The
basic purpose of Positive accounting theory is to predict the firm’s actions
and reactions regarding which accounting policies are used and what react of
firm regarding expected accounting standard.
Definition
“The
positive accounting theory determine that manager of the organization will do
work in the interest of the organization and use those accounting practices
which encourage reducing the contracting cost.”
Purpose
The
main target of positive accounting theory is to explain the accurate financial
performance of the firm. Identify the accounting practices i.e. which type of
accounting method used
The
main target of positive accounting theory is to define the relation between the
individual who providing the resources to the organization such as;
Ø Relation
between the manager and owner
Ø Relation
between the debt provider and manager
Assumptions of Accounting Theory
There
are four assumptions of accounting theory:-
1.
Wealth Maximization
The
main target of the organization is to enhance the business worth. For this
purpose the manager should perform in opportunistic manners.
2.
Self-Interest
The
action of each individual within the organization is based on their
self-interest.
3.
Nature of group
The
organization must be collection of those people who have interest in the
corporation.
4. Loyalty & Morality
The
theory could not cover the notions of loyalty and morality within corporation.
Origin
The
initiative taken regarding the positive accounting theory in the late 1960s
when Ball and Brown (1968) and beaver (1968) introduced the methods of
financial accounting.
Background
The
positive accounting theory development started by Watts and Zimmerman at
William E, SBA at the University of Rochester and published in journal of
Accounting and economics in 1979.
Reasons of developing Positive
Accounting Theory
There
are few reasons regarding the development of positive accounting theory
1.The
financial accounting methods that is developed by Ball and brown (1968) only
predict the market condition , earning per share, return on equity and share
price of the firm but it could not provide accurate information about the firm
accounting methods.
Example:
The financial accounting did not provide the information why the all the firms
in same industries use the same depreciation method regarding change in tax
rate.
2.
The financial Accounting information did not provide accurate information if
the Tax did not change the firm worth also can’t change.
3.
Financial Research based on the cost of debt so they increase the equity cost.
That’s
why it is essential to develop such type of theory that provides the accurate
information about business performance.
Development steps of Positive
Accounting Theory
1. Concept
The
main concept that plays a key role in the positive accounting theory is known
as contracting cost.
Why contracting cost is used? The
contracting cost is used because it connected with the political [process that
provides the information regarding business bonus plans and sales contract
information all these cost describes the company’s conditions.
Bases of contracting cost
The
theory is based on the contracting costs which include the transaction cost,
information cost, and bankruptcy cost. All these cost describes the firm’s
worth.
2. Variables
The Bonus plan, Debt/Equity and political cost used
as a variables.
·
Bonus
plan
Incentives paid to the manager from the
output of the business.
The output of the business based on
§ Firms
Profit
§ Firms
Net Sales
§ Assets
Return
Political
costs
•
These cost included the external factors
that affect the firm growth such as
§
Taxes enhancement
§ Shortages
of products
§
Shortages of wages
•
Government instability, low numbers of
subsidies and change in consumer behavior.
4. Methodology
The
linear programming regression models are used as a methodology.
Implications
·
Agency Relationship
·
Self Interest
·
Earnings Management
·
Social Disclosure, Social Responsibility
Campaigns & Political Costs
·
Environmental Disclosure & Political
Costs
Further
are the explanations of the above mentioned implications
·
Agency
Relationship:
The
relationship that exists between two parties where, one party acts or works on
the behalf of other party and gets paid, which is agency cost. In terms of PAT,
the relationship between managers and shareholders represent the agency
relationships.
The
managers get paid for maximizing the wealth. So they prepare financial
statements with such a mindset which helps them to present financial statements
with an objective of wealth maximization. As (Milne, 2002)
reported that managers lobby some of the accounting practices, they use
accounting standards which best suit them in order to maximize the reported
income and ultimately the management’s wealth. The managers get higher
incentives for manipulating the financial statements. This shows how much agency
relationship is important in Positive Accounting Theory.
·
Self
Interest:
Agency
relationship arising as result of Positive Accounting Theory (PAT) can be
viewed in the other form of Self-Interest. The managers protect and work
according to the agency relationship because of their own self interest. They
want to earn more incentives. Similarly, (Watts, 1978)
have same arguments regarding the agency relationship. They also state that individuals
act to maximize their own utility that’s why the managers act and choose such
accounting standards so as to maximize the management’s wealth and protect
their agency relationships. They stated the managers get benefit and incentive
in the form of compensation for choosing those accounting standards that lower
the firms earning and ultimately showing a rise in cash flows of the firm.
