accounting theory revision
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lecture_4_positive_accounting_theory.zipLecture 4 Positive Accounting Theory/British Gas.docx
London Evening Standard 27 February 2013
11% profits rise as British Gas increases bills
Jonathan Prynn, Lucy Tobin, and Nicholas Cecil
British Gas sparked fresh fury today as it unveiled an 11 per cent surge in profits just weeks after pushing up bills to record levels.
Britain’s biggest energy supplier was accused of being “contemptuous of its customers” when it revealed that it made £606 million profit last year from the gas and electricity it sold to almost 16 million households.
Consumer groups and Labour MPs ripped into the company — owned by energy giant Centrica — and warned that thousands of pensioners will die this year because they cannot afford to turn the heating on.
British Gas raised its tariffs by six per cent in November, adding about £80 a year to the typical bill. This was despite profits at its residential energy supply arm shooting up by £62 million, or 11 per cent, last year.
Ann Robinson, director of consumer policy at price comparison website uSwitch.com, said: “Asking customers to swallow a six per cent winter price hike and then unveiling an 11 per cent increase in profits is tantamount to waving a red rag at a bull.”
Shadow consumer affairs minister Ian Murray said: “It is unacceptable that the Prime Minister is letting the energy companies get away with inflation-busting price rises when they are already making huge profits and pensioners, in particular, are having to choose whether to heat or eat.”
British Gas also confirmed that managing director Phil Bentley, 54, will step down as its boss at the end of June, although he will remain on the pay-roll until the end of the year “to ensure a smooth transition”. Mr Bentley will leave with Centrica shares, rights to long-term incentive bonuses and a pension pot expected to be worth up to £11 million in total, although he will not get a separate pay-off on top.
Company chiefs were despatched to TV and radio studios to defend the financial results after they were announced in the City at 7am. Centrica chief executive Sam Laidlaw said rises were justified by its huge investment in energy infrastructure to “keep the lights on” and said the profits rise was artificially boosted by the much colder weather last year compared with 2011.
The group needed to make a “fair and reasonable return so that we can continue to make our contribution to society and to invest”. Company bosses said it was “too early” to say whether there would be further tariff rises this year.
Consumer groups called for a more radical root and branch shake-up of Britain’s energy supply market.
Richard Lloyd, executive director of Which? said: “Prices will only be kept as low as possible if there is more effective competition and switching between energy companies.”
Answer the following three questions:
(1) How does this newspaper article relate to PAT’s political cost hypothesis?
(2) Would British Gas have faced similar criticism if it had reported a loss?
(3) What are the political costs British Gas faces as a result of the media attention?
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Lecture 4 Positive Accounting Theory/PAT 2014 2015.pptx
Lecture 4
Positive Accounting Theory:
Accounting policy choice
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D&U Chapter 7
R Chapter 5, Chapter 7
Roberts (2004): Criticism of agency theory (on blackboard)
Background reading
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Positive accounting theories
Explain and predict accounting/financial reporting practice
e.g., why firms use specific accounting methods
Contrast with normative accounting theories
Prescribe how an item should be accounted for or how/when it should be disclosed
The prescription might depart from existing practice
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Positive accounting theories
Started coming to prominence in mid 1960s
Paradigm shift from normative theories
Dominant research paradigm in 1970s and 1980s
Shift resulted from US reports on business education, and improved computing facilities enabling large-scale statistical analysis
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Origins of positive accounting theories
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Agency theory and the role of accounting information
Agency theory
Positive Accounting Theory (PAT)
Corporate governance theories
Separation of ownership and control
Management – owners (shareholders)
Management - debt holders (lenders)
Moral hazard
Information asymmetry
Role of accounting in contracting process:
monitoring
bonding
Role of accounting in corporate governance mechanism
Accounting policy choice
Directing and controlling managerial behaviour
Disclosure
Managerial
self-interest:
Reporting bias
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Agency theory concepts
Agency theory: Which of these relationships are agency?
https ://www.youtube.com/watch?v=cpu0dw9VY2E&index=3&list=UUnC_mJ3DkfxEwmOzq-EnyHA
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Used to understand relationships whereby a principal employs the services of and delegates the decision making authority to an agent
Principal = shareholders
Agent = managers
Jensen and Meckling (1976):
“a contract under which one or more (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent”
Agency Theory
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Agency relationship
Asymmetric Information
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Creates a moral hazard
Managers may undertake actions detrimental to shareholders
Leads to 3 ‘costs’
Monitoring costs
Bonding costs
Residual loss
Agency Theory
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Monitoring costs
Costs incurred by principals to measure, observe, and control agent’s behaviour
Auditing, costs of setting up managerial compensation plan
Get passed on to agent
Bonding costs
Costs incurred bonding agent’s interests to those of the principals
Producing and providing financial statements, agreeing to link remuneration to firm performance
Residual loss
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Agency costs
One particular type of positive accounting theory
Watts & Zimmerman (1978, 1986)
Watts, R. and J. Zimmerman (1978), “Towards a Positive Theory of the Determination of Accounting Standards,” The Accounting Review 53 (January), pp112-134.
