Professional Documents
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27, 02
8.1 Outline
In the text, Scott defines Positive accounting theory (PAT) as: “concerned
with predicting such actions as the choices of accounting policies by firms and
how firms will respond to proposed new accounting standards.” (263) 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.
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.
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.
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.
These three hypotheses form the cornerstone of Positive Accounting Theory.
They all lead to empirically verifiable predictions.
9.403 Chapter 8 Summary Feb. 27, 02
Jones investigated the tendency for firms to reduce their reported net income
during import relief investigations. These firms have to prove to the government
that their income has deteriorated as a result of foreign competition, and deserve
assistance such as tariff protection or trade legislation. There is a financial
motivation for these organizations to reduce their net income to qualify for relief.
Jones also investigated whether firms used discretionary accruals to lower
reported earnings. She concluded that there was a tendency for organizations to
manipulate accounting policies relating to accruals.
can also be chosen on an efficiency criterion. Quite often, these two theories
make similar forecasts. It is difficult to determine whether opportunism or
efficiency is driving the policy changes.
8.5 Conclusion
Quiz
True/False Questions
2. One would expect that managers of firms with bonus plans would oppose
proposed accounting standards that may lower reported net income.
6. We would expect that managers of firms with bonus plans would welcome
proposed accounting standards that may lower reported net income.
7. A firm can be viewed by the set of contracts it enters into, so a firm will
want to minimize its various contracting costs associated with these
contracts?
8. Sweeney did not support both versions of PAT from her research.
9. A firm can be viewed by the set of contracts it enters into, so a firm will
want to minimize its various contracting costs associated with these
contracts?
10. Sweeney researched firms that were first time debt covenant violators.
These firms had significantly more voluntary accounting policy changes
that decreased income to avoid covenant violation
9.403 Chapter 8 Summary Feb. 27, 02
1. The Political Cost Hypothesis states that the closer a firm is to violating
debt covenants, the more likely they are to:
a) efficiency, different
b) efficiency, similar
c) positive, different
d) positive, similar
9.403 Chapter 8 Summary Feb. 27, 02
a) total accruals
b) negative accruals
c) discretionary accruals
d) positive accruals
1. Which of the three hypotheses of positive accounting deals with debt, and
what is the reasoning behind the hypothesis?
5. What are discretionary accruals and give examples of some. How could
these accruals be used concerning firms that are unfairly affected by
foreign competition
9.403 Chapter 8 Summary Feb. 27, 02
Quiz Answers
True/False
1. True
2. True
3. True
4. True
5. True
6. False
7. True
8. False
9. False
10. False
Multiple Choice
1. C
2. D
3. B
4. B
5. D
6. B
Short Answer
1. The debt covenant hypothesis deals with debt, and it states that all
other things being equal, the closer a firm is to violation of 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.
9.403 Chapter 8 Summary Feb. 27, 02