Question

Question 2 How do the three key hypotheses of Positive Accounting Theory (PAT) explain managerial motivations for corporate earnings management? Make use of appropriate academic evidence in supporting your arguments (50 marks)

Answer 1

PAT is the theoretical approach of anticipating actions of firms if there is any change in accounting standards.

Hypotheses are as below:

No.1) Bonus plan: if there is bonus plan, mangers want to utilize that by shifting future earnings to current periods. Suppose in the month of January, the February revenues have been included; this is done because there is a bonus on January revenues amount – showing more revenues increase the bonus amount.

No.2) Dealing with creditors: if there is any probable violation on creditors’ due the chance of shifting earnings from future period to current period would be high, since after such violation there may be legal formalities and managers know that such future earnings may not be enjoyed.

No.3) Political cost: if such cost is high, managers don’t want to report earnings now but could shift it in future, keeping all the other factors remaining the same. Suppose political party asks for huge donation now; the managers of the firm may show that there is not much income in the books of accounts – it could be done by shifting few earnings to future periods.