ACC518 - Positive Accounting Theory

Main ideas / concepts conveyed

• Purpose of Positive Accounting Theory (PAT)

  • PAT aims to explain why accounting outcomes happen and predict what accounting choices managers/accountants are likely to make in given circumstances.
  • It is contrasted with normative (prescriptive) accounting theories, which tell managers/accountants what they should do.

• Positive vs. normative theories

  • Positive theories:
    • Explain/predict behavior (“why something happens”).
    • Do not instruct managers what to do.
    • Predict which accounting methods managers are likely to select under certain incentives/constraints.
  • Normative theories:
    • Are prescriptive (“what should be done”).
    • Have a historical basis (as referenced by the lecturer, though details aren’t provided).

• Core assumption behind PAT

  • Individuals (managers) are assumed to act from self-interest / self-wealth maximization.
  • The lecturer notes some real-world counterexamples (people may act nobly or for other goals), but PAT’s working assumption treats self-interest as dominant.

• Why PAT is studied / where it shows up

  • The lecturer frames PAT as observable in business life and everyday experience.
  • Course relevance is tied to motivations and incentives shaping managers’ decisions.

• Terminology confusion noted in the lecture

  • “positive accounting theory” (lowercase) refers to a general type of positive theories.
  • Positive Accounting Theory (capitalized) refers to a specific theory associated with Watts and Zimmerman.
  • The capitalized name can be confusing because it overlaps with the general school of theories.

• Underlying relationships PAT focuses on

  • PAT emphasizes agency relationships:
    • Owners (shareholders) delegate decision-making to managers/agents.
    • Owners do not fully trust managers to act solely for the firm’s interests, so they monitor/control them.
  • Agency monitoring tools and mechanisms:
    • Monitoring (including financial reporting and audits)
    • Bonding: contractual arrangements meant to align manager actions with owner expectations
    • Agency costs, including unavoidable residual loss (managers can still act opportunistically)

• Efficient Markets Hypothesis link

  • PAT is described as evolving from the efficient markets hypothesis:
    • Share prices react to information (e.g., earnings announcements).
  • Ball & Brown (1968) is used as evidence:
    • Positive earnings announcements → share price rises
    • Negative earnings announcements → share price falls
  • Key limitation:
    • This market-reaction evidence shows earnings matter, but it doesn’t explain why specific accounting methods are chosen—that’s where PAT’s incentive/contract focus comes in.

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Methodology / structure (the “hypotheses” PAT uses)

PAT’s framework, as described, contains three main hypotheses. Each predicts what accounting method a manager may select based on incentives and pressures.

1) Bonus Plan Hypothesis (Management Compensation Hypothesis)

• Main prediction

  • Managers in firms with bonus plans are more likely to choose accounting methods that increase current-period reported income.

• Rationale (incentive mechanism)

  • Bonuses are assumed to increase the manager’s self-interest payoff (higher personal compensation).

• Likely accounting behavior

  • Choose accounting methods that make the firm look more profitable in the bonus-relevant period.

• Examples of opportunistic timing/manipulation

  • If managers won’t reach a bonus threshold, they may shift earnings to a future period (e.g., delaying recognition of invoices until after period end).

• Empirical support described

  • Evidence suggests managers manage earnings to maximize bonuses, including shifting income across periods.

• Observed behavioral consequence

  • Incentives can create short-term focus over long-term value creation.

• Additional examples given

  • Managers nearing retirement may be less likely to fund long-term R&D when compensation is tied to near-term accounting performance measures.

2) Debt Hypothesis (Agency Costs of Debt)

• Main prediction

  • The higher the firm’s debt-to-equity ratio / leverage, the more likely managers are to use accounting methods that increase reported income.

• Rationale (debt contract constraints)

  • Debt contracts (bank loans) often include constraints (e.g., covenants) tested with accounting numbers.
  • Managers benefit if results avoid covenant violations, helping preserve access to financing.

• Likely accounting behavior

  • Manipulate/report in ways that keep key ratios within covenant limits.
  • Use discretion in accruals and accounting choices.

• Concept of incentive over time

  • Incentive to manipulate increases as the firm approaches covenant breach.

• Other related pressures

  • Risk and interest rates can be linked:
    • Higher risk may mean higher interest rates.
    • Managers may try to appear less risky to negotiate better terms.

• Empirical support described

  • References include research such as “Lell and Loer and Martin” and a “CTer in 98” citation (as stated) about leverage covenants and accounting manipulation near thresholds.

• Examples of covenant measures mentioned

  • Debt-to-assets
  • Interest coverage
  • Current ratio
  • Coverage/threshold ranges (including interest coverage requirements, as described)

3) Political Cost Hypothesis

• Main prediction

  • Larger firms (size) face more political attention (“political cost” pressure), leading managers to reduce reported profits to lessen scrutiny.

• Proxy variable

  • Firm size is treated as a proxy for political attention.

• Why political attention matters

  • Scrutiny from governments, lobby groups, collective action, and public opinion can lead to:
    • Higher taxes
    • Wage claims/product boycotts
    • Regulatory changes (e.g., “super profits tax” style policies)

• Likely accounting behavior

  • Use accounting methods that reduce profits to lower political pressure.

• Illustrative examples mentioned

  • Shell example: large profits with minimal Australian tax due to transfer pricing leads to senate inquiry and potential regulatory/tax changes—PAT predicts managers would reduce reported profits/accounting-managed figures.

• Lobby group mechanism

  • Political costs are not only government-driven:
    • Interest groups can pool resources to investigate more effectively than individuals.
    • Representatives may act to maximize constituents’ welfare, influencing corporate outcomes.

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Usefulness and limitations / criticisms of PAT

• No direct prescription

  • PAT does not tell managers which accounting method to use; it predicts likely choices.

• Not value-free in practice

  • Criticism: PAT is based on an overly negative/simplistic view of humans as purely self-interested.

• Limited development / dated evidence

  • The lecture suggests that empirical/theoretical development hasn’t advanced much, implying older research dominance.

• Limits of large-scale empirical research

  • Much research uses broad capital market data (e.g., share price reactions), which may:
    • Ignore organizational-specific relationships
    • Ignore how internal structures (owners/managers/debt holders/political connections) drive behavior more directly than market-wide patterns.

• How this affects interpretation

  • Share price reactions to earnings announcements may not fully capture the managerial incentives shaping accounting-method selection.

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Speakers / sources featured (identified in the subtitles)

Speaker(s)

• Unspecified lecturer (the subtitles do not name the speaker)

Named researchers / sources

• Watts and Zimmerman (for the specific “Positive Accounting Theory” referenced)
• Jerry R. Ross (as spoken) — subtitle text appears garbled (“Jerry RS and Ross simmerman”); the lecturer later attributes the capitalized theory clearly to Watts and Zimmerman
• Ball and Brown (1968)
• Lell (Lell and Loer) and Martin (1987) (spelling/names appear subtitle-erroneous in the text, per the retirement/R&D discussion)
• “CTer in 98” (subtitle-unclear; context suggests leverage covenant/loan agreement research)
• Shell (company example)
• BHP (company example)
• QBE (company example)
• Australia (policy/regulatory examples; no individual cited)