Topic 6x - ACCT3003 Issues in Accounting Theory 2009 Topic 6 Positive accounting theory Solutions to topic review questions 7.1 Early research

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Unformatted text preview: ACCT3003 Issues in Accounting Theory 2009 Topic 6: Positive accounting theory Solutions to topic review questions 7.1 Early research considering share price reactions to accounting information relied on various assumptions about the efficiency of the capital market and assumed that capital market participants could ‘undo’ the effects of organisations using different accounting methods. It also assumed the absence of transaction costs. Accepting these assumptions, and to the extent that the selection of accounting method did not affect taxation, then the choice of accounting method would have limited implications for the firm and hence managers should be indifferent when choosing between alternative accounting methods. However, evidence indicates that managers are not indifferent. The development of agency theory suggested that where there is a delegation of decision making within an organisation there can be inefficiencies because agents will not necessarily work in the interests of the organisation, but rather, will work in their own interests. However, the principals will anticipate the opportunistic actions of the agents and will reduce their payments accordingly (that is, the principals will price protect). To minimise the agency costs, and to align the interests of principles and agents, numerous contractual arrangements will be put in place. Accepting the perspectives provided by Agency Theory, Watts and Zimmerman (1978) showed how accounting‐based contractual arrangements can act to minimise the transaction costs that might arise within an organisation. The choice of one method of accounting in preference to another was deemed to be important in maximising the value of an organisation. Because there are many uncertainties when investing or lending funds to an organisation managers will agree to provide investors and lenders with financial statements. This reduced risk associated with being able to monitor the performance of the entity will be expected to reduce the costs associated with attracting funds to the entity. Because some methods of accounting are able to better reflect the performance of an entity, managers will select some methods in preference to others (the efficiency perspective). This will have direct implications for the cost of attracting funds into the organisations. Issues in Accounting Theory 2009 Solutions: Topic 6 1 7.2 Further, accepting that managers might not always work in the interests of the owners, it is common to find accounting‐based bonus plans. Again, some methods of accounting might be more relevant in some organisations than alternative methods of accounting, and again, PAT provides an explanation for why certain accounting methods might be selected in preference to others. Managers are often rewarded in terms of accounting‐based bonus plans. Such plans are introduced to align the interests of the managers of the firm with those of the owners. The establishment of management bonus plans can be explained from an efficiency perspective. The management bonus plan hypothesis predicts that managers who are rewarded in terms of accounting numbers are more likely to select accounting methods that increase income to the extent that this will lead to an increase in the size of the bonus. This is an opportunistic perspective. (The efficiency perspective relates to the initial establishment of the bonus scheme and the opportunistic perspective relates to the subsequent efforts to manipulate profits, and hence, the bonus.) The debt hypothesis (also called the debt/equity hypothesis) predicts that firms with higher debt/equity or debt/assets ratios are more likely to adopt accounting methods which increase income (and assets and residual equity) than firms with lower ratios. This prediction is made on the basis of an assumption that firms will have entered into debt contracts with external lenders (with the purpose of reducing agency costs and hence explained from an efficiency perspective) and these debt contracts will rely upon accounting numbers. The incentive to adopt income increasing methods will increase the closer the firm comes to breaching the accounting‐based debt covenant. While debt contracts will initially be entered into in an endeavour to reduce the costs of borrowing (the efficiency perspective), the view that management will subsequently choose ‘favourable’ methods to loosen the restrictions imposed by debt‐related contractual covenants is considered to represent an opportunistic perspective. It is predicted by Positive Accounting Theory (PAT) that on an ex ante basis (that is, upfront), mechanisms will be put in place that align the interests of the managers (agents) with those of the owners (as principals). As the evidence provided in the chapter indicates, such mechanisms will include offering management a bonus which is tied to reported profits. Assuming self‐interest, such mechanisms will lead to a reduction in agency costs (they will encourage the self‐interested manager to work harder) and hence can be explained from an efficiency perspective. 