POSITIVE ACCOUNTING THEORY

POSITIVE ACCOUNTING THEORY

1. DEFINITION

   • Watts and Zimmerman (1986) : is concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method of valuing assets, but it says nothing as to which method a firm should use.
     • EXAMPLE: Efficient Market Hypothesis (EMH) attempts to predict and explain the process of security price formation.
   • Attempts to DESCRIBE and PREDICT the results of individuals' action.
     • is judged by the accuracy of its predictions.
     • “Explanation” means providing reasons for observed practice. For example, positive accounting theory seeks to explain why firms continue to use historical cost accounting and why certain firms switch between a numbers of accounting techniques.
     • “Prediction” of accounting practice means that the theory predicts “unobserved phenomena”.
       • “Unobserved phenomena” are not necessarily future phenomena; they include phenomena that have occurred, but on which systematic evidence has not been collected.

2. ORIGIN AND DEVELOPMENT

   • Started coming to prominence in mid-1960s. - Paradigm shift from normative theory
     • Appeared to become the dominant research paradigm within financial accounting in 1970s and 1980s.
       • Caused the shift in paradigm: Resulted from US reports on business education (Watts, 1995)
       • Caused the shift in paradigm: Resulted from improvement of computing facilities enabling large-scale statistical analysis. (Watts and Zimmerman, 1986)
       • Development of EMH by Fama and others - Published in the Journal of Accounting Research by Ball and Brown (1968)
         • Investigated stock market reaction to accounting earning announcements.- If the earnings announcements were useful to the capital market, then the share prices would adjust to reflect the new information.
         • PAT assume that the price of a security is determined on the basis of beliefs about the present value of future cash flows pertaining to the security, and when these beliefs change the expectation is that the security's price will also change.
         • ROLE: The EMH is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information.
         • Use of AGENCY THEORY to help explain and predict managerial choice if accounting policies
           • AGENCY THEORY : provided a necessary explanation of why the selection of particular accounting methods might be matter, and hence was an important facet in the development of PAT
             • Focus on the relationships between principals and agents (shareholders and managers). - a relationship that create much uncertainty, due to various information asymmetries.
               • Jensen and Meckiling (1976) : Define the Agency Relationship - ' A contract under which one or more (princials) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent'
             • Reliance on traditional economic literature : assumptions of self-interest and wealth maximization and efficiency of market
           • PAT predict that organisations will seel to align interests of managers and owners
           • View the firm as a 'nexus of contract'
             • Smith and Watts (1983) - Define corporation as - a set of contracts among various parties who have claim to a common output. These parties include stockholders, bondholders, managers, employees, supplier and customers. The bounds of the corporation are defined by the set of contracts. the corporation has an indefinite life and the set of contracts which comprise the corporation evolves over time.
           • PAT emphasize the role of accounting in reducing the agency cost of an organization. It also emphasize that efficiently written contracts, with many being tied to the output of the accounting system, were a crucial component of an efficient corporate governance structure.

3. CRITICISMS

   • [1] PAT does not provide prescription and therefore does not provide a means of improving accounting practice. It is argued that simply explaining and predicting accounting practice-which it the aim of PAT-is not enough. Sterling (1990) states that PAT cannot rise above giving the same answers because it restricts itself to the descriptive question. Howieson (1996) provides aview that by failing to provide prescription, Positive Accounting Theorists may alienate temselves from practising accountants.
   • [2] PAT is not value-free, as it asserts. In many PAT researchs, a general absence of priscription as there is no guidance as to what people should do-rather than explains or predicts what they will do. Selecting a theoy to adopt for research is based on a value judgement; what to research is based on a value judgement; believing that all individual action is driven by self-interest is a value judgement. Clearly, there are many other view s about the role of accounting theory. Hence, no research, whether conducted under PAT or otherwise, is value free.
   • [3] PAT relates to the fundamental assumption that all action is driven by a desire to maximize one's wealth. It is argued the assumption represents a far too negative and simplistic perspective of humankind. Gray et al. (1996) state that PAT promotes 'a morally bankrupt view of the world'.
   • [4] Issues being addressed have not shown great development. The three key hypotheses listed by Watts and Zimmerman (1978) indicates continues to be tested in different environments and in relation to different accounting policy issues, even after passing of over 30 years. Sterling (1990) questioned about the potential accomplishment. In commenting on the perceived lack of development of PAT, Fields et al. (2001) state that they are calling for a return to work in these basics areas, before the field is able to advance futher.
   • [5] The measurement or proxies being used within the literature are to simplistic. For instance, Fields et al. (2001) : Duke and Hunt (1990) determine that the debt to equity ratio is a good proxy for the closeness to some covenants violations, including retained earnings, net tangible assets and working capital, but not for other covenants.
   • [6] PAT is scientifically flawed. it has been argued that as the hypotheses generated pursuant to PAT are frequently not supported (they are falsified), then scientifically PAT should be rejected. As a study of people, however (accounting is a process undertaken by people and the accounting process itself cannot exit in the absence of accountant), it is hard to consider any model or theory that could ever fully explain human action. In fact, ability to do so would constitute a dehumanizing action.

