Question

Define Positive Accounting Theory. Explain the PAT hypotheses giving appropriate examples.b)What is ‘opportunistic behaviour’ in the context of PAT c)Explain what ‘discretionary accruals’ and why they are important to PAT.

Answer 1

Definition of PAT: Positive accounting theory (PAT) is defined as "concerned with predicting such actions as the choices of accounting policies by firms and how firms will respond to proposed new accounting standards". It is a general term for any theory that provides descriptive information regarding the behavior of accountants. PAT uses theory to predict the choices that management will make regarding their choice of accounting policies. This theory is introduced as a way to merge efficient securities markets with economic consequences. PAT takes the view that firms will conduct themselves in the way that maximizes their own best interests. Managers do not always do what is best for shareholders, but what will be the most beneficial to their organization. The choices that an organization makes are dependant on what industry they are in, and the factors within that industry.

PAT hypotheses:

Positive accounting theory is organized around three hypotheses:

• the bonus plan hypothesis
• the debt covenant hypothesis
• the political cost hypothesis

The bonus plan hypothesis dictates that managers will use accounting policies that are likely to shift reported earnings from future periods to the current period. This is to maximize their personal compensation as by reporting a high net income, their utility will be maximized through bonuses and incentives. For example, managers of firms with bonus plans, based on reported net income, systematically adopted accrual policies to maximize their expected bonuses.

The debt covenant hypothesis states that the closer a firm is to compromising their debt covenants, the more likely management is to use accounting policies that shift reported earnings from future periods to the current period. This is because higher net earnings will reduce the probability of technical default on the debts. Examples of income increasing accounting changes include adoption of FIFO inventory, liquidation of LIFO inventory layers changes in pension plan assumptions, and pension terminations.

The political cost hypothesis states that the greater the political costs to the firm, the more likely management is to use accounting policies to defer reported earnings from current periods to future periods. This hypothesis brings politics into the choice of accounting policies. Highly profitable firms attract media and consumer attention. This attention can create an increase in taxes and other regulations. With respect to the political cost hypothesis, most of the empirical investigation has been on firm size. However, the correlation of size with other firm characteristics, such as profitability and risk, complicates this measure of political cost.

b) Opportunistic behaviour means given the available set, managers may choose accounting policies from their set for their own interests.

Ex: Managers who are actively exploring oil companies whose remuneration contracts are based on reported net income may choose full-cost accounting over successful-efforts with the intention to smooth out income and increase the present value of their bonus streams.

c) Discretionary accruals are hard-to-detect manipulations of accounting policy changes relating to accruals. These accrual values are estimated from the professional judgment of firm managers. These values can be increased or decreased depending on the circumstances that the firm faces. Some examples are increase of depreciation and amortization charges, it may record excessive liabilities for product guarantees, contingencies, and rebates, and it may record generous provisions for doubtful accounts and obsolescence of inventories.

Discretionary accruals can be used to report a lower net income during import relief investigations. Firms that are unfairly affected by foreign competition typically need assistance in the form of trade legislation. Discretionary accruals allow firms to bolster their case of a lower reported net income. The fact that they are hard to detect strengthens disincentives to uncover earnings manipulation by the International Trades Commission and consumers alike. Thus, making discretionary accruals a good tool for firms to use when relief is needed from foreign competition.