2 Class Announcements Assignment #6 due February 20th; available on-line Research Paper Part #2 due February 13th (today)Assignment #5 available for pick up on Friday (14th) from SCHW 396 until 2:00pmMidterm is February 17th (in-class)Business Banquet - April 2nd – 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and AsiaAdditional Office Hours:Friday (14th) 10:00am to 2:00pm
3 Midterm Worth – 25% When –Monday (17th) Coverage – Format: Conceptual Framework (CICA 1000); Accrual Accounting;Efficient Markets (Chapter 4);Information Perspective (Chapter 5);Measurement Perspective (Chapter 6);Positive Accounting Theory (Chapter 8);Format:short answer with multiple parts;choice of 3 out of 4;no quantitative problems
4 Class Objectives Viewing the firm as a series of contracts Contracts between agents and principles define the relationship and expectationsDefining a rationale personHypotheses of Positive Accounting Theory (PAT)
5 Positive Accounting Theory (PAT) The term positive refers to a theory that attempts to make good predictions of real world events“Positive accounting theory is concerned with predicting such actions as the choice of accounting policies by firm managers and how managers will respond to proposed new accounting standards.” p. 304Accounting policy choice is part of the overall process of corporate governance.
6 Positive Accounting Theory Positive: the objective is to understand and predict managerial accounting policy choice across different firms.Normative: the objective is to tell managers what they should or ought to do.
7 Positive Accounting Theory “Firms organize themselves in the most efficient manner so as to maximize their prospects for survival” p. 304depends on factors such as legal & institutional environment, technology, degree of competition, etc. firm can be viewed as nexus of contractsFirm is a nexus of contractsA firm will want to minimize the various contracting costs associated with these contractsMany of these contracts involve accounting informationPAT argues that the firm’s accounting policies are selected to reduce contracting costs – efficient contractingManagers require flexibility in accounting policies to allow adoption to new or unforeseen circumstances
8 Positive Accounting Theory Flexibility to choose from a set of accounting policies opens up the possibility of opportunistic behavior.PAT assumesmanagers are rational (self interested, risk adverse, effort adverse)will choose accounting policies in their own best interests (not necessarily profit maximization) – opportunisticwill choose accounting policies to attain corporate governance objectives of the firm – efficient contracting
9 Positive Accounting Theory: Distinguishing Versions (opportunistic vs Positive Accounting Theory: Distinguishing Versions (opportunistic vs. efficient)Difficulty in distinguishing between versions (p ):Mian & Smith (1990)Consolidated financial statementsChristie & Zimmerman (1994)Takeover targetsDichev & Skinner (2002)Debt covenantsDechow (1994)Net income more highly associated with share returns than cash flowsGuay (1999)Limit firm risk using derivativesEvidence from empirical research of both
10 Positive Accounting Theory: Accounting Implications-Managing Earnings Ways to manage earnings:Changing accounting policiesManaging discretionary accrualsTiming of adoption of new accounting standardsChanging real variables-R&D, advertising, repairs & maintenanceSPEs (Enron), capitalize operating expenses (WorldCom)William R. Scott:The tick mark beside Accruals is only to emphasize that this is the most important and interesting earnings management method .
11 Positive Accounting Theory: Accounting Policies The optimal set of accounting polices for the firm represents a compromise:A) Tightly prescribing accounting policies beforehand will minimize opportunistic accounting policy choices by mangers but incur cost of lack of accounting flexibility to meeting changing circumstancesB) Allowing managers to choose from a broad array of accounting polices will reduce costs of accounting inflexibility but expose the firm to the cost of opportunistic manager behavior.
12 Positive Accounting Theory: Hypotheses The predictions made by PAT are largely organized around three hypothesis: (in opportunistic form)1) Bonus plan hypothesis – select accounting policies to move earnings to current period for remuneration2) Debt covenant hypothesis - select accounting policies to move earnings to current period to reduce possibility of technical default3) Political cost hypothesis - select accounting policies to move earnings to future period
13 Positive Accounting Theory: Empirical Investigation 1) Bonus plan hypothesis – Healy (1985), managers do choose accounting policy to maximize earnings2) Debt covenant hypothesis – Dichev & Skinner (2002), managers choose accounting polices to maintain covenant ratios; managers work harder to avoid first covenant violation3) Political cost hypothesis – Jones (1991), firms choose accounting policy consistent with improving their case of import protectionOverall – the three PAT hypothesis may predict manager reaction.
14 Class Objectives - Revisited Viewing the firm as a series of contractsContracts between agents and principles define the relationship and expectationsDefining a rationale personHypotheses of Positive Accounting Theory (PAT)