1. Positive Accounting Theory

2. Class Announcements Guest: Peter Bower, Former CEO American Eagle Airlines in class next day Assignment #6 is due in class next day (October 20th) 3rd year financial accounting students need tutors Midterm is Tuesday October 25th in-class November 1st is movie “Smartest Guys in the Room” and we will be meeting in SCHW 110 for an extended class (30-45 minutes extra) RIM http://www.youtube.com/watch?v=AdjAqsWIyMI&feature=related

3. 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)

4. Midterm Worth – 25% When –Tuesday (25th) Coverage – 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 4 out of 5; no quantitative problems

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.” 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 A firm can be viewed as 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 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 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: 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 . William R. Scott: The tick mark beside Accruals is only to emphasize that this is the most important and interesting earnings management method .

10. 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.

11. Positive Accounting Theory:Distinguishing Versions Difficulty in distinguishing between versions: 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

12. Positive Accounting Theory:Hypotheses The predictions made by PAT are largely organized around three hypothesis: 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), mangers choose accounting polices to maintain covenant ratios; mangers 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.