Watts, R. and J. Zimmerman (1986), Positive Accounting Theory, Edgewood Cliffs, NJ: Prentice Hall.
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Positive Accounting Theory (PAT)
Used to explain and predict accounting policy choice
Why do firms select particular accounting methods in favour of others?
Why do managers lobby regulators in regard to particular accounting methods?
“PAT…is concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method…but it says nothing as to which method a firm should use” (Watts & Zimmerman, 1978)
Positive Accounting Theory
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It examines a range of relationships between the entity and
Suppliers of equity capital (owners)
Managerial labour (management)
Debt capital (lenders or debt holders)
Based on the ‘rational economic person’ assumption
Positive Accounting Theory
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Contracting theory
Suggests that the organisation is characterised as a legal ‘nexus of contracts’
With contracting parties having rights and responsibilities under these contracts
Positive accounting theory focuses on
Managerial contracts and
Debt contracts
These are agency contracts used to manage relationships where there is a separation between management and capital providers
Positive Accounting Theory
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Agency theory identifies a number of problems that can exist between managers and owners
Contracts and accounting information can be used to ‘bond’ the interests of owners and managers
Addresses 3 specific problems
Horizon problem
Risk aversion
Dividend retention
Owner–Manager agency relationships
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Shareholders: long-term horizon
Long-term growth and value of firm
Managers: short-term horizon
Short-term cash flows
Changing jobs, retirement
Short-term profitability
Delay upgrades to equipment, reduce R&D expenditure
Solution: Linking managerial rewards to long-term performance
Bonuses linked to share price, share-based compensation
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Horizon problem
Shareholders: less risk-averse
Diversification of risk
Managers: more risk-averse
No diversification of risk
Linking bonus to profits
Solution: Limiting share-based compensation as managerial share ownership in the company increases
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Risk aversion
Shareholders: prefer more dividends
Managers: prefer to maintain greater level of funds within the firm
Expand size of the firm
Pay their own salaries and benefits
Solution: paying bonus linked to dividend payout ratio; linking bonuses to profits
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Dividend retention
When a lender agrees to provide funds to an entity there is the risk that the lending party may not repay those funds
Agency costs of debt include:
Excessive dividend payments
Leaves fewer assets to service debt
Underinvestment
Investment in high-risk projects may not be beneficial to debt holders as they have a fixed claim
Asset substitution
Claim dilution
The organisation may take on additional debt, with new debtholders competing with original debtholders for repayment
Manager–lender agency relationships
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To avoid higher interest costs managers have incentives to show they are acting in a way that is not detrimental to lenders
Managers enter into debt covenants with lenders
Manager–lender agency relationships
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Management: Want to satisfy shareholders and pay out high level of dividends
Lenders: Excessive dividend payments could lead to reduction in asset base securing debt
Solution: Covenants that restrain dividend policy and dividend payout as a function of profits
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Excessive dividend payments
Managers may not want to invest in positive net present value projects, if projects would lead to increased funds being available to lenders
Lenders: In the case of bankruptcy any funds from these projects would go to creditors, rather than shareholders
Solution: covenants restricting investment opportunities of the firm; working capital ratios
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Underinvestment
Management has incentives to invest in high risk assets or projects, as it may result in higher returns
Lenders do not want managers to invest in assets or projects of a higher risk level than agreed
Solution: debt contracts restricting investment opportunities; debt to tangible assets ratios
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Asset substitution
Managers: may want to take on additional debt (of a higher priority)
Lenders: Additional debt increases risk that firms will not pay pack debt
Solution: leverage covenants (ratio of total liabilities to total tangible assets); interest coverage, current ratio constraints
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Claim dilution
Accounting information forms one of the major components of both manager remuneration and lending contracts
For managers accounting information plays two roles in the contracting process:
Bonding: To write the terms of managerial contracts
Monitoring: To determine performance against the terms of the contracts and consequently the amount of bonus and other pay components managers will receive
Lenders look to regular financial updates to ensure companies are maintaining the terms of their covenants
Role of accounting information in reducing agency problems
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Accountants use judgement to make a range of accounting decisions on a daily basis
Examples include:
Whether to expense or capitalise costs
What accounting estimates to use
What, where and how to disclose information
PAT (by Watts & Zimmerman, 1978, 1986) offers explanations of managers’ and accountants’ accounting choices
Using PAT to understand accounting choices
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Not possible to write complete contracts, so managers are assumed to opportunistically act to maximise own wealth
Based on the ‘rational economic person’ assumption
Known as ex post perspective
Considers opportunistic actions after contracts have been put in place
Managers make accounting choices which:
Increase managerial compensation bonus hypothesis
Avoid defaulting on debt repayments debt hypothesis
Decrease political cost political cost hypothesis
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Managerial opportunistic behaviour
