group81 - 8.1 Outline of Positive Accounting Theory...

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8.1 Outline of Positive Accounting Theory Positive accounting theory (PAT) is concerned with predicting such actions as the choices of accounting policies by firms and how firms will respond to proposed new accounting standards. Positive accounting theory helps us reconcile efficient securities market theory with economic consequences. It asserts that the contracts which firms enter into drive management’s concern about accounting policies. 8.2 Three Hypotheses of Positive Accounting Theory Watts and Zimmerman have formulated three hypotheses with regards to Positive Accounting Theory. The text defines the “opportunistic” form of these hypotheses as follows: The bonus plan hypothesis - Maximize compensation All other things being equal, managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period. The debt covenant hypothesis – Minimize problems with creditors 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. The political cost hypothesis - Minimize political heat All other things being equal, the greater the political costs faced by a firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods. The theory then predicts that managers will choose accounting policies to further these objectives. We can not infer fraudulent and unethical behaviour here; rather, the accounting policies that management chooses are typically all within GAAP. However,
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there is considerable room to manage reported net income under historical cost accounting. This can be done through choice of amortization policy, choice of full-cost versus successful-efforts for costs of oil and gas exploration, being conservative or optimistic about provisions for warranties and bad debts, and so on. It is obvious why financial accounting policies have economic consequences. New standards or the reduction of acceptable accounting policy alternatives may interfere with management’s attainment of its objectives. 8.3 Empirical PAT Research This section examines the large amount of empirical research that positive accounting theory (PAT) has generated. Healy (1985) found evidence regarding the bonus plan hypothesis. He discovered that managers of firms with bonus plans, based on reported net income, systematically adopted accrual policies to maximize their expected bonuses. Sweeney (1994) analyzed the debt covenant hypothesis, and found that defaulting firms voluntarily made more income-increasing policy changes than a control group of firms.
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