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POSITIVE ACCOUNTING THEORY (PAT) - Coggle Diagram
POSITIVE ACCOUNTING THEORY (PAT)
Positive theories
do not
prescribe
What should occur
– they
focus on explaining or predicting
what does occur
PAT
focuses on relationships
between
various individuals and explains
how accounting
is used to
assist
in the
functioning of these relationships
Assumptions underlying PAT
All
individuals
’ action is driven by
self-interest
and individuals will act
in an
opportunistic manner
to the extent that the actions will increase their wealth.
Key hypotheses
key hypotheses frequently
used to explain and predict support or opposition to an accounting method
. These hypotheses are central to understanding
how managers may act opportunistically
when selecting accounting methods.
debt
Debt Hypothesis: The debt hypothesis suggest that managers' accounting method choices are
influenced by the firm's debt contracts.
Specifically, managers may
select accounting methods that affect reported profits to minimize the costs of financial distress or to avoid violating debt covenants.
For example, managers may prefer accounting methods that smooth reported earnings to avoid signaling financial distress to creditors. Therefore, the debt hypothesis predicts that
managers will choose accounting methods that align with the firm's debt contracts
to minimize the costs associated with debt .
political
Political Cost Hypothesis: The political cost hypothesis suggests that
managers' accounting method choices are influenced by the firm's political environment and the potential costs of political intervention
. Large firms, rather than small firms, are more likely to use accounting choices
that reduce reported profits, as size is a proxy variable for political attention.
By reducing reported income,
firms may aim to reduce the possibility that stakeholders will argue that the organization is exploiting other parties.
Therefore, the political cost hypothesis predicts that managers will choose accounting methods that
minimize the potential political costs associated with high reported profits
bonus plan
Bonus Plan Hypothesis: This hypothesis suggests that managers' accounting method choices are
influenced by their compensation arrangements,
particularly bonus plans. Managers may
select accounting methods that maximize their short-term performance measures
, such as reported profits, to increase their bonus payments. Therefore, the bonus plan hypothesis
predicts that managers will choose accounting methods that lead to higher reported profits
when their bonuses are tied to reported performance measures
Orign of PAT
Firstly, there was a paradigm shift from normative theories to positive theories, which emphasized empirical observations and predictions based on real-world data
Additionally, the development of the Efficient Markets Hypothesis (EMH) by Fama and others provided an environment suitable for PAT research, as it suggested that capital markets react efficiently and unbiasedly to publicly available information.
Furthermore, the origins of PAT can also be linked to capital markets research. Ball and Brown's seminal paper in 1968, which investigated stock market reactions to accounting earnings announcements, was crucial to the acceptance of the positive research paradigm. Their findings provided evidence that historical cost information is useful to the market, but the literature was unable to explain why particular accounting methods were selected.
Moreover, agency theory played a crucial role in the development of PAT. Agency theory focuses on the relationships between principals and agents, such as between shareholders (principals) and managers (agents). It explains why the selection of particular accounting methods might matter, as information asymmetries create uncertainty, and transaction costs and information costs exist
Agency Theory
Agency theory is a branch of economics that focuses on the
relationships between principals and agents
. It seeks to explain how these relationships can be structured to minimize the costs associated with information asymmetry and opportunistic behavior.
In an agency relationship, one party
(the principal) hires
another party
(the agent) to perform some service on their behalf,
which involves delegating some decision-making authority to the agent
The central problem in agency theory is the
agency problem
, which
arises when the interests of the principal and the agent are not aligned.
This misalignment can occur because of differences in information, incentives, and risk preferences between the principal and the agent. For example, a manager may have an incentive to pursue their interests rather than those of the shareholders they represent, or they may have access to information that the shareholders do not have.
Agency theory assumes that
agents are self-interested
and motivated by their own goals, such as maximizing their wealth or power. This assumption is based on the idea that individuals are rational and seek to maximize their utility.
To address the agency problem, agency theory proposes various
mechanisms to align the interests of the principal and the agent
. These mechanisms
(agency cost)
include
monitoring, bonding, and incentives.
Monitoring involves the principal monitoring the agent's behavior to ensure that they are acting in the principal's best interests. Bonding involves the agent providing a financial guarantee to the principal to demonstrate their commitment to the relationship. Incentives involve aligning the agent's interests with those of the principal by providing them with financial or non-financial rewards for achieving certain goals.
firms and contract
A firm can be defined as a nexus of contracts between consumers of products and the suppliers of factors of production.
In other words, a firm is an organization that brings together various resources, such as labor, capital, and technology, to produce goods or services that are sold to consumers. The contracts between the various parties involved in the production and consumption of these goods and services define the relationships and obligations between them.
Contracts, in this context, refer to all types of agreements between two or more parties, not necessarily written contracts. These agreements can be formal or informal and can take many different forms, such as employment contracts, supply contracts, and sales contracts. Contracts define the terms of the relationship between the parties involved, including the rights and obligations of each party, the price to be paid, and the conditions under which the contract can be terminated.
By bringing together various resources and coordinating their use, firms can reduce the transaction costs associated with negotiating and enforcing contracts between individual parties. This is because firms can internalize many of the transactions that would otherwise take place in the market, such as the negotiation of prices and the monitoring of performance. In this way, firms can provide an efficient means of organizing economic activity and reducing the costs associated with contracting in the market.
Perspectives adopted by PAT research
Efficiency perspective
The efficiency perspective assumes that managers are rational and seek
to maximize the efficiency
of the firm's operations.
This perspective suggests that managers will
select
accounting methods that
most efficiently
reflect the underlying firm performance.
PAT theorists argue that regulation forcing firms to use a particular accounting method
imposes unwarranted costs
and introduces
inefficiencies
.
therefore the efficiency perspective predicts that managers will
choose
accounting methods that
minimize the costs
of information production and processing, and that maximize the efficiency of the firm's operations.
Opportunistic perspective
The opportunistic perspective assumes that
managers are self-interested
and
motivated by their own goals
, such as maximizing their wealth or power.
This perspective suggests that managers will
select
accounting methods
that maximize their interests,
even if these methods do not reflect the underlying firm performance.
The opportunistic perspective predicts that managers will
choose accounting methods that increase their wealth
or power, such as methods that increase reported profits to increase their bonuses or stock options
EMH
The Efficient Markets Hypothesis (EMH) is a theory in finance that suggests that
financial markets are efficient
and that
asset prices reflect all available information
.
This means that it is impossible to consistently achieve returns that are higher than the market average, as all available information is already reflected in asset prices.
The EMH has three forms: weak, semi-strong, and strong. The
weak
form suggests that asset prices reflect
all past market data
, the
semi-strong
form suggests that asset prices
reflect all publicly available information
, and the
strong
form suggests that asset prices
reflect all information, including insider information.
The EMH was important for PAT research because it provided a framework
for understanding how financial markets react
to accounting information.
Researchers such as Ball and Brown (1968) used the EMH to investigate stock market reactions to accounting earnings announcements. They sought to explain market reactions to accounting information and to understand how accounting information is used in financial markets.