Managers
have greater incentives to choose accounting standards which report lower earnings
(thereby increasing cash flows, firm value, and their welfare) due to tax,
political, and regulatory considerations than to choose accounting standards
which report higher earnings and, thereby, increase their incentive
compensation.
There
are many ways with the help of which the managers (a part of agency
relationships) manipulate financial statements, and present maximized
management’s wealth. These ways are originally the hypothesis as given by (Watts, 1978) . The factors are as
follows,
1) the bonus plan,
i.e. choosing accounting standards that shift reported earnings from future to
current periods,
2) Debt/equity ratio,
i.e. the greater the ratio, the greater are chances that the manager will shift
the reported earnings from future to current period.
3) The size hypothesis
i.e. the greater the firms size, the greater are the chances that the manger
will adopt such practices which will defer reported earnings from current to
future period.
Managers
use any of the above processes or ways to maximize the wealth.
·
Earnings
Management:
As
already discussed the sole purpose of the agency relationship and the self
interest of managers are to manage the earnings of the firm. They solely want
to manage the earnings and to protect the corporations from heavy taxes. (Vivien Beatte, 1994) , came up with the
idea that managers manage the earnings basically by utilizing the term in
Income statement that is Extraordinary Items. Normally the details about items
these are given in the Financial Statements. But by external auditors no such
detailed investigation is carried out if any part of office or some items or
some data is burnt, as recovering those things is difficult. In order to avoid
heavy taxes, some of the losses which might be artificially created or are not
as big as mentioned, are written in the financial statements. This helps the
managers not only to reduce taxation but also to manage earnings. So Positive
Accounting Theory is justified here. The author (Vivien Beatte, 1994) also stated that
this practice has been very common in large corporations in United Kingdom.
·
Social
Disclosure, Social Responsibility Campaigns & Political Costs:
This
argument can be better understood by the concept which (Watts, 1978)
introduced i.e. Political Costs. According to them, politicians have the power
to impact the businesses and all other stakeholders can also impact business by
questioning on the reported income or changing tax laws, subsidies, or by
bringing any social changes.
So
in order to avoid these impacts and divert the attention, businesses start
social and responsibility campaigns.
§
Corporations employ a number of devices,
such as social responsibility campaigns in the media, government lobbying and
selection of accounting procedures to minimize reported earnings. By avoiding
the attention that “high” profits draw because of the public’s association of
high reported profits and monopoly rents, management can reduce the likelihood
of adverse political actions and, thereby, reduce its expected costs (including
the legal costs the firm would incur opposing the political actions). Included
in political costs are the costs labor unions impose through increased demands
generated by large reported profits.
§ The
magnitude of the political costs is highly dependent on firm size.
§ The
amount spent on the social disclosures and social responsibility campaigns are
the political Costs. The purpose is not only to reduce the attention on the
firm’s huge profits, but also to reduce the attention on the firm’s abusive
monopolies or any other un-ethical practices they are facing.
1) Advocacy
advertising:
Companies
which are monopolies or are practicing some unethical practices, they tend to
start advocacy advertising. If any questions are raised against their
monopolistic behavior or unethical practices, they immediately start the
advocacy advertising. In Pakistan lays started such advertising advocacy.
According
to (Sethi, 1977)
the purpose of advocacy advertising is that companies defend themselves against
slander and unfair treatment in media as Mobil Oil did. Since the companies and
corporations are constantly under attack by the stakeholders (including the
federal government, environmentalists, consumers etc); silence is considered a
crime, and if corporations remain silent, they are thought to be guilty. Hence,
it is an aspect that provides the mechanism of self-defense. It is platform
that provides the firms that they are not guilty or it helps them proving their
innocence.
Furthermore,
in the opinion of (Sethi, 1977) ,
the direct lobbying against the legislature, impacts the image of the firm in
the negative way. So, they defend their image with the help of advocacy
advertising.
·
Social
Responsibility Campaigns:
According
to (Shocker, 1974)
“Any
social institution [including business] operates in society via a social contract,
expressed or implied ”
Since
the stake holders can have huge impacts on the further decision making of the
corporation, the corporation seems to engage the stakeholders just to depict
that stakeholders mean to them. But they are actually manipulating the
stakeholders and under the cover they are carrying out the unethical practices.
