefit opportunistically through
substantial tax costs from switching accounting policies, chose not to do so – in
favour of a more efficient alternative. Her results show support for both the
opportunistic and efficient views of hypotheses, and firm specific analysis is
required to distinguish between the two. Dechow did research that found net
income to be more highly associated with net returns than cash flow.
Subramanyam that manager’s choices of discretionary accruals served to
improve the predictive value of current earnings to predict future earnings.
These findings support the efficient contracting version of PAT, as opposed to
the opportunistic.

8.5 Conclusion

Positive accounting theory is used to predict and comprehend the

accounting policy choices that firms make. It is introduced as a way to merge
market theory with economic consequences.
9.403 Chapter 8 Summary Feb. 27, 02

Quiz

True/False Questions

1. The Three Hypotheses of Positive Accounting Theory all lead to

empirically testable predictions

2. One would expect that managers of firms with bonus plans would oppose
proposed accounting standards that may lower reported net income.

3. Foreign competition may lead to reduced profitability unless affected firms

can influence the political process to grant import protection.

4. The sheer size of an organization can lead to political costs.

5. The prospect of covenant violation constrains management’s actions in

running the firm.

6. We would expect that managers of firms with bonus plans would welcome
proposed accounting standards that may lower reported net income.

7. A firm can be viewed by the set of contracts it enters into, so a firm will
want to minimize its various contracting costs associated with these
contracts?

8. Sweeney did not support both versions of PAT from her research.

9. A firm can be viewed by the set of contracts it enters into, so a firm will
want to minimize its various contracting costs associated with these
contracts?

10. Sweeney researched firms that were first time debt covenant violators.
These firms had significantly more voluntary accounting policy changes
that decreased income to avoid covenant violation
9.403 Chapter 8 Summary Feb. 27, 02

Multiple Choice Questions

1. The Political Cost Hypothesis states that the closer a firm is to violating
debt covenants, the more likely they are to:

a) shift reported profits from current to future periods

b) make arrangements, to pay back the debt
c) shift reported profits from future to current periods
d) negotiate to ease the debt covenants

2. Which one of these is not one of the Three Hypotheses of Positive

Accounting?

a) The Political Cost Hypothesis

b) The Bonus Plan Hypothesis
c) The Debt Covenant Hypothesis
d) The Normative Opportunistic Hypothesis

3. According to Positive Accounting Theory, if a firm wants to maximize its

probability for survival it would:

a) organize itself to have a large amount of capital assets

b) organize itself in the most efficient manner
c) organize itself to have less debts
d) organize itself to acquire more dependable employees

4. According to PAT, the opportunistic form can be stated in “________” form

which both make __________ predictions?

a) efficiency, different
b) efficiency, similar
c) positive, different
d) positive, similar
9.403 Chapter 8 Summary Feb. 27, 02

5. Positive accounting theory has generated a large amount of ______

research. Lev emphasized on how investors ______ react to the prospect of
policy changes in oil and gas firms, not on how firms and investors ______ react.

a) nominal, did, should

b) nominal, should, did
c) empirical, should, did
d) empirical, did, should

6. Delaying payment of current liabilities, writing off large amounts of slow-

moving inventory , and lowering receivables are all examples of ______.

a) total accruals
b) negative accruals
c) discretionary accruals
d) positive accruals

Short Answer Questions

1. Which of the three hypotheses of positive accounting deals with debt, and
what is the reasoning behind the hypothesis?

2. Define Opportunistic behavior? Give an example?

3. Briefly describe what Christie and Zimmerman found in their study?

4. Explain how defaulting firms, that Sweeney researched, confirm

assumptions of the debt covenant hypothesis and give specific examples
of accounting policy changes they used.

5. What are discretionary accruals and give examples of some. How could
these accruals be used concerning firms that are unfairly affected by
foreign competition
9.403 Chapter 8 Summary Feb. 27, 02

Quiz Answers

True/False

1. True
2. True
3. True
4. True
5. True
6. False
7. True
8. False
9. False
10. False

Multiple Choice

1. C
2. D
3. B
4. B
5. D
6. B

Short Answer

1. The debt covenant hypothesis deals with debt, and it states that all
other things being equal, the closer a firm is to violation of accounting-
based debt covenants, the more likely the firm manager is to select
accounting procedures that shift reported earnings from future periods to
the current period.
9.403 Chapter 8 Summary Feb. 27, 02

2. Opportunistic behaviour- Given the available set, managers may

choose accounting policies from their set for their own interests.
Ex: Managers who are actively exploring oil companies whose
remuneration contracts are based on reported net income may choose
full-cost accounting over successful-efforts with the intention to smooth out
income and increase the present value of their bonus streams.

3. Christie and Zimmerman found that although firms who have

become takeover targets were expected to have behaved
opportunistically, showed that income-increasing accounting policies were
relatively small.

4. The debt covenant hypothesis implies that a firm's main managerial

objective is to minimize problems with creditors. Especially at times where
firms are close to violating accounting-based debt covenants, they are
more likely to select accounting procedures that shift reported earnings
from future periods to the current period. Basically firms choose
accounting procedures that increase income to avoid these violations with
creditors.
This is exemplified in Sweeney's research. She has shown that in
comparison to control sample firms, among years prior to default, the
defaulting firms made significantly more voluntary income-increasing
accounting policy changes. They did this to avoid violating any covenants
to decrease costs incurred, such as, increased security, restrictions on
further borrowing, and higher interest rates. Examples of income
increasing accounting changes include adoption of FIFO inventory,
liquidation of LIFO inventory layers changes in pension plan assumptions,
and pension terminations.

5. Discretionary accruals are hard-to-detect manipulations of accounting

policy changes relating to accruals. These accrual values are estimated
from the professional judgment of firm managers. These values can be
increased or decreased depending on the circumstances that the firm
faces. Some examples are increase of depreciation and amortization
charges, it may record excessive liabilities for product guarantees,
contingencies, and rebates, and it may record generous provisions for
doubtful accounts and obsolescence of inventories.
Discretionary accruals can be used to report a lower net income during
import relief investigations. Firms that are unfairly affected by foreign
competition typically need assistance in the form of trade legislation.
9.403 Chapter 8 Summary Feb. 27, 02

Discretionary accruals allow firms to bolster their case of a lower reported

net income. The fact that they are hard to detect strengthens
disincentives to uncover earnings manipulation by the International Trades
Commission and consumers alike. Thus, making discretionary accruals a
good tool for firms to use when relief is needed from foreign competition.