Question

Watts and Zimmerman note that the “positive accounting theory” has been criticized because there are alternative hypotheses that may explain the bonus, debt/equity, and size results. What are these alternatives the critics suggest?

Answer 1

Watts and Zimmerman highlight three key hypotheses as follows:

• The bonus plan hypothesis: Ceteris paribus, 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/equity hypothesis: Ceteris paribus, the larger a firm’s debt/equity ratio, the more likely the firm’s manager is to select accounting procedures that shift reported earnings from future periods to the current period.
• The size hypothesis: Ceteris paribus, the larger the firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods.

The early tests of the bonus hypothesis are not very powerful tests of the theory because they rely on simplifications of the theory that are not appropriate in many cases. For example, a bonus plan does not always give managers incentives to increase earnings. If in the absence of accounting changes earnings are below the minimum level required for payment of a bonus, managers have the incentive to reduce earnings this year because no bonuses are likely paid. Taking such an "earnings bath" increases expected profits and bonuses in future years. By using bonus plan details to identify situations where managers are expected to reduce earnings, Healy's (1985) tests encompass more kinds of manipulation. His results are consistent with managers manipulating net accruals to affect their bonuses.

The debt/equity hypothesis predicts the higher the firm's debt/equity ratio, the more likely managers use accounting methods that increase income. The higher the debt/equity ratio, the closer (i.e. "tighter") the firm is to the constraints in the debt covenants (Kalay i982). The tighter the covenant constraint, the greater the probability of a covenant violation and of incurring costs from technical default. Managers exercising discretion by choosing income increasing accounting methods relax debt constraints and reduce the costs of technical default.

The evidence is generally consistent with the debt/equity hypothesis. The higher firms' debt/equity ratios, the more likely managers choose income increasing methods. Press and Weintrop (forthcoming) and Duke and Hunt (forthcoming) find that debt/equity ratios are correlated with closeness to bond ovenants as assumed in the debt/equity hypothesis. Some studies, however, have avoided using the debt/equity ratio as a proxy variable for closeness to the COvenant constraint by using more direct tests, For example. Bowen et al. (a981)

examine whether accounting choice varies with the tightness of the dividend constraint as specified in the debt covenant and measured by "unrestricted retained earnings. The association between leverage and accounting method choice is an empirical regularity unknown prior to the positive accounting studies.