L06Positive

L06Positive - 1Positive Accounting Theory and Economic...

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1Positive Accounting Theory and Economic Consequences of Accounting Choice A.Introduction Definition: Positive accounting theory : is concerned with predicting such actions as the choices of accounting policies by firms (i.e., senior management) and how firms will respond to proposed new accounting standards. Positive theory (in general) tries to further our understanding of “what is,” in contrast to normative theory, which tries to prescribe what should be. However, this does not mean that positive theory is only about what is the status quo. An understanding of the forces that drive current behaviour helps us to predict how events will unfold in the future. Just as the theory of gravitation was derived from observing the behaviour of physical objects such as planets, the laws of motion also help us predict planetary orbits. B. Why accounting matters – contract theory From the discussion in previous lectures about efficient markets, it would seem that accounting choices matter very little, if at all. Why? Because capital market participants can undo whatever accounting choices managers make. The key to understanding why accounting matters is to recognize the role of accounting information in settings outside the capital market. In particular, the contracting role of accounting is substantial. The importance of the contracting role is clearly evident when a business enterprise is viewed as a “nexus of contracts.” An enterprise can be thought of as a collection of contracts between managers and shareholders, managers and subordinates, shareholders and suppliers, shareholders and debtholders, and so on. These contracts may be explicit (a loan agreement) or implicit (relationships with vendors or customers). In many of these contracts, reference will be made to accounting numbers. There are two distinct roles for accounting in contracts. To see this, think about the essential ingredients required to enforce a provision of any contract. 6-1
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First, an agreed upon rule is required. For example, a loan agreement might require the company to maintain a debt-to-equity ratio below 2. Second, the contract requires a standard or instrument to measure whether the parties are in compliance with the rule. GAAP generally serves this role, but other accounting alternatives are possible if specified in the contract. Third, an actual measurement is required to check for compliance. In the example, the debt- to-equity ratio would usually be calculated at year-end (or at some other time specified in the contract). Thus, accounting is involved in the latter two of these three components. GAAP provides the standards of measurement, and the financial statements provide those measurements. To confirm your understanding of the role of accounting in contracting, think about how
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L06Positive - 1Positive Accounting Theory and Economic...

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