For example, Exon Oil and Shell Corporation etc which are oil companies; they
extract oil and petrol beneath the surface of earth. But the practices being
followed are unethical. Hence, they carry out different conferences, just to
depict how environment friendly they are. Along with the conferences, they
carry out different social events and donation processes to depict that they
respect and love the stakeholders.
Thus
a business can use social disclosure to attempt to affect public policy. Such
disclosures may address policy issues themselves or, alternatively, may be used
to attempt to create an overall image of social responsibility for the firm.
The goal is to deal with what Miles (1987) calls throughout his book the
“exposure” of a business to both the social environment and the political
environment.
Just
like the advocacy advertising, the amount of money spent on the ‘adopting’ the
social responsibility campaigns are again the political cost which is the basic
premise by (Watts, 1978)
·
Environmental
disclosures & Political Costs:
So
the above implications provide a brief overview that why corporations want to
maximize their wealth and how do they do it in terms of Positive accounting
theory.
Since
PAT is mainly associated with wealth maximization premise, above arguments
present how wealth can be maximized. It can be maximized by using some specific
accounting standards (i.e. bonus plan hypothesis, equity/debt hypothesis, size
hypothesis). Moreover, in order to keep a good name of the corporation, which
further helps indirectly in maximizing the wealth of the corporation, various
campaigns are carried out (social disclosures, social responsibility and
environment disclosure campaigns) which lead to the rise in Political Costs.
Criticism:
The
criticism given by (Milne, 2002)
states that Positive Accounting Theory (PAT) is not concerned with the social
disclosures are or in fact it describes why they are done and how they are
done. Milne has taken the basic premise/assumption of Positive Accounting
Theory (PAT) i.e. Wealth maximization and has described it with references to
the previous authors Patten, (Watts, 1978) ,
(Cahan, 1997) etc.
He
further states that arguments given by the various authors about the
implications are not consistent but they agree on the major portion i.e.
Political Cost (Why does is arise and how does it arise) and wealth
maximization assumption. Author also states that according to (Cahan, 1997) , the wealth
maximization premise is solely dependent upon the management’s behavior. Hence,
they take various actions and steps to keep a good name, but they do not
specify them particularly. However, (Watts, 1978) ,
(Patten, 1991) specify them under
Political Costs. The author also criticize the work of (Watts, 1978)
that how the behavior of management (i.e. Spending money in form of Political
Costs to tackle the issue which arise due to the stakeholders or their own
unethical practices) is related to the lobbying behavior. The author then
further takes this premise and explains that this is also lobbying behavior as
the corporations are just depicting how socially and environment friendly they
are, but under cover they carry out the unethical practices. Not only the
lobbying behavior but also the unethical practices and the choosing of specific
accounting standards leads to wealth maximization i.e. fulfilling the
assumption of Positive accounting Theory.
Critiques
of Positive Accounting Theory (PAT)
(IQRA KHAN LODHI)
The
widely cited research paper of Watts & Zimmerman, which they named as (PAT)
Positive Accounting Theory was confronted by many published research articles.
This theory is supposed to be the most controversial theory in the history of
accounting theories. Critiques cover the specific areas in this theory.
Categories of Critiques
According
to most cited critiques, we can categorize it into three mainly targeted groups
of arguments that are as follows:
1. Critiques
regarding philosophy of science
2. Technical
criticism regarding Research method
3. Critiques
regarding Economic based issues
|
|
Categories of Criticism
|
Research method issues
|
|
Economics based research
|
|
Philosophy of sciences
|
1.
Critiques
regarding philosophy of science
In
this criticism, it is argued that, the methodology of this paper is
inefficient. Sociology term was used by the authors as Individual behavior is
observed rather than of multi-person, this theory observed the rational
behavior of individual and inefficient ways used to build explanatory
variables. They did not follow the Famous philosophers of science. The
phenomenon in this theory is “when the cost aspect changes, individual changes
the desire to maximize his/her wealth by observing the cost factor.” As
Economics is mainly focused on the cost aspect. The authors primarily focused
on the Philosophical issues are as follows:
1.
(Tinker 1982)
2. (Christenson
1983)
3. (Schreuder
1984)
4. (Whittington
1987)
5. (Sterling
1990)
6.
(Lowe et al 1983)
(Tinker 1982)
§ They
critized that Watts & Zimmerman claimed their theory to be distinguish from
normative theory as explain their theory as not a value laden and biased one
but objective and descriptive however theory is failed to do so.
