Question

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.

Answer 1

Ans. Positive Accounting Theory (PAT) is a positive theory that aims to predict actions such as which accounting policies firms will choose and how newly proposed accounting standards will cause firms to react. Its overall intention is to understand and predict the choice of accounting policies across differing firms. It recognizes that economic consequences exist.

Three key hypotheses of Positive Accounting Theory (PAT) explain managerial motivations for corporate earnings management in following ways:

(i) The bonus plan hypothesis states that all other things being equal, managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period. By doing so, they can increase their bonuses for the current year.

(ii) The debt covenant hypothesis states that all other things being equal, the closer a firm is to violating accounting- based debt covenants, the more likely the firm manager is to select accounting procedures that shift reported earnings from future periods to the current period. By increasing current earnings, the company is less likely to violate debt covenants, and management has minimized its constraints in running the company.

(iii) The political cost hypothesis states that all other things being equal, the greater the political costs faced by the firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods. This is because high profitability can lead to increased political “heat”, and can lead to new taxes or regulations.