7.3 Issues in Accounting Theory 2009 Solutions: Topic 6 2 However, maintaining the assumption of self‐interest, it is assumed that once a profit‐sharing bonus scheme is put in place then management will seek to undertake actions to increase the size of the bonus, and hence their own financial rewards. One way is to work harder, but another way is to manipulate reported profits by selecting accounting methods that lead to an increase in reported profits (the opportunistic perspective). Within PAT it is assumed that principals expect managers to be opportunistic and unless managers can demonstrate that they have not been opportunistic principals will assume that they have been, and accordingly, the principal will pay the managers a lower salary (this is called ‘price protection’). The lower salary compensates the principals for the expected opportunistic behaviour of the agents. To reduce this ability to be opportunistic (with consequent implications for increasing the managers’ bonuses) contractual agreements will be put in place up front to reduce the ability of the managers to manipulate accounting profits (but this ability can never be fully removed). Such agreements may include a clause which restricts the choice management has when selecting between alternative accounting methods, or it may include a requirement that the financial statements be audited by an independent third party who will attest to whether appropriate accounting methods have been selected by the manager. An agency relationship occurs when decision‐making authority is delegated from one party (the principal) to another party (the agent). Jensen and Meckling (1976, p. 308) define the agency relationship as: A contract under which one or more (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision‐making authority to the agent. From the Agency Theory perspective, the contract itself does not need to be written. Because it is assumed that all individuals will act in their own self‐ interest there will be costs (agency costs) associated with appointing agents to make decisions on behalf of the principals. Agency costs can be defined as costs that arise as a result of the agency relationship and relate to the costs that arise as a result of the process of delegating decision making to others. Pursuant to Agency Theory it is argued that various contractual arrangements will be put in place to minimise anticipated agency costs, and hence to increase the value of the organisation. For example, to minimise the agency costs relating to appointing a manager, contractual arrangements might be put in place to provide the manager with a share of profits. That way, the manager will be motivated to make decisions that lead to an increase in Issues in Accounting Theory 2009 Solutions: Topic 6 3 7.4 7.5 profits, and all things being equal, this will also be in the interests of the owners. An organisation is considered to represent a nexus of contracts between many self‐interested individuals and the reason for having the various contracts is to reduce the agency costs that the organisation might otherwise encounter and, consequently, to maximise the expected value of the organisation. Political costs are those costs that particular groups external to the firm may be able to impose on the firm as a result of various actions. For example, the costs associated with the community lobbying the government to decrease the subsidy support for an organisation, the costs associated with labour unions taking actions to increase the wages of their members, or the costs associated with consumer boycotts associated with the firm’s products. The political cost hypothesis predicts that those organisations under political scrutiny (usually assumed to be larger firms) will undertake actions to minimise the possibility of adverse cash flows associated with the scrutiny. For example, if a company is being scrutinised in a particular period because of its perceived monopoly powers and those external parties undertaking the scrutiny claim that these monopoly powers enable it to generate excessive profits then in such periods the entity may elect to adopt accounting methods which reduce its reported profits, and hence, its susceptibility to actions to reduce the wealth of the organisation (perhaps, in the form of increased taxes). Watts and Zimmerman provide the following explanation of the political cost hypothesis: The political cost hypothesis predicts that 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. Underlying this hypothesis is the assumption that it is costly for individuals to become informed about whether accounting profits really represent monopoly profits and to ‘contract’ with others in the political process to enact laws and regulations that enhance their welfare. Thus rational individuals are less than fully informed. The political process is no different from the market process in that respect. Given the cost of information and monitoring, managers have incentive to exercise discretion over accounting profits and the parties in the political process settle for a rational amount of ex post opportunism (1990, p. 139). Issues in Accounting Theory 2009 Solutions: Topic 6 4 7.6 As reflected in the above quote, the political cost hypothesis assumes that various parties will simply react to the quantum of reported profits and will not necessarily focus on which accounting methods were used to generate these profits. The efficiency perspective takes the view that contractual arrangements will be designed to reduce future conflicts of interest (and associated agency costs) between various individuals involved in the operations of an organisation. Well‐designed contracts are expected to reduce future transaction costs. By reducing future costs, well‐designed contracts can have the effect of increasing the value of an organisation. Because the contractual arrangements are designed to reduce future conflicts they are considered to be introduced on an ex ante (up‐front) basis. Many of the contractual arrangements use the output of the accounting system (such as rewarding managers on the basis of a share of profits, or utilising debt to asset ratios in debt contracts). The opportunistic perspective relies upon the assumption that individuals are always motivated by their