§ PAT
is an exactly value laden as NAT normative theory.
§ Conservative
biased and ignored the underlying struggles
(Christenson 1983)
§ He
claimed that the positivism term used in their article is logical which was
outdated version of methodological approach.
§ Theory is sociology based accounting
§ Confused
between the phenomenal domains, philosophical rejection of their term
positivism.
§ He
claimed that they used “hypothetic deductive approach for PAT and argued this
paper by different perspectives, which are;
§ Economic
framework used in paper is unjustified
§ Unscientific
proof for nature was used
§ Empirical
evidence was not justifiable
(Schreuder 1984)
They are not properly able to
differentiate between the Normative and positive accounting, they were confused
and mix the terms by quoting different references.
(Whittington 1987)
§ He
claim as other authors mentioned their critiques about the PAT similarity with
Normative accounting, that the
conclusion is not adequate support with its assumptions and less efficient than
alternative approaches.
§ Presented
assumptions & concluded results are unbalanced.
(Sterling 1990)
He claimed that the theory is
suppose to rhetoric as the arguments not properly support their conclusion.
2.
Technical
criticism regarding Research method
Testability of PAT lack different powers which are
related to methodology, model constructions, variables. Evidence are not
obtained from stated hypothesis. The
authors primarily focused on the research method issues are as follows:
1. (Ball
& foster 1982)
2. (Holthausen
& leftwich 1983)
3. (Mc
et al 1984)
(Ball
& foster 1982)
§ The
size of the firm and the bonus hypothesis plan can be proxy for omitted
variables.
§ Weak
theoretical framework inadequate for construction of political cost.
§ Conclusions
of results of PAT are limited because of incompletion of political theories.
§ Specifications
issues with the variables.
(Mc
et al 1984)
§ Biased
parameters are used.
§ Hold
samples not used.
3. Critiques regarding Economic
based issues
Watts
and Zimmerman termed their theory as Economic based theory of accounting, in
which they explains two features which are;
1. Methodological
Individualism
2. Neoclassical
maximizing hypothesis
Methodological Individualism:
Each
member of decision making committee has equal contribution in that decision
making procedure.
Neo-Classical Hypothesis:
Everyone
makes such decision with a rational behavior that goes with his/her personal
benefit of wealth maximization. Some researchers claimed that maximization
assumption can be prove possible but practically it is not possible. The
authors primarily focused on the research method issues are as follows:
(Whittington
1987)
§ It
presents biased view of PAT.
§ Theory
is not seems to be empirically testable.
§ Weak
methodology is presented.
(Sterling
1990)
He
attacks the major findings of 1980’s paper of Watts & Zimmerman. They
claimed that there findings are just as they assumed. In Paper lack of
universality is observed about the conclusion as they assumed that everyone is
maximize and inadequate evidence they mention in conclusion that everyone is
maximize.
§ PAT
relies on Equilibrium based accounting
§ Extensive
use of behavioral instead of formal equilibrium analysis.
Timeline (AREEBA BATOOL)
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Author
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Article
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Study
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An
Empirical Evaluation of accounting numbers
|
The
primary purpose of this study was to evaluate the current accounting numbers
by checking their information subject matter and correctness. In this study
method was provided for a theoretical approach to limited class of debatable
options in the external reporting.
|
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Towards
a positive theory of determination of accounting standards
|
This
theory provided the initiation of positive accounting theory by discovering
the factors that affected the opinion of the management on the accounting
standards which probably influence firm’s politicization on accounting
standards. The results were coherent with the theory.
|
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The
demand for and supply of accounting theories: the market excuses
|
This
paper reports about why the accounting theories are mostly normative and why
not only one theory is accepted generally. In this paper the suggestions of
the author’s theory for the change in accounting work in response to changes
in the environment of the institutions are assessed with the examined
phenomena.
|
|
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The
normative origins of positive theories: ideology and accounting thought
|
This
paper contends that positive or empirical theories are also normative and
over loaded as they often cover debatable ideological unfairness in their
accounting policy suggestions.
|
|
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The
methodology of positive accounting
|
Jensen,
watts and Zimmerman blame that most of the accounting theories are irrational
as they are normative. They support the growth of optimistic to explicate
real office carry out. The program of Rochester school points out many
procedural issues that have been highlighted in this commentary. First it is
said that Rochester schools disapproval of conventional accounting theory was
off the mark because it could not differentiate the two dissimilar levels of
phenomena. Second it is said that constructive theory is based on fallacy.
