Positive Accounting Theory Revision

Positive accounting theory revision

To predict and explain accounting choice accounting researches had to introduce information and transactions costs. The initial empirical studies in accounting choice used positive agency costs of debt and compensation contracts and positive information and lobbying costs in the political process to generate value effects for and, hence hypotheses about accounting choice.

Financial researchers had introduced costs of debt that increase with the debt/equity ratio to explain how optimal capital structures could vary across industries. The debt costs first introduce were bankruptcy and agency costs. The agency costs were of particular interest to accountants because accounting appeared to play a role in minimizing them. Debt contracts apparently aimed at reducing dysfunction behaviour use accounting numbers. Accounting researchers recognised the implications for accounting choice and began using the accounting numbers in debt contracts to generate hypotheses about accounting choice.

In the marketplace, direction of productive activity and cooperation is by market prices; within the firm alternative mechanisms such as standard costs are used. While productive activities are carried out by markets and which by firms depends on which arrangement is cost effective. In competition among firms, those that organise themselves to minimize contracting costs are more likely to survive. It was a short step to suggest that accounting methods affect the firm’s organisational costs and so the accounting methods that survive are the result of a similar economic equilibrium that notion of an efficient set accounting methods to explain accounting choice.

As noted above, the agency costs associated with debt and management compensation contracts and the agency, information, and other contracting costs associated with the political process provided the hypotheses testes om the early empirical accounting choice studies. However, the more general approach suggested agency and other costs associated with other contracts to play a role in explaining organisation choice. The term contracting costs instead of agency costs. The concept of contracting costs and the notion of accounting methods as part of efficient organisational technology play key roles in contemporaneous positive accounting theory.

Contracting costs consist of transaction costs, agency costs, information costs, renegotiation costs, and bankruptcy costs. The existence of contracting costs is crucial to models of both the organisation of the form and accounting choice. Some people suggests that within the firm the lack of a market price is replaced by systems for allocation decisions among managers, and measuring, rewarding and punishing managerial performance. Accounting plays a role in these systems and so appears to be part of the firm’s efficient contracting technology. Trying to predict and explain the organisation of the firm with zero contracting costs is pointless. Modelling accounting choice while assuming zero contracting costs is not productive.

The extent to which accounting choices affects the contracting parties’ wealth depends on the relative magnitudes of the contracting costs. For example, assume accounting-based debt agreement have higher renegotiation costs than accounting bonus plans. Then, mandatory changes in accounting procedures by the FASB imposed greater relative costs on firms with debt agreement than on firms with bonus plans. And firms with debt agreements will conduct more lobbying and undertake more accounting, financing and production changed to undo the effects of the mandatory change than firms with only bonus plans. Thus, developing a positive theory of accounting choice requires an understanding of the relative magnitudes of the various type of contracting costs.

Most accounting choice studies assume managers choose accounting methods to transfer wealth to themselves at the expense of another party to firm because they can take the firm’s observed contracts as given the determine managers’ incentive for accounting choice. Some research studies assume accounting methods are chosen for efficiency reasons available being shared among all parties to the firm.

Most accounting choice studies attempt to explain the choice of the single accounting method instead of choice of combination of accounting methods. Focusing on a single accounting method reduces the power of the tests since managers are concerned with how the combination of methods affected earnings instead of the effect on just one particular accounting method. Accounting accruals aggregate into a single measure the net effect of all accounting choices. Bust use of accruals as a summary measure of accounting choice suffers from a lack of what accruals would be without managerial accounting discretion.

The choice studies to date find results generally consistent with the bonus plan hypothesis. The early tests of the bonus hypothesis are not very powerful tests if the theory because they rely on simplifications of the theory that are not appropriate in many cases. For example, a bonus plan does not always give managers incentive to increase earnings. If, in the absence of accounting changes, earnings are below the minimum level required for payments of a bonus, managers have incentive to reduce earnings their year because no bonus are likely paid. Healy’s tests encompass more kinds of manipulation. His results are consistent with managers manipulating net accruals to affect their bonus.

The debt/equity hypothesis predicts the higher the firm’s debt/equity ratio, the more likely manager’s use accounting methods that increase income. The higher the debt/equity ratio, the closer the firm is to the constrains in the debt covenants. The tighter the covenant constraint, the greater the probability of a covenant violation and of incurring costs from technical default. Managers exercising discretion by choosing income increasing accounting methods relax debt constraints and reduce the costs of technical default. The evidence is generally consistent with the debt/equity hypothesis. The higher firm’s debt/equity ratios, the more likely managers choose income increasing methods. Some researcher examined whether accounting choice varies with tightness of the dividend constrained as specified in the debt covenant and measured by unrestricted retained earnings. The association between leverage and accounting method choice is an empirical regularity unknown prior to the positive accounting studies.

Many accounting would be uncomfortable with the explanation that managers choose their accounting procedures based in what most other firms are doing. The real issue is the lack of an alternative model with greater explanatory power, not the low explanatory power if the extant theory.

Alternative hypothesis can explain the bonus, debt/equity, and size results found in the positive accounting literature. Several scenarios illustrate how this problem might arise:

 If the accounting system is part of the firm’s efficient set of implicit and explicit contracts, accounting choice is endogenous. Contracting, investment, and production decisions are determined jointly. The type of contracts used depends on the firm’s investment opportunity set. Hence, the firm’s investment opportunity set is correlated with the firm’s financial, dividend compensation, and accounting policies. The documents correlations between debt/equity and accounting choice and between bonus plans and accounting choice would be due to the correlation between financial and compensation politicise and the optimal set of accounting procedures for contracting from opportunistic actions by managers and have not considered efficiency-based hypothesis.