Positive Accounting Theory Analysis: Finance Assignment Solution

This document presents a comprehensive analysis of Positive Accounting Theory (PAT). It delves into the efficiency and opportunistic perspectives, exploring how contractual agreements minimize conflicts of interest and how individuals may exploit contract flexibilities for personal gain. The assignment addresses the impact of obligatory covenants on default risk, the influence of accounting-based bonus plans on accounting methods, and the political cost hypothesis's effect on large firms' accounting choices. It also examines the implications of debt restrictions and market-based measures, as well as the effects of accounting standards on lease accounting. Furthermore, the assignment discusses how debt holders and managers make choices regarding accounting practices to minimize risk, and how they respond to changes in accounting standards, particularly concerning leased assets and debt covenants. References to relevant academic literature are also included.

Running head: POSITIVE ACCOUNTING THEORY
Positive Accounting Theory
Name of the Student:
Name of the University:
Author’s Note:
Course ID:

1POSITIVE ACCOUNTING THEORY
Table of Contents
Answer to Question 1:.....................................................................................................................2
Answer to Question 2:.....................................................................................................................2
Answer to Question 3:.....................................................................................................................3
Answer to Question 4:.....................................................................................................................3
Answer to Question 5:.....................................................................................................................4
Requirement a:.............................................................................................................................4
Requirement b:.............................................................................................................................4
Requirement c:.............................................................................................................................4
References:......................................................................................................................................6

2POSITIVE ACCOUNTING THEORY
Answer to Question 1:
According to the efficiency perspective, the contractual agreements are formed to
minimise the expected conflicts of interest and related agency costs between different individuals
associated with the business operations of an organisation. With the help of such contracts, the
future transactions could be minimised and as a result, the value of the firm increases (Alayemi,
2015). Since these agreements are formed for minimising future conflicts, they are taken into
account to be initiated on upfront basis, which is termed as ex ante.
According to the opportunistic perspective, the self-interest of the individuals motivate
them at the expense of others and after involvement in contractual agreements, they would tend
to capitalise on flexibility to ensure favourable pay-offs, which is again at the expense of others.
Since it is not possible to cover all points in details in contracts, the opportunistic managers
anticipate the flexibilities in the contracts. Moreover, it is crucial for the independent auditors in
assuring the reasonableness of the adopted accounting standards in line with the accepted
practice. Since these behaviours happen after negotiation of transactions, the actions are
considered to take place on ex post basis.
Answer to Question 2:
In the words of Beattie (2014), the increasing obligatory covenants would provide a prior
sign to point towards default risk and this would lead to fall in the risk exposure of the lending
party. The reason is that the management would have lower ability of circumventing restrictive
agreements. For instance, by undertaking asset revaluation, these covenants would lead to
technical default related to loan agreement earlier than if the management has the scope of

3POSITIVE ACCOUNTING THEORY
loosening restrictions. Thus, if a senior manager within an organisation is rewarded by means of
accounting based bonus plans, the shareholders would choose conservative accounting methods.
The reason is that the utilisation of conservative methods of accounting minimise the ability of
the managers in manipulating accounting numbers opportunistically.
Answer to Question 3:
As commented by Avelé (2014), the political cost hypothesis estimates that the large
firms are more probable of using accounting choices than small organisations for minimising
reported profits. The proxy variable in relation to political attention is size, which implies that
the big organisations have to deal with increased political scrutiny. If it is assumed that an
organisation is encountered with increased political scrutiny and greater profits would draw
unwanted political attention, the organisation would expense an expenditure item, instead of
capitalising the same.
Answer to Question 4:
Based on the PAT theory perspective, a firm would negotiate a specific debt restriction
for drawing funds at lower cost. At the time the firm negotiated the restriction, it was perceived
that the requirement of minimum market capitalisation has lower chance of violation, as the
shares declined from $34.63 to $5.25 over the year (News.com.au, 2018). However, the risks
associated with borrowers at time of using market-based measures are the responses of the share
prices in relation to market factors that could not be controlled by the organisation. As a result,
market-based measures are not preferred by many organisations. However, by assuming the
rationality of the management, the risk accepted would be offset by the benefits obtained from
restriction agreements.

4POSITIVE ACCOUNTING THEORY
Based on the viewpoint of the lender, if it is assumed that there is presence of efficient
market, using the market price as sign of organisational health could be an effective policy for
adoption. Hence, when there is fall in share price, it signifies that the market expectations need to
be revised regarding the cash flows to be obtained in future associated with having a security and
thus, a basis is provided to monitor the value of a specific investment.
Answer to Question 5:
Requirement a:
The realisation of leased assets as well as leased liabilities would result in worsening of
debt to assets or debt-to-equity ratio. In case, an organisation is near to violate a specific debt
covenant, the new standard of accounting could tip over the negotiated upper limit of the ratio.
As a result, the organisation might be placed in a situation of being in technical default related to
the debt covenant (Dutta & Patatoukas, 2016).
Requirement b:
It would be probable that the proposed standard of accounting would be affecting
whether the firms would be considering leases and the related terms of lease contracts. It is
inherent for the organisations along with their advisors to find loopholes in specific accounting
standards and transactions need to be devised in a manner for exploiting such loopholes.
Therefore, the organisations would select to keep debt from their balance sheet statements.
Requirement c:
The debt holders generally opt that managers do not exercise discretion for reducing the
impact of negotiated debt contracts. They would prefer that the activation of debt covenants is
made earlier. The reason behind this is that they would access the assets over which they have

5POSITIVE ACCOUNTING THEORY
control before the financial stress of the organisation is increased (Ghanbari et al., 2016). Hence,
the debt holders would like to recognise leases in the balance sheet statement.

6POSITIVE ACCOUNTING THEORY
References:
Alayemi, S. A. (2015). Choice of accounting policy: Effects on analysis and interpretation of
financial statements. American Journal of Economics, Finance and Management, 1(3),
190-194.
Avelé, D. (2014). Positive accounting theory: theoretical and critical perspectives. International
Journal of Critical Accounting, 6(4), 396-415.
Beattie, V. (2014). Accounting narratives and the narrative turn in accounting research: Issues,
theory, methodology, methods and a research framework. The British Accounting
Review, 46(2), 111-134.
Dutta, S., & Patatoukas, P. N. (2016). Identifying conditional conservatism in financial
accounting data: theory and evidence. The Accounting Review, 92(4), 191-216.
Ghanbari, M., Manesh, M. Z., Khorasani, H., Hesam, H., & Nejad, H. (2016). PAT (positive
accounting theory) and natural science. International Research Journal of Applied and
Basic Sciences, 10(2), 177-182.
News.com.au. (2018). Battered Babcock to meet bankers. Retrieved 2 September 2018, from
https://www.news.com.au/finance/markets/battered-babcock-to-meet-bankers/news-
story/ee1be28658cab28ffa0869b133fab