Agency contracts can explain managerial accounting choices:
Managers and accountants, acting in self interest, are likely to ensure their own bonuses are maximised and the entity is not at risk of breaching debt contracts
The political cost hypotheses suggests that there are times entities, for political reasons, will actively reduce their reported profits
Accounting estimates
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Three key hypotheses frequently used in PAT literature to explain and predict support or opposition to an accounting method:
Bonus plan hypothesis
Debt hypothesis
Political cost hypothesis
Research assumes managers will act opportunistically when selecting methods
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Key hypotheses underlying the opportunistic perspective
Managers of firms with bonus plans are more likely to use accounting methods that increase current period income
Also called management compensation hypothesis
Action increases the present value of bonuses paid to management
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Bonus plan hypothesis
Incentives to manipulate accounting numbers
Rewarding managers on the basis of accounting profits may induce them to manipulate accounting numbers
Will affect their rewards
Bonuses based on profits cause short-term rather than long-term focus
May affect investment in positive NPV projects if returns not expected to be consistent
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Bonus plan hypothesis
Remuneration can be tied to:
Profits of the firm
Sales of the firm
Return on assets
All based on output from the accounting system
May also be rewarded in line with market price of the firm’s shares
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Bonus schemes
May be more appropriate to remunerate managers in terms of market value
Methods include:
Cash bonus based on share price increases
Shares
Options to shares
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Market-based bonus schemes
Managers have incentives to increase the value of the firm
Problems include:
Share price also affected by factors beyond the control of managers, e.g., general market movements
Only senior managers likely to have a significant impact on share value
With share options potential for manipulation both around grant dates and exercise dates
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Market-based bonus schemes
The higher the firm’s debt/equity ratio, the more likely managers use accounting methods that increase current period income
Also called debt/equity hypothesis
The higher the debt/equity ratio, the closer the firm is to the constraints in debt covenants
Covenant violation results in costs of technical default
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Debt hypothesis
In the absence of safeguards to protect the interests of debtholders, it is assumed they will require the firm to pay higher costs of interest to compensate
If firms contract not to pay excess dividends, take on high levels of debt or invest in risky projects, then they can attract debt at lower cost
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Use of debt contracts
Ex post, the incentive to manipulate numbers increases as the constraints approach violation
Managers found to manipulate accounting accruals in the years before and the year after violation of a debt agreement
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Debt contracts: Manager’s incentive to manipulate
Large firms rather than small firms are more likely to use accounting choices that reduce current period reported profits
Size is a proxy variable for political attention
Reduction of reported income is hypothesised to reduce the possibility that people will argue that the organisation is exploiting other parties
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Political cost hypothesis
Costs resulting from political attention from government, lobby groups etc.
Commonly directed at larger firms
Indication of market power
May result in increased taxes, increased wage claims, product boycotts etc.
Firms likely to adopt accounting methods to reduce profits to lower political scrutiny
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Political costs
Politicians know that highly profitable companies could be unpopular with members of constituency
Politicians could win votes by taking actions against the companies
Argue that in public interest even though in own interest
May rely on reported profits to justify actions
Provides incentives for firms to reduce reported profits
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Actions of politicians
PAT would hold that:
Managers on compensation contracts which have bonuses tied to a current measure of entity performance would prefer to capitalise costs manage earnings upwards
Entities with lending agreements with a leverage covenant, would prefer to capitalise costs manage earnings upwards
Entities in the public eye would prefer to expense costs manage earnings downwards
Example: Expensing versus capitalising costs
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Summary: Manager – shareholder/ debtholder relationship in PAT
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Agency theory originates in economics
Agency theory has been very influential in accounting research
Assumptions about accounting policy choice (PAT)
Informs corporate governance mechanisms
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Summary
Accounting information plays an important role in the design of contracts between management and shareholders, management and debt holders, and the organisation and society PAT accounting policy choice for opportunistic reasons
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Summary
Key assumptions of agency theory:
Human behaviour: Self-interested utility maximisation (rational, self-interested, and risk averse)
Relationship between the firm and its environment/society: Firm is a nexus of contracts
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However …
What if managers are irrational/emotional and their behaviour conforms to social norms and rules?
What if managers are not inherently self-interested, but the incentive contracts foster self-interested behaviour? (Roberts, 2004)
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Human behaviour
What if the firm is an integral part of society?
What is organisational practices can be explained by conformity to social/industry norms?
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Environment
