#2962 - Stream 1 Reading Towards A Positive Theory Of The Determination Of Accounting Standards – - Financial Accounting, Analysis and Valuation

• Parties have in the past and continue to expend resources to influence the setting of accounting standards

• Moonitz (1974), Horngren (1973) document sometimes intense pressure exerted on the accounting standard-setting bodies

• Positive theory of the determination of accounting standards:

  • Helps us to understand better:

    • the source of the pressures driving the accounting standard-setting process

    • the effects of various accounting standards on different groups of individuals

    • The allocation of resources, and why various groups are willing to expend resources trying to affect the standard-setting process

  • Necessary to determine if prescriptions from normative theories (e.g. current cash equivalents) are feasible

• Watts and Zimmerman believe that management plays a central role in the determination of standards

  • Moonitz supports this view

• A precondition of a positive theory of standard-setting is understanding management’s incentives

• Watts and Zimmerman assume that individuals act to maximize their own utility

  • Implication of this is that management lobbies on accounting standards based on its own self-interest

• One function of financial reporting is to constrain management to act in the shareholders’ interest

• Assuming congruence of management and shareholder interests without further investigation may cause us to omit from our lobbying model important predictive variables

• Assumption that management selects accounting procedures to maximize its own utility is used by Gordon (1964) in an early attempt to derive a positive theory of accounting

  • Gordon’s model and its variants are called the ‘smoothing’ literature by Watts and Zimmerman

  • Lack of confirmation

  • Assumed that shareholder satisfaction (and presumably, wealth) is solely a positive function of accounting income

• Watts and Zimmerman assume that management’s utility is a positive function of the expected compensation in future periods and a negative function of the dispersion of future compensation

• Mechanisms which increase management’s wealth:

  • 1) Increases in share price (i.e. stock and stock options are more valuable

  • 2) Increases in incentive cash bonuses

Taxes

• Not directly tied to financial accounting standards except in a few cases

  • Indirect relationship is well documented by Zeff (1972) and Moonitz (1974)

• Adoption of a given procedure for financial accounting does not decrease the likelihood of that procedure’s being adoption in future tax codes, and more likely, will increase the chance of adoption

• Thus lobbying behavior is affected by the future tax law effects

Regulations

• A new accounting standard which reduces a utility’s reported income may provide its management with an “excuse” to argue for increased rates

  • Depends on factors such as information costs

• Utilities have an incentive to favour such changes

• The have an incentive to oppose changes in accounting standards which might lead to a rate decrease (the commission rate they receive)

Political costs

• Corporate sector is especially vulnerable to wealth redistribution

• Certain groups of voters have an incentive to lobby for the nationalization, expropriation, break-up or regulation of an industry or corporation

• Corporations employ a number of devices, such as social responsibility campaigns in the media, government lobbying and selection of accounting procedures to minimize reported earnings

  • Avoiding the attention that “high” profits draw

• Management can reduce the likelihood of adverse political actions and reduce its expected costs

• The magnitude of the political costs is highly dependent on firm size

Information production

• Changes in accounting procedures are not costless to firms

Management compensation plans

• Incentive (bonus) plan

  • These plans are based on accounting income

• Majority of companies formally incorporate accounting income into the compensation plan

• A change in accounting standards which increase the firm’s reported earnings would, ceteris paribus, lead to greater incentive income

Incentives for various groups to adjust for a change in accounting standards

• An individual (whether a shareholder, nonmanaging director, or politician) will adjust a firm’s accounting numbers for a change in accounting standards up to the point that the MC of making the adjustment equals the MB

• Watts and Zimmerman predict that managers have greater incentives to choose accounting standards which report lower earnings (thereby increasing cashflows, firm value, and their welfare) due to tax, political and regulatory considerations than to choose accounting...