4. USEFULNESS

   • [1] Provide a useful framework for making financial reporting decisiona
   • [2] Help to predict the effects of changes to accounting regulation.- Useful in relation to the future development of accounting regulation.
   • [3] Indicates the factors to consider when making financial reporting decisions.

5. NORMATIVE THEORY

   • No attempts to GUIDE
     • is judged against consistency within underlying theories for rational behaviour.
   • Prescribe how persons should behave in order to achieve an objective.
     • EXAMPLE: Investment theory lays down procedures for decision making. Also, many accountants argue that we should use Capital Cost Allowance (CCA) or Fair Value (FV) accounting.

6. KEY HYPOTHESES ( Watts and Zimmerman (1990)

   • Bonus Plan Hypothesis [Shareholders]
     • * Managers of the firms with bonus plans are more likely to use accounting methods that increase current period reported income. Such selection will presumably increase the present value of bonuses if the compensation committee of the board of the directors does not adjust for the method chosen. the choice studies to date find results generally consistent with the bonus plan hypothesis.
   • Debt/Equity Hypothesis [Debt holders]
     • * Predicts that the higher the firm's debt/ equity ratio, the more likely managers use accounting methods that increase income. The higher the debt/ equity ratio, the closer [tighter] the firm is to the constrains in the debt covenants. The tighter the covenant constraint, the greater the probability of a covenant violation and of incurring costs from technical default. Managers exercising discretion by choosing income increasing accounting methods relax debt constrains and reduce the costs of technical default.
   • Political Cost Hypothesis [Politicians, Media]
     • * Predict that large firms rather than small firms are more likely to use accounting choice to reduce reported profits. Size is a proxy variable for the political attention. Underlying this hypothesis is the assumption that it is costly for individuals to become informed about whether accounting profits really represent monopoly profits and to 'contract' with others in the political process to enact laws and regulations that enhance thier welfare. thus, this rational individuals are less than fully informed. The political process is no different from the market process in that respect. Given the cost of information and monitoring, managers have incentive to exercise discretion over accounting profits and the parties in the political process settle for a rational amount of ex post opportunism.

7. TWO PERSPECTIVES ADOPTED BY PAT RESEARCH

   • Efficiency Perspective
     • Explain how contracting mechanisms can be put in place to minimize the agency costs of the firm, that is, the cost associated with the assigning decision-making authority prom the principal to the agent.
     • Referred as ex ante (before the fact) perspective , mechanisms put in place up-front to minimizing the future agency and contracting cost.
     • Arguments :
       • {1} Accounting practices adopted by firms are often explained on the basis that such methods best reflect the underlying financial performance of the entity. Different organizational characteristics are used to explain why different firms adopt different accounting methods.
         • Example: The selection of a particular asset depression rule from among alternative approaches is explained on the basis that it best reflects the underlying use of the asset.
           • By providing measure of performance that best reflect the underlying performance of the firm, it is argued that other parties will not need to gather as much additional information from other resources, which may lead to cost savings.
       • {2} Regulation of financial accounting imposes unwarranted costs on reporting entities.
         • Example : If a new accounting standard is released that bans an accounting method that being used by particular organizations, proponents of PAT would see this as leading to inefficiencies as the resulting financial statement will no longer provide the best reflection of the performance of the organizations.
           • PAT theorist argue that management is the best able to select appropriate accounting methods in given circumstances, and government should not intervene in the process.
   • Opportunistic Perspective
     • Seeks to explain and predict certain opportunistic behaviors that will subsequently occur. However, it is not possible to complete contracts that provide guidance on all accounting methods to be used in all circumstances, so managers are assumed to opportunistically act to maximize own wealth.
     • Referred as ex post (after the fact) perspective, because it considers opportunistic actions that could be undertaken once various contractual agreement has been put in place.