own self‐interest (at the possible expense of others) and once they enter contractual arrangements they will subsequently capitalise upon any flexibility within the contracts to cause any related pay‐ offs to be more favourable to themselves (again, at the expense of others). Because it is not practical to attempt to write ‘complete contracts’, there will always tend to be some degree of flexibility in most agreements and it is anticipated that the opportunistic manager will uncover such flexibility. In relation to the selection of accounting methods, independent external auditors will frequently be used to ensure that the accounting methods adopted by managers appear to be reasonable and in accordance with generally accepted accounting practice. Because the opportunistic behaviours frequently occur after transactions have been negotiated (after the fact) the actions are described as occurring on an ex ante basis. (a) The perspective taken by PAT is that organisations can elect to either enter, or not enter, contracts which provide various safeguards to debtholders. It is anticipated that debt funds would be available in either case (perhaps not necessarily from the same investors, but perhaps from other market participants). However, assuming the notion of price protection, those firms that provide contractual safeguards (and hence reduce the expected risk associated with the debtholders’ funds) will attract funds at a lower cost than might otherwise be available. Hence, while organisations might be able to 5 7.8 Issues in Accounting Theory 2009 Solutions: Topic 6 attract funds in the absence of negotiated safeguards, organisations that negotiate to restrict their ability to expropriate debtholders’ wealth will be expected to attract funds at lower cost and this in itself will motivate managers to agree to such arrangements (which might include agreements not to use the funds in particular types of investments, to borrow additional or excessive levels of debt from other parties, or to pay dividends unless certain earnings requirements are met). (b) The argument is that capital markets are efficient and that higher risk requires a higher rate of return. Hence, it is assumed that debtholders are indifferent such that if organisations do not contractually commit to restrict actions which might be detrimental to the interests of the debtholders then the debtholders (the same debtholders or other participants in the market) will simply charge a higher price for the funds in the form of higher interest charges—that is, they will price protect. The view taken is that the expected returns (based on agreed future cash flows and the probability of receiving the interest and principal repayments) to debtholders do not change as a result of particular contractual arrangements, and hence debtholders neither gain nor lose as result of negotiating restrictive covenants (while negotiated safeguards will reduce the amount of the interest payments, the probability of the debtholders ultimately receiving the cash flows will increase and hence the risk rate will decline). 7.10 According to Watts and Zimmerman (1990, p.139) the political cost hypothesis predicts that large firms rather than small firms are more likely to use accounting choices that reduce reported profits. Size is deemed to be a proxy variable for political attention ‐ that is, the larger the organisation the more likely it is assumed to be subject to political scrutiny. If we assume that an entity is subject to a high degree of political scrutiny, and if we assume that high profits will attract unwanted political attention, the entity would expense an item of expenditure rather than capitalizing it. 7.11 (a) The debt/equity hypothesis predicts that the higher the firm’s debt/equity (or debt/asset) ratio, the more likely managers will use accounting methods that increase income (increase assets) and thereby decrease the likelihood that an entity would breach any debt covenants that might exist. Issues in Accounting Theory 2009 Solutions: Topic 6 6 If Kahuna Company Ltd undertook an upward revaluation just prior to year end the debt hypothesis would suggest that perhaps the company was close to breaching a debt covenant and the revaluation was required to reduce the likely of a technical default of the debt agreement. The management compensation (or bonus plan) hypothesis predicts that managers of firms with bonus plans [tied to reported income] are more likely to use accounting methods that increase current period reported income. To determine whether the act of undertaking an upward asset revaluation is consistent with the management compensation hypothesis we need to establish whether an upward revaluation has the implication of increasing reported profits. If we undertake an upward revaluation, and the assets are depreciable, then this will increase the depreciable base of the assets leading to an increase in depreciation expense and therefore a reduction in profits. Further, the upward revaluation will result in a credit to revaluation surplus, rather than being treated as part of profits. Also, any gain on sale of a non‐current asset will be reduced as a result of a revaluation increment (the gain on sale being the difference between the fair value of the consideration less the carrying amount of the asset). Hence, the effect of an upward revaluation is to decrease reported profits despite the fact that the revaluation acts to increase the net assets of the entity. Therefore, an upward revaluation cannot be explained by the management compensation hypothesis. If we accept that PAT provides sound predictions or explanation of accounting choices then perhaps the firm was close to breaching a debt covenant and the benefits to managers of avoiding the breach more than