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Economic Consequences and Positive Accounting Theory

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Betty Yan Ma

on 6 December 2013

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Transcript of Economic Consequences and Positive Accounting Theory

Opportunistic Approach
Managers are all rational economic decision makers
3 Hypotheses
Bonus Plan Hypothesis
Debt Covenant Hypothesis
Political Costs Hypothesis
Situation 2
Debt Covenant
Situation 3
Political Costs
Situation 1
Bonus Plan
Yous bonus is based on a % of sales.

What kind of accounting policy would you choose?

Economic Consequences and Positive Accounting Theory

Betty Yan Ma
Carl Fong
Stephanie Clement
You have a contract with the bank that requires you to have a specific debt-to-equity ratio. You are close to violating this agreement.

What accounting policies do you choose in order to avoid penalties?
Introduction/ overview
The Concept Of Economic Consequences
Relationship between EMH and Economic Consequences
Positive Accounting Theory (PAT)
Efficient Contract Approach
Opportunistic Approach
Three Hypotheses of PAT
Efficient Contract vs Opportunistic Approach
Criticisms of PAT
Your company has been experiencing high growth in earnings and increasing media coverage. You are worried you will be subject to government scrutiny.

What accounting policies should you choose in order to decrease the possibility of new regulatory requirements?
Concept of Economic Consequences
What are Economic Consequences
Criticisms on (PAT)
Economics Consequences
Shift future earnings to current periods

Higher Bonus

Disregard negative effects on company
A concept that asserts that, despite the implications of efficient market hypothesis (EMH), accounting policy choice can affect firm value.
Efficient Contracting Approach

Firms' accounting policies, and changes in accounting standards
Raise current earnings

Raise equity

Avoid penalties

Does not reflect "true" company value
Especially to managers
Even if there is no effect on cash flows
Income Decreasing

Profits are "suffering"

No longer large and powerful
Efficient Market Hypothesis (EMH)
Nexus of Contracts: A center of contractual agreements

Contracts have associated costs: Negotiating and Renegotiating costs, Moral Hazard costs, Monitoring Costs, and Contract Violating Costs.
give management the choice?
Efficiency Perspective explains how various contracting mechanisms can be placed to reduce these costs.

Example: Implementation of Employee Stock Option (ESO).
Efficient Contracting
Security prices reflect the information content of publicly available information and this information is not restricted to accounting disclosures

Beaver (1973) argued that Accounting Policy Choices
affect firm's security price

Fails to provide guidance on any means of improving accounting practices.

PAT suggests that all actions of an individual are driven by self-interest and opportunistic manner to increase their wealth.

Notions of loyalty and morality are not accommodated in the theory.

Not Value-free but rather Value-laden.

Since its inception in the 1970’s, the issue being addressed have not shown any great development. Thus, the efficiency and effectiveness of PAT remains uncertain.
There is no impact on cash flows and profitability

Accounting policies are fully disclosed

Then Market will evaluate value of securities in light of the policies
Some Solutions to Criticisms
EMH V.S Economic Consequences
Efficient Contract &
Opportunistic Approach
Management Oversight by the Board of Directors.

Bonding with managers.

Hire an Auditor to evaluate the company’s financial performance.

Disclose the accounting practices and any change in accounting methods.

Segregation of Duties in the accounting information.

Choose the same accounting policy

WHY they chose that policy
Several Us Corporations tried to reduced
earnings by implementing replacement cost accounting during 1947 to 1948, a period of high inflation.
Efficient Contracting
The Relationship Between EMH and Economic Consequences
Existence of Economic consequences reinforce that security markets are
not fully efficient
Inconsistent observations lead to
Positive Accounting Theory (PAT)
Positive Accounting Theory (PAT)
Positive Theory
A theory to predict managers' accounting policy choices

A good prediction of real world events
Normative Theory
A theory that prescribes how people should behave in order to accomplish a given objective.

How people should react in real world situation.
Types of Accounting Theories
Positive Accounting Theory (PAT)
This Theory attempts...
1. To understand why and predict which accounting policies a firm will use.
2. To explain manager's choices of accounting methods in terms of self-interest (Opportunistic Manner).
3. How financial accounting can be used to minimize cost by aligning competing interests
"What is best for me?"
"What is best for the company"
Its time for :
Presented by
While the criticisms have merits, (PAT) continues to be used throughout the world.
kinds of accounting Policies?

do they matter?

It matters to the investors as well because management might change operation practices.

It matters to the investors because managers' action on firm's value (e.g Net Income)

Reduced Earning to:


What is PAT?
Full transcript