Positive Accounting Theory in Management

Introduction

This paper consists of two parts. Part A will explain statement about the accounting policy choice literature which is opportunistic policy motivated by various factors while part B will explain Foster’s accounting policy choice from two viewpoints – from an opportunistic behavior and an information and signaling perspective.

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Analysis and Discussion

Part A

This part would explain the statement: The accounting policy choice literature refers to opportunistic policy choices being motivated by factors related to contracts or political costs, and to involved profit increasing/decreasing, profit sharing, and/or ‘big bath’ accounting strategies.

Managers in their choice of accounting policy are motivated by factors related to contracts or political costs. This means that managers will generally consider the impact of the accounting policy on existing contract that may affect the bottom line of the business and their consequent responsibility to stockholders.

To illustrate, it could happen that an accounting standard may allow the company in its design and choice of an accounting policy that could affect its existing contracts with creditors that require a certain level of income otherwise these creditors would have to invoke agreed conditions like making the acceleration clauses in agreements. Management would most likely choose to design a policy that would make the impact of the accounting standard to have less effect on the bottom line. In a choice of having a longer or shorted life for some of its fixed assets, which are depreciated over its useful life, the company would most likely choose a longer period because the deprecation charges would be less over a longer period.

Hence the effect on income would mostly minimal since the less the depreciation charges, the less would the reduction in income. The same behavior could happen when there is mandatory standard on goodwill amortization, where the managers are influenced in the choice of accounting policy by considering the effect of the policy on company cash flows which may entail political costs in terms of affect prices of stocks if there is perceived changes in the cash flow effects.

The choice of the policy on depreciation of fixed assets and amortization of goodwill could also affect the dividend policy of company. If the company has made it a policy to declare dividend regularly, any changes on standard that may potentially impact on said dividend policies must be considered in the choice of accounting policy in a way that would not violate or contradict earlier declared policies.

The opportunistic policy choice by managers also involves profit increasing/decreasing, profit smoothing, and/or ‘big bath’ accounting strategies. This means policy choice by managers, described to opportunistic, is in a sense a resort to creative accounting for the purpose of possibly manipulating or designing the information presented to decision makers, particularly the investors. This practice would have the appearance of maximizing the value of the wealth of stockholders but in reality still possessed of the management’s inherent interest in protecting themselves by preserving their stay in their positions.

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Although profits are generally perceived to be aimed to increase consistently over the years in the life of the business entity, managers have the tendency to for increase or decrease of profits under different conditions consistent with their interests. The matter of income smoothing is one practice of management where there is deliberate control which would have a restraining effect expected growths in income or profits for the company.

Amat, et al. (1999) explained that under income smoothing, entities would have the tendency to make it appear to the investing public there is a steady leaning towards profit growth rather than making it appear that the company is capable of showing changing or unstable profits where there could rise and fall that are dramatically observed and felt by investors. It is more consistent with experience and human nature that management would like to show that management can control some business variable by choosing to adopt a policy that could indicate volatility rather than instability which is bad for business. From the financial point of view, the greater the volatility in the profits or income, the greater is the risk that company may have and investors would normally shy away risks.

The manner of achieving income smoothing could vary but generally companies would do it by making unnecessary provision for liabilities and lower assets values during good years. This would have the effect of improving the reported profits or level of profitability when times are not good. It is believed that remedy to this by management would in effect prevent the danger of being focused on the short term criteria for evaluating investment. In other words, management practices the same so that if subsequent yield of the investments in the following years would not be as good as the previous years, investors may infer that the company could not even be unstable in the short term.

There are however criticisms for this management behavior in relation of the right of investors which may be sacrifices unjustifiably. One criticism is the fact that investors have the right to know the true level of volatility in trading conditions if such is a fact. The other criticism is that the practice of income smoothing in the choice of accounting policy may possibly hide long-term changes in the profit trend that may have caused investors to have invested more for the company.

This is however the essence of having this policy choice of being opportunistic on the part of management such it that could be taken by investors that management is always motivated by value maximization behavior as expected but behind it are the self interest of managers (Amat, et al. ,1999).

Although management is expected to make the company look profitable to investors, their choice of accounting policy becomes opportunistic because it also resorts to the practice of ‘big bath’ accounting, where management would seek to maximize the reported loss during bad time that there could better financial picture for the company in future years (Amat, et al. ,1999). The logical consequence for this is a that one cannot do anything about a loss in a bad year, so that since there would be no bonus for that year, management might just as well maximize if not exaggerate the same losses so the rise or increase in the coming year or years would be higher which would entitle executive to have larger bonus.