8. OWNER-MANAGER CONTRACTING

   • Bonus Schemes
     • Managers' remuneration being rewarded to be based on the output of accounting system, which can be tied to profits of the firm, sales of the firm, or return on assets. May also be rewarded in the line with market price of the firm's shares.
   • Accounting-Based Bonus Plans
     • Bonuses paid to managers affected by any changes of accounting practices. It may occur as a result of new accounting standard in place. Contract in some cases may be based on old method in place so changes will not affect bonuses. Contract that rely on accounting numbers may rely on 'floating' Generally Accepted Accounting Principle (GAAP). this would suggest that would be ac accounting rule change, and should it affect an item used within a contract negotiated by the firm, and the value of the firm might consequently change.
     • Emanuel et al. (2003) explained the used of accounting-based bonus schemes: " Accounting earning are often used to calculate the manager's payoff (Healy, 1985; Sloan, 1993; Smith and Watts, 1982) because it is more efficient measure of manager's performance than other measures such as stock prices and realized cash flows. This is because: [1] the stock prices are influenced more by markets factors that are outside the control of management, hence, are less effective in isolating that part of performance that result from manager's action (Sloan, 1993); [2] Realized cash flow do not take into the account of manager's actions on firm performance, especially when performance is measured over short intervals (Dechow, 1995).
   • Incentive To Manipulate Accounting Numbers
     • [1] Rewarding managers on the basis of accounting profit will induce managers to manipulate accounting numbers. This is because it will effect their rewards gain.
     • [2] Investment strategies that maximize the present value of the firm's resources will not necessarily produce uniform periodic cash flows of accounting profit. it is possible that some strategies may generate minimal accounting return in early years, yet still represent the best alternative for the firm. Rewarding management on the basis of accounting profit may discourage them from adopting such strategies. that is, it may encourage management to adopt short-term, as opposed to long-term focus.
   • With the assumption that all actions by individuals is driven by self-interest, mostly to maximize their own wealth. Owners would expect the managers to undertake the activities that may not always in the interest of the owners. Hence, managers will have access to information not available to the principals, and this will increase the manager's ability to undertake actions beneficial to themselves at the expense of the owners.
   • Debt Contracting
     • A mechanism to reduce the agency cost of debt ( can be explained in effeciency perspective), provide management with subsequent (ex post) incentive to manipulate the number increasing as the accounting-based constraint approaches violation. It is too costly to stipulate all acceptable accounting methods in contract, hence managers always have some discretionary ability to manipulate.
     • How management might manipulate accounting numbers in the presence of debt agreement * Invenstigated the behaviour of management of the firms known to have defaulted on accounting-related debt covenants: [1] DeFond and Jiambalvo (1994) provides evidences that managers manipulate accounting accruals in year before and the year after the violation of the agreement. [2] Sweeney (1994) a firm approaches violation of debt agreement, managers have greater propensity to adopt income-increasing strategies relative to the firms that are not approaching technical default of accounting-based debt covenants.
   • Political Cost
     • The size of a firm is often used as an indication of market power and this in itself can attract the attention of regulatory bodies. Political costs refer to the cost resulting from the political attention from government, lobby groups and etc. . Politicians may simply rely on the reported profits of companies to provide an excuse for thier actions. thus, firms are likely to adopt the accounting methods which reduce the profits, to lower the political scrunity. Further, political attention may result in increased taxes, increased wages claims, product boycoots, and etc..