Question

Define the Debt Covenant Hypothesis from Positive Accounting Theory. Describe and explain its predictions on the choices of accounting policies by firm managers and also how managers will respond to proposed new accounting standards.

Answer 1

Answer-:

Positive Accounting Theory (PAT) tries to make good predictions of real world events and translate them to accounting transactions. While normative theories tend to recommend what should be done, Positive Theories try to explain and predict.

Debt covenant hypothesis

• The closer a firm is to violating 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.

• By increasing current earnings, the company is less likely to violate debt covenants, and management has minimized its constraints in running the company.

PAT has led to a large amount of empirical studies. Positive researchers empirically test their predictions around the bonus plan hypothesis, the debt covenant hypothesis, and the political cost hypothesis. These hypotheses can be used in two distinguished forms of positive accounting theory. The first form is the opportunistic form asserting that managers in electing accounting procedures react to maximize the wealth, and the second form is the efficiency form for good corporate governance.

PAT has been subjected to severe and numerous criticisms from different perspectives, which are critiques on research method, economics base, and reference to philosophy of science. It is said that PAT seeks to predict and explain why managers choose to adopt particular accounting methods in preference to others but says nothing as to which method a firm should use.

We believe that PAT and its hypotheses will continue to be a rich field of empirical research and the basic questions that it raises are still relevant today. This chapter aims to put light on the PAT and related empirical studies and identify its broad contributions to the accounting research. Our objective is to provide a review of extant literature in order to synthesize findings, identify areas of controversy in the literature, and evaluate critiques.

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