This is again evidently opportunistic and would inherently violate or contradict the real essence of value maximizing objective for stockholders since any bonus that may be given to these executives in future years is in a sense a reduction of company resources and wealth of stockholders as well. It is in this aspect the purpose of giving incentives to management to reduce the conflict on interest with the stockholders is being manipulated in favor of management.

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The chief executive officers (CEOs) of companies stand to benefits by big bath because they will still receive their salaries whether the business is failing or not and this could sound legitimized by an announcement that company cannot meet the target, thus a there is a great incentive to delay realization of revenues as a matter of accounting policy choice for the meantime. The moment that next year would be expected as good year, then previously deferred revenues (Meigs and Meigs,1995) will go to the credit of the CEO next year.

In the eyes of stockholders, this will deserved bonus as incentive of a job well done. In other words, accounting information is an essential requisite of managing a business and there is an incentive to adjust it in the favor or the management who has control and who will present the information to stockholders.

CEOs also employ the ‘big bath” accounting practice a way to company lackluster performance of the previous CEOs. By blaming the previous heads, the new chiefs necessarily take credit for any changes that may improve the company in the future.

Foster’s Accounting Policy Choice

This part of the paper seeks to explain Foster’s accounting policy choice from two viewpoints. The first viewpoint would be on opportunistic behavior and the second view point is on information and signaling perspective.

Opportunistic behavior

Under this concept, it is assumed that managers are not doing value-maximizing activities for the company and that the CEOs are basically doing their functions nearer to their self interest rather than maximize value for stockholders (Christie and Zimmennan, 1991).

What is illustrated by the case of Foster’s accounting policy is a clear of the ‘big bath’ accounting strategy or practice. Under the said strategy, there is tendency to maximize the appearance of a loss status by the business in times of bad year for the self interest purposes. The first effect as discussed earlier in part A earlier. Since Foster could not do anything about the loss in the bad year due to big inventory write-downs (Gettler, L., 2008) because of low demand for company’s products, its CEO Trevor O’Hoy could just as well maximize the loss.

By so doing, Foster’s Trevor O’Hoy would hopes to make a big turnaround in future years which could be a big source of bonus or financial incentives for his and his fellow executive officers. The announcement made by Trevor O’Hoy is clearly opportunistic and violative of the normal stockholders’ expectation of maximized value for their investments (Brigham and Houston, 2002). The amount of bonus that may be given to Foster in future, assuming he will continue to take reigns of the company, would effectively reduce company resources and wealth of stockholders as well.

Another reason why Foster’s CEO is doing the said announcement for the company is the possibility that he is just new for the company. It is therefore a way of blaming the past CEO. Since he will receive his salary whether the business is failing or not, next year would most likely be a great year to look forward for by then the company would not have any place to go but to recover or go up and his bonus would mostly likely be justified in the light of the big rise or increase, hence it is called ‘big bath’ strategy.

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Information and signaling perspectives

Based on information-signaling perspective, managers are expected to communicate to the capital future market about future net cash flows from firm’s current situation and subsequently thereafter (James and Verhoeven, 2006). What was done by Foster’s CEO was a function that is expected by stockholders. This function is in the context of present separation of ownership and control in the modern corporation where the important issue may come because of information asymmetry situation. In such situation, one contracting party knows more than the other party about the probability of future cash flow from where the company is coming.

In other words, the announcement of decline in the value of inventory would have to be expected to generate a negative impact to the company in terms of lower stock prices. The management of Foster is however bound to do it so that knowledge that could affect investors should be properly disclosed to stockholders to allow them to make proper decisions as a matter of their right in keeping their investment in the company.

Conclusion

It can be concluded that management interest is different from the interest of the stockholders. A conflict was found evident between the two corporate stakeholders. Since management has a choice to make for the corporation on matters of accounting policy, the said choice is evidently opportunistic as discussed in the paper. The opportunistic behavior was confirmed in the case of Foster announcing the inventory write downs under the ‘big’ bath practice. But since management is formally recognized to discharge a responsibility to stockholders, it must fulfill its duty of leveling the playing field for all investors concerned by disclosing the true state of the corporation since the company is endowed with public interest under the information signaling perspective.

References

Amat, et al. (1999) THE ETHICS OF CREATIVE ACCOUNTING. Web.

Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, US.

Christie and Zimmennan (1991) William Efficient vs. Opportunistic Choice of Accounting Procedures: Corporate Control Contests. Web.

Gettler, L., 2008, Grapes of Wrath, Business Review Weely, pp. 32-3,

James and Verhoeven (2006) Accounting for Goodwill in Australian Business Combinations: Is there value to choose?. Web.

Meigs and Meigs (1995), Financial Accounting, McGraw-Hill, Inc., New York USA.

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StudyCorgi. (2021, October 9). Positive Accounting Theory in Management. Retrieved from https://studycorgi.com/positive-accounting-theory-in-management/

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