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Unit 4: Economic Consequences > Positive Accounting Theory

Positive Accounting Theory

Here are some questions to test your knowledge of PAT.

  1. Which of the following manager actions is most consistent with the efficient contracting version of Positive Accounting Theory (PAT)?

    a) The firm switches from declining balance to straight-line amortization of capital assets.
    b) The firm reduces its R&D program.
    c) The manager uses derivatives primarily to hedge.
    d) The manager issues a pessimistic earnings forecast shortly before a scheduled Employee Stock Option (ESO) grant date.

    Incorrect. This is less consistent with efficient contracting since it could be consistent with either version of PAT. For example, the manager may be attempting to increase bonus compensation by increasing reported net income, or he/she may be attempting to avoid debt covenant violation, which could benefit both the firm and the bondholders.

    Incorrect. This is less consistent with efficient contracting since it could be consistent with either version of PAT. For example, the manager may be attempting to increase bonus compensation by increasing reported net income, or he/she may be attempting to avoid debt covenant violation, which could benefit both the firm and the bondholders.

    Correct. Using derivatives to control the amount of firm risk is consistent with the efficient contracting version of PAT. Excessive risk can benefit the manager and shareholders at the expense of bondholders, which is more consistent with the opportunistic version of PAT.

    Incorrect. This supports the opportunistic version of PAT, not the efficient contracting version.

  2. Which statement is the most important implication of the political cost hypothesis of positive accounting theory (PAT)?

    a) Managers may prefer lower reported net income.
    b) Large firms are subject to more political "heat" than small firms.
    c) It is inconsistent with the opportunistic version of PAT.
    d) Empirical tests of the hypothesis have failed to support it.

    Correct. This is the main implication. Managers of very large firms may prefer to show lower rather than higher earnings to reduce political “heat” and forestall possible legislation that may reduce their competitive advantage.

    Incorrect. This underlies the political cost hypothesis but is not an implication.

    Incorrect. The hypothesis may be consistent with either the opportunistic or the efficient contracting version of PAT. For example, the manager of a very large firm may behave opportunistically to manage reported earnings downwards so as to make his/her job easier. Alternatively, the manager may behave efficiently by managing reported earnings downwards so as to reduce the possibility of government regulations that may control or reduce firm profits.

    Incorrect. There is empirical support for the political cost hypothesis. For example, the research of Jones (1991) found evidence that firms lowered reported net income when appealing for protection from foreign competition.

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