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Copy of accounting theory

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on 1 October 2013

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Transcript of Copy of accounting theory

POSITIVE ACCOUNTING THEORY Bonus Plan Hypothesis Debt Covenant Hypothesis Political Cost Hypothesis Concept:

Managers of firm with bonus plan have greater incentives to choose accounting policies which report higher income for the current period.


a. managers being rational
b. no congruence between manager and shareholder Bonus Plan Hypothesis
Self-interested Behavior Supporting research papers

Toward a Positive Accounting Theory in Determination of Accounting Standards (Watts and Zimmerman, 1978)

a. Management has greater incentives to increase the reported earnings for maximization of bonus via its choice of accounting procedures.

b. Management would favor the accounting policies that smooth accounting income provided that the managers are risk averse and act opportunistically. Bonus Plan Hypothesis Supporting research paper

Toward a Positive Accounting Theory in Determination of Accounting Standards (Watts and Zimmerman, 1978) (continued)

c. shareholders or non-managerial directors will only adjust the changes in accounting numbers for accounting changes when the benefits of such adjustment justify the costs. Bonus Plan Hypothesis Empirical research

The Impact of Bonus Schemes on the Selection of Accounting Principles ( Healy, 1985)

a. Healy examines the relationship between bonus plan and accounting choices with underlying assumption of costly monitoring

b Result: cap

bogey Bonus Plan Hypothesis Conclusion

Managers being rational always place their own interest in the first place when comes to decision making regarding accounting policies.

Managers with bonus plans usually choose less conservative and less volatile accounting policies in order to obtain higher bonus for their own sake.

Solely based on the managers’ bonus plans we cannot perfectly predict and fully explain managers’ choices of accounting procedures; therefore, we have to consider other determinants such as debt covenant and political costs. Bonus Plan Hypothesis CONCEPT
The closer a firm is to violation 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.
Closer debt covenant violation

Select accounting policies

Increase current earnings Debt Covenant Hypothesis DEBT CONTRACTS

Depend on accounting variables

Contain covenants requiring borrowers to meet

Impose penalties for violation Debt Covenant Hypothesis PREDICT EARNINGS MANAGEMENT

Motivation of EM: avoid debt covenant violation

An example:

-Required debt/equity ratio: < 50%
-real D/E ratio: nearly 50%

Questions: Are you willing to engage in earnings management to shift D/E ratio downwards? Debt Covenant Hypothesis SUPPORTING PAPER
Watts and Zimmerman (1990)
The debt/equity hypothesis predicts the higher the firm’s debt/equity ratio, the more likely the managers use accounting methods that increase income.

Sweeney (1994) –(130 default firms compared with 130 control firms)
-defaulting firms made more income-increasing policy changes than control firms. Debt Covenant Hypothesis Debt Covenant Hypothesis RESEARCH FINDINGS(continued)
Sweeney( 1994)
-Defaulting firms tended to early adopt new income-increasing standards, and to delay adoption of new income-decreasing standards.

Dichev and Skinner (2002) (DS)
Managers will have strong incentives to manage covenant ratios to avoid an initial violation since the costs of initial covenant violation are much higher. MANAGERS' CHOICE

Accounting policies:

less conservative
and/ or
less volatile Debt Covenant Hypothesis Conclusion --Managers would balance the conflict when choosing accounting policies.

--These three hypotheses of PAT can be interpreted under both opportunistic and efficienct contracting prospectives.

--A huge amount of empirical evidence consistent with both of perspectives.

--PAT helps understand why and predict which accounting policies a firm will use. Two Perspectives The objective of the positive accounting theory is to explain and predict the accounting practice. This theory assumes that:

The market is efficient

All individuals in the market are rational Two perspectives of PAT What would you do? *******50 millions dollars in earnings******** BUT... for every dollar of earnings The government will tax you $0.46
Your employees wants a raise of $0.18
Information cost is $0.37 The greater political costs the firm faces, the more the management have tendency to show lower profits.

“Huge accounting profits, but not high profit rates… This makes these companies obvious targets for public criticism.”
(Watts, Zimmerman, 1978, p.115,fn 12)

“… political costs are function of reported profits. Thus, incentives are created to manage reported accounting numbers” (1990, p.133) Political Cost Hypothesis Why would the politicians wants to mingle with the corporations?

Prevent monopoly power is the main reason.

The notion that politicians seek to redistribute wealth away from the corporations to prevent monopoly power comes from the earlier work of the other scholars such as Stigler (1971) Politicians The task to justify the behavior and the choices of the management is by examining how the accounting policies affect the management's wealth. Management Wealth In turn cash flows and stock prices can be affected by:

Information costs
Political costs
Regulatory procedures of the government

Therefore, mangers would have to consider the effects reported earnings might have on the costs that could be imposed on the firm and themselves. Managers tend to lobby for prospective legislation that allows them to move current periods to future periods. Counter pressure The management have incentives to choose accounting standards which report lower earnings or move current period profit to future periods.

Conditioning on the firm being regulated or subjected to political pressure. In small unregulated firms, the managers have to incentive to select accounting standards which report higher earnings. Watts and Zimmerman from the bonus plan hypothesis... We know that the management's wealth is affected by stock options, cash bonuses and basic salary. the previous two is related to the performance of the company. managers would want the earnings to go up Counter pressure Watts and zimmerman suggest that corporations can employ a number of devices, such as social responsibility campaigns in the media.
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