Excremental theories it is revealed are, unhelpful in their significance,
they utter what is to be taken as empirically impractical.
|
|
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The
economic consequences of accounting choice implications of costly contracting
and monitoring
|
In
this article study is assessed into financial consequences of chosen and
obligatory choices of accounting techniques and values. Accounting choices
have consequences if changes in the set of laws used to compute the
accounting figures adjust the allocation of the firms money flows or the
assets of the parties who use those numbers for contracting and decision
making. Contracting and monitoring cost cover the cost of the scheming,
negotiating, writing and evaluating the fulfillment with written and
disguised contracts.
|
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Simple
theories for complex processes: accounting policy and market for myopia
|
The
propensity to use simple models to apprehend and predict the complex
phenomena in the social sciences is conversed and criticized in this paper by
observing Watts and Zimmerman’s Demand for and supply of Accounting theories.
|
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Positive
accounting: review article
|
In
this review article the work of Watts and Zimmerman was fully examined. The
limitations positive methodology and limitations imposed by predictions
related to market and finally the limitations to their own positive theory of
accounting choice.
|
|
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Positive
accounting theory: a review
|
Watts
and Zimmerman positive accounting theory is an important contribution and it
is refreshing and debatable as well. It is debatable because theory and
techniques are not fully developed and in this article review an attempt to
verify the content and importance of the positive accounting theory.
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|
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Popper’s
methodology of falsificationism and accounting research
|
Popper’s
falsificationism is in fact being adopted as a model for book keeping
researcher. For instance Christenson (1983) has disagreed with Watts and
Zimmerman (1978, 1979) theories for not compliant with Poppers ideas. This
paper maintains that Popper falsificationism should not be adopted as a
reasonable model by book keeper’s experts and that standard rigidity and
research and investigational plan are enough to hold up the Christenson’s
criticism without choice to Popper’s attitude.
|
|
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Possibility
and Utility of positive accounting theory
|
This
paper discusses the possibilities and utilities of the positive accounting
theory. The degree to which this type of research follows the teachings of
the theoretical philosophers is a controversial matter.
|
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Positive
accounting: an assessment
|
Positive
accounting theory using same book name as of Watts and Zimmerman as a chief
cause of information about the theory, is subjected to inspection. The two
pillars 1. Value free study 2. Accounting practices upon which the legality
of the theory are said to rest are set up to be thin. The deeds –definite and
perspective- of the optimistic theory are found to be zero and are
anticipated to go with to be nil. Based on these results, the suggestion is
to grade the positive accounting theory as a small industry at a margin of
accounting consideration and refuse its endeavor to take center point by
completely redefining the basic enquiry of accounting.
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Positive
accounting theory: a ten years perspective
|
This
theory gives a bracing divisive and vital input to the accounting notion. It
is significant fir the reason of its strong stress on the financial reporting
activity in a more explicit way. It is debatable as the techniques used in it
are not fully matured.
|
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Extra
ordinary items and income smoothing: A positive accounting approach
|
This
was the first study which was income smoothing to check the classificatory
options inside clear incentive based framework. The model used in the study
succeeded in defining the considerable percentage of change in the
classificatory options.
|
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Positive
accounting theory, political costs and social disclosure analysis: a critical
look
|
In
this paper a critical review of the work has been done which seeks to create
an evidence for a positive accounting theory of corporate social exposes. In
this paper a detailed example and evidence is found to show the attempts of
theorists of accounting settle environmental and social accounting research
have showed a failure. This paper also provides the theoretical proof
assembled to date in the favor of positive accounting theory of the social
revelations fails mostly in its efforts.
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Conclusion
Overall,
the work was discussed from the origination of theory and implications were
discussed along with criticism and timeline.
The
theory is mainly concerned with the self interest motive. Moreover, not much
work in done after 2000s. but since theory is based on the premise of self
interest and wealth maximization that’s why it faced high criticism from many
researchers.
References:
Ball, R. and P.
Brown (1968). "An empirical evaluation of accounting income numbers."
Journal of accounting research: 159-178.
Wright, J. S. (1979). "Advocacy Advertising and
Large Corporations. Sethi, S. Prakash. Lexington, Massachusetts: Lexington
Press, 1977." Journal of Advertising8(2):
45-45.
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