07 - Positive Accounting Theory
07 - Positive Accounting Theory
Agency Theory
Moral Hazard
Principal
Agent
Adverse Selection
Why it may be mutually beneficial to both parties to have an audit Why firms may lobby for certain accounting regulations
3
Agent
A party engaged as a steward to perform some service on the behalf of others, often involving safeguarding assets belonging to them. The principals delegate decision making authority to the agent Agent has access to superior information Agent may be able to act in ways unfavorable to or not approved by the principal shirking, fraud, etc. Agents also benefit from monitoring activities like an audit since such devices permit them to demonstrate effective performance and charge more for their services
Monitoring costs
Owner-Manager Relationship
That is, accounting policies are chosen strategically Positive (descriptive) rather than normative. Tries to understand and predict managers accounting policy choices
6
ASSUMPTIONS OF PAT
Firm is a nexus of contracts Managers are rational economic decision makers
Act to maximize their own utility, which may not include the firms profits May be effort averse (lazy)
Hypotheses of PAT
Bonus Plan Hypothesis Management chooses policies to shift earnings to improve their bonus Current earnings can go up or down Debt Covenant Hypothesis Policies chosen to shift future earnings to avoid violation of debt contracts Political Cost Hypothesis Defer earnings from current to future to minimize political heat Compliance Hypothesis Shift earnings to ensure that you meet regulator requirements
Versions of PAT
Opportunistic Version
Managers choose accounting policies to attain corporate governance objectives of the firm
9
Per Scott Text: significant evidence in favor of efficiency version of PAT This implies that the inherent conflict between investor and manager interests is reasonably controlled
10
Earnings Managment
Ways to Do It
Changing accounting policies Managing discretionary accruals Timing of adoption of new accounting standards Changing real variables--R&D, advertising, repairs & maintenance Structured transactions like SPEs Fraud like Worldcom capitalizing operating expenses
11
12
TAjt = j + 1jREVjt + 2jPPEjt + jt This is the simplified version of the model. TA is total accruals or Net Income Cash Flows
actual total accruals predicted total accruals The s are coefficients to be estimated. No relation to firm beta.
13
To maintain market share, net income should be correlated with manager effort
Most useful net income for investors is not necessarily the most highly correlated with manager effort
15