1. Positive Accounting Theory

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 2:00pm
Midterm 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 Asia
Additional 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 expectations
Defining a rationale person
Hypotheses 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. 304
Accounting 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. 304
depends on factors such as legal & institutional environment, technology, degree of competition, etc. firm can be viewed as nexus of contracts
Firm is a nexus of contracts
A firm will want to minimize the various contracting costs associated with these contracts
Many of these contracts involve accounting information
PAT argues that the firm’s accounting policies are selected to reduce contracting costs – efficient contracting
Managers 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 assumes
managers are rational (self interested, risk adverse, effort adverse)
will choose accounting policies in their own best interests (not necessarily profit maximization) – opportunistic
will 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 statements
Christie & Zimmerman (1994)
Takeover targets
Dichev & Skinner (2002)
Debt covenants
Dechow (1994)
Net income more highly associated with share returns than cash flows
Guay (1999)
Limit firm risk using derivatives
Evidence from empirical research of both

10. Positive Accounting Theory: Accounting Implications-Managing Earnings
Ways to manage earnings:
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)
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 circumstances
B) 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 remuneration
2) Debt covenant hypothesis - select accounting policies to move earnings to current period to reduce possibility of technical default
3) 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 earnings
2) Debt covenant hypothesis – Dichev & Skinner (2002), managers choose accounting polices to maintain covenant ratios; managers work harder to avoid first covenant violation
3) Political cost hypothesis – Jones (1991), firms choose accounting policy consistent with improving their case of import protection
Overall – the three PAT hypothesis may predict manager reaction.

14. Class Objectives - Revisited
Viewing the firm as a series of contracts
Contracts between agents and principles define the relationship and expectations
Defining a rationale person
Hypotheses of Positive Accounting Theory (PAT)