offset the potentially negative impacts on management compensation (also, the firm may have been subject to political costs and an upward revaluation may have been part of a portfolio of accounting choices used to reduce reported income and therefore the possibility of political costs being imposed). (b) Issues in Accounting Theory 2009 Solutions: Topic 6 7 7.14 There are a number of criticisms of PAT: • One criticism of PAT is that by limiting its focus to explaining and predicting accounting practice it fails to provide guidance to practitioners. In defence, Positive Accounting theorists might argue that before we prescribe one method of accounting in preference to others it is necessary to predict the consequences of alternative methods of accounting. • Another criticism of PAT is that it is not value free as it asserts. As explained in this chapter, no research can really be value free. Hence, while we might not criticise PAT because it is not value free, we can challenge the early claims that it was value free. • A further criticism that has been made of PAT relates to the assumption that all individual actions are driven by wealth maximising self‐interest considerations. Some individuals consider that such a perspective provides a ‘morally bankrupt view of the world in general and of accounting in particular’. However, most theories about human behaviour rely upon simplifying assumptions about how people behave. At issue is whether the assumption is too simplistic. • PAT provides predictions which are not always supported by available evidence. However, we can probably expect that most theories about human behaviour will not always provide accurate predictions of actual behaviour. • PAT relies upon various assumptions about the efficiency of markets, including the capital market, the managerial labour market and the market for corporate takeovers. In practice markets will not always be efficient. Further, Positive Accounting theorists often use the idea of efficient markets to support calls for the deregulation of accounting practice by arguing that accounting information should be treated like any other good, and hence, the forces of supply and demand should be allowed to operate to determine the optimal amounts of information to produce. Such a perspective ignores the fact that accounting information has ‘public good’ characteristics (the good can be used without payment), and that it is generally accepted that markets do not operate efficiently with respect to public goods. • PAT researchers typically undertake their research by collecting a large number of observations of data emanating from different reporting entities. They ignore many underlying differences in organisations and assume that their unit of measurement provides an accurate reflection of the issue under investigation (realist philosophy). Researchers that are critical of the PAT paradigm argue that no two organisations are the same and hence that doing large scale studies over many organisations is quite naïve. Issues in Accounting Theory 2009 Solutions: Topic 6 8 7.17 (a) It is accepted within PAT (as derived from economic and finance theory) that the value of an organisation is based upon expectations about future cash flows. Hence, if expectations about future cash flows change then the value of the firm’s securities will also change. There could be many contractual arrangements within a firm which rely upon profit calculations. For example, managers might be paid a percentage of profits or, due to restrictive debt covenants, managers may be restricted from taking on more debt unless certain levels of profits are achieved. Also, pursuant to the political cost hypothesis, a change in reported profits could have implications for the political visibility of an organisation with consequent implications for wealth transfers related to the political process. Hence, if an accounting standard has implications for reported profits, and if we accept the existence of political scrutiny linked to profitability, as well as the existence of various contractual arrangements with cash flows associated with reported profits, then the release of the new accounting standard can affect the value of the organisation. For example, the new requirements pertaining to goodwill which no longer require goodwill to be systematically amortised mean that, to the extent that the value of goodwill has not declined (there are no impairment losses), then reported profits will increase. This could have cash flow consequences because potentially this could increase the political scrutiny of the organisation, or it could lead to increases in bonuses paid to managers if they are given a percentage of reported profits. In either case, the change in cash flows could translate to a change in firm value. (b) From the ‘efficiency perspective’ of PAT it is assumed than managers will select accounting methods that best reflect the underlying performance of the entity. Among other things, this will enable them to attract funds at lower costs. If accounting regulators prohibit the use of methods that the firm had been using then it can be argued that the firm is then less able to present a reliable measure of the firm’s performance and this will have implications for the costs associated with attracting funds. That is, inefficiencies will be introduced. This view assumes that managers have an extremely comprehensive knowledge of the existence and relevance of alternative accounting methods. Issues in Accounting Theory 2009 Solutions: Topic 6 9 ...
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This note was uploaded on 04/30/2011 for the course ACCT 3003 taught by Professor Jennymarks during the Three '10 term at South Australia.

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