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Lecture 22

BU457 Lecture Notes - Lecture 22: Moral Hazard, Management, Financial Statement

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Bixia Xu

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The Positive Theory of Accounting
Outline of Positive Accounting Theory
Positive accounting theory (PAT) is concerned with predicting such
actions as the choices of accounting policies by firm managers and how
managers will respond to proposed new accounting standards
PAT takes the view that firms organize themselves in the most efficient
manner so as to maximize their prospects for survival
A firm can be viewed as a nexus of contracts, that is, its organisation can
largely be described by the set of contracts it enters into
The firm will want to minimize the various contracting costs associated with
o Includes negotiation, costs arising from moral hazard and monitoring
of contract performance, costs of possible renegotiation or contract
violation, costs of bankruptcy and financial distress
o Contracting costs are also affected by the firms capital structure
(bonds and shares)
Contracts with the lowest contracting costs are called efficient contracts
o Efficient contracts minimizes the costs of moral hazard, by motivating
the manager to act in shareholder’s best interests
PAT argues that firms accounting policies will be chosen as part of the
broader problem of attaining efficient corporate governance
o Ex. Greater the interdependence between parent and subsidiary, the
more efficient it is to evaluate the joint results rather than individually
o It is more efficient to monitor manager performance by use of
consolidated financial statement-based performance measures than
by performance measures based on separate parent and subsidiary
financial statements when interdependence is high
Giving management flexibility to choose from a set of accounting policies
open up the possibility of opportunistic behaviour ex post, that is, given the
available set, managers may choose accounting policies from the set for their
own purposes, thereby reducing contract efficiency
PAT assumes that managers are rational (like investors) and will choose the
accounting policies in their own best interest if able to do so to maximize
their own utility
The optimal set of accounting policies for the firm then represents a
o Tightly prescribing accounting policies beforehand will minimize
opportunistic accounting policy choice by managers but incurs the
cost of lack of accounting inflexibility to meet changing circumstances
o On the other hand, allowing the manager to choose from a broad array
of accounting policies will reduce costs of accounting inflexibility but
expose the firm to the cost of opportunistic manager behaviour
Thus, PAT does not attempt to tell individuals or constituencies what they
should do (called normative theories)
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