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Ethics and Positive Accounting Theory

Abstract

This monograph, Ethics and Positive Accounting Theory, is the product of the work of Ms. Trish O'Malley, Professors Efrim Boritz, Sally Gunz, and Amin Mawani under the leadership of Professor Gordon Richardson. The monograph breaks new ground in examining positive accounting theory.

While agency theory and PAT have been well known to accounting academics since the late 1970s, our objective in this monograph is to disseminate this knowledge to practitioners and accounting students. We believe that PAT has been slow to find its way into the everyday vocabulary of accounting professionals. This monograph is intended for senior undergraduate financial accounting and auditing courses as well as firm training courses.

Chapter one explains how the theory works, and assumes the reader is not an academic and has no prior exposure to the ideas. It starts off by explaining agency conflicts between firm claimants, and how the various parties agree to control these conflicts by contracting on verified accounting numbers. Here, the emphasis is on the properties accounting numbers must have (objectivity, verifiability, "hardness") in order to enhance ex ante contracting efficiency. Indeed, the evolution of generally accepted accounting principles can be understood when one understands how these principles enhance contracting efficiency. Once contracts are in place (bonus contracts, debt contracts, etc.), ex post PAT opportunism takes over, since accounting choices are predicted once these contracts are in place. According to the notion of opportunism, choices are made that may be inside or outside the contractually agreed upon set of accepted reporting methods (in class, we call this set the "PAT circle"). If outside the set of accepted reporting methods, choices by preparers can lead to unforeseen wealth transfers from vulnerable firm claimants. The great irony is that, the more successful efficient contracting is at the outset, the smaller will be the scope for opportunism after the fact. The latter is the "residual" of the former contracting process. As explained in Chapter one, much of the early PAT academic literature tested various predictions arising from PAT opportunism. More recently, the focus has shifted to notions of ex ante contracting efficiency, and away from opportunism. This shift is due in part, we believe, to the fact that the above irony became apparent to many academics doing research in the area. Nevertheless, we believe knowledge of ex post PAT opportunism is still a very useful tool for auditors, precisely because auditors enforce choices within the contractually agreed upon set of methods. The flip side of unforeseen wealth transfers can be auditor negligence, a theme that we return to in Chapter five.

Chapter two surveys audit partners in order to explore their attitudes and familiarity with PAT phenomena. This chapter describes the PAT-type phenomena they encounter in practice, to obtain a reasonably complete picture of the robustness of PAT. Perhaps not surprisingly, the partners we surveyed had generally never heard of PAT but were very familiar with PAT-type behaviour. What they appear to lack is a unifying theory, something we hope this monograph will help to instill in today's accounting students, some of whom will be the audit partners of the future.

Chapter three contains five case studies. Real life episodes that we believe illustrate Positive Accounting Theory in action have been included for two important reasons. First, our experience as both teachers and students leads us to the conclusion that concrete examples of how theory works in practice are always more interesting than pure theory by itself. Second, people need experience in attempting to identify the incentives and make the PAT predictions about accounting choices. We found that leading students through one or two examples made it much easier for them to spot the incentives and make appropriate predictions in the other cases, and to identify their own PAT episodes. The cases have been extensively class tested at the University of Waterloo, with considerable success.

Chapter four, by Professor J. Efrim Boritz, is a path-breaking exploration of the links between PAT and fraud detection. Efrim concurs with our view that PAT is a very useful tool for auditors and forensic accountants. In particular, Efrim stresses the role of PAT in assessing inherent audit risk.

Chapter five, written by Professor Sally Gunz, develops the link between a failure to spot PAT red flags and an auditor's exposure in negligence suits. It is very important for audit working papers to demonstrate an awareness of the red flags when documenting inherent risk factors.

Chapter six, by Professor Amin Mawani, is important because it addresses the link between PAT and ethics. PAT is not a complete theory of managerial reporting choices, precisely because we observe managers trying to do the "right thing" despite economic incentives or pressures. Ethics can explain behaviour that PAT fails to explain. As emphasized by the partners we surveyed, most managers behave in an ethical fashion, most of the time. The "economic" view of behaviour is inevitably incomplete, as Amin explains.