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Chapter 8

Economic Consequences and

Positive Accounting Theory

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Positive Accounting Theory (PAT)

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What is PAT?• Studies Managers’ Accounting

Policy Choices, As Part of the Overall Process of Corporate Governance

• That Is, Accounting Policies are Chosen Strategically

• Positive, Not Normative. Tries to Understand and Predict Managers’ Accounting Policy Choices.

© 2006 Pearson Education Canada Inc.

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ASSUMPTIONS OF PAT• Managers are Rational (Like

Investors) Conflict (Between Interests of Managers and Investors)

• Efficient Securities Market• Efficient Managerial Labour Market

– But may be inside information about manager effort and ability (moral hazard problem)

– A second major role for financial reporting--to report on manager effort and ability

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The 3 Hypotheses of PAT

• Bonus Plan Hypothesis– Derives from managerial incentive

contracts• Debt Covenant Hypothesis

– Derives from debt contracts• Political Cost Hypothesis

– Very large firms minimize political “heat”

• NB: Contacts are Rigid

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Managing Reported Earnings

• Ways to Do It– Changing accounting policies– Managing discretionary accruals– Timing of adoption of new accounting

standards– Changing real variables--R&D,

advertising, repairs & maintenance– SPEs (Enron), capitalize operating

expenses (WorldCom)–

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Managing Reported Earnings Through

Discretionary Accruals• NI = OCF ± Net Accruals

= OCF ± Net Non-Discretionary Accruals ± Net Discretionary Accruals

• Examples of Discretionary Accruals– Allowance for doubtful accounts– Provision for reorganization

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Estimating Discretionary Accruals

• Use Total Accruals as Proxy– Healy (1985)

• Examine Specific Accounts– Accounts receivable &

allowance•McNichols & Wilson (1988)

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2 Versions of PAT• Opportunistic Version

– Managers choose accounting policies for their own benefit

• Efficient Contracting Version– Managers choose accounting

policies to attain corporate governance objectives of the firm

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Distinguishing Opportunistic v.

Efficiency Versions of PAT, Concl.

• Conclude: Significant Evidence in Favour of Efficiency Version of PAT

• This Implies that the Inherent Conflict Between Investor and Manager Interests is Reasonably Controlled– How this is done is subject of Chapter

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