Positive Accounting Theory

This theory attempts: to explain managers choices of accounting methods in terms of self-interest, the relationships between stakeholders and, how financial accounting can be used to minimize cost by aligning competing interests.

Returning our focus, PAT focuses on the relationship between the various individuals involved in providing resources to an organization and how accounting is used to assist in the functioning of these relationship

PAT, as developed by Watts and Zimmerman and others, is based on the central economicbased assumption that all individuals action is derived by self-interest and that individuals will act in an opportunistic manner to the extent that the actions will increase their wealth. Given an assumption that self-interest drives all individual actions, PAT predicts that organization will seek to put in place mechanisms that aligns the interests of the manages of the firm (agent) with the interests of the owners of the firm (the principal). EMH Efficient market hypothesis The genesis of positive accounting theory is the Efficient Market Hypothesis (EMH). According to Fama, the EMH is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information.

The perspective taken is that security prices reflect the information content of publicly available information and this information is not restricted to accounting disclosures.

The capital market is considered to be highly competitive, and as a result, newly released public information is expected to be quickly impound into share prices. Agency Theory

A key to explaining managers choice of particular accounting method came from Agency theory.

Agency theory provided a necessary explanation of why the selection of particular accounting methods might matter, and focused on the relationships between principals and agents, a relationship which, due to various information asymmetries, created much uncertainty.

Agency theory accepted that transaction costs and information costs exist.

Relying upon traditional economic literature (i.e. maximize own wealth), Jensen and Meckling considered the relationship and conflicts between agents and principals and how efficient markets and various contractual mechanisms can assist in minimizing the cost to the firm of these potential conflicts. (Page 211)

It is assumed within Agency Theory that principles will assume that the agent will be driven by self-interest, and therefore the principle will anticipate that the manager, unless restricted from doing otherwise, will undertake self-serving activities that could be detrimental to the economic welfare of the principle. (Page 211)

In the absence of any contractual mechanism to restrict the agents potentially opportunistic behavior, the principle will pay the agent a lower salary in anticipation of the opportunistic actions. The agents are therefore assumed to have an incentive to enter into contractual arrangements that appear to be able to reduce their ability to undertake actions detrimental to the interests of the principals.

That is, if it is assumed that managers would prefer higher salaries, then there will be an incentive for them to agree to enter into contractual arrangement that minimize their ability to undertake activities that might be detrimental to the interests of the owners. Contracting theory

Agency Theory does not assume that individual will ever act other than in self-interest, and the key to a well functioning organization is to put in place mechanism (Contracting theory) that ensure that actions that benefit the individual also benefit the organization.

By the mid to late 1970s, theory had therefore been developed that proposed Markets were efficient and that Contractual arrangements were used

as a basis for controlling the efforts of self-interested agents.

It is also emphasis 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.

PAT development and Accounting method In 1990 Watts The accounting Review identified three key hypothesis that had become frequently used in the PAT literature to Explain and Predict whether an organization would support or oppose a particular accounting method. These hypotheses as follow: The bonus plan hypothesis The debt / equity hypothesis; and The political cost hypothesis

The bonus plan hypothesis assumes that managers with bouns plan as more likely to use accounting methods that increase current period reported income. It predicts that if a manager is rewarded in terms of a measure of performance such as accounting profits, the manager will attempts to increase profits..

The bonus plan hypothesis dictates that managers will use accounting policies that are likely to shift reported earnings from future periods to the current period. This is to maximize their personal compensation as by reporting a high net income, their utility will be maximized through bonuses and incentives. The debt/ equity hypothesis predicts that the higher the firms debt/equity ratio, the more likely managers use accounting methods that increase income. Managers exercising discretion by choosing income increasing accounting method, relaz debt constraints and reduce the costs of technical default.

Another factor that entities have to consider when choosing their measurement bases for class of property, plant and equipment is the effect of the model on the income statement. Where assets are measured on a fair value basis, the depreciation each year would be expected to be higher as the depreciable amount is higher. Besides the effect of depreciation, there will be an effect on disposal of the assets. When an asset is measured at fair value, there is expected to be an immaterial amount of profit/loss on sale, as the recorded amount of the asset at time of sale should be close to that of the market price at time of sale. For an asset measured at cost, any gain on sale will be reported in the income statement the income is recognized upon disposal of assets which is determined by the management decision.

The debt covenant hypothesis states that the closer a firm is to compromising their debt covenants, the more likely management is to use accounting policies that shift reported earnings from future periods to the current period. This is because higher net earnings will reduce the probability of technical default on the debts. The effect of adopting the revaluation model is to increase the entitys assets and equities. Hence, entities which need to report higher amounts in these areas would consider adoption of the revaluation model.

For example, entities which have debt covenants generally have constraints relating to their debtasset ratio e.g. the debt-asset ratio must not exceed 50%. Hence, for an entity with increasing debt, adoption of the revaluation model for a class of assets which is increasing in value will ease pressure on the debt-asset ratio by increasing the asset base of the entity, providing, of course, that the debt covenant allows revaluations to be taken into account in measuring assets.

The political cost hypothesis states that the greater the political costs to the firm, the more likely management is to use accounting policies to defer reported earnings from current periods to future periods. This hypothesis brings politics into the choice of accounting policies. Highly profitable firms attract media and consumer attention. This attention can create an increase in taxes and other regulations.

The incentives for entities to adopt fair value measures, then, tend to be entity-specific because of pressures placed on the entities relating to external circumstances.

For example: an entitys reported profit figure may be under scrutiny from a specific source, such as a trade union seeking reasons to support claims for higher pay, or regulators looking at monopoly control within an industry.

Distinguishing the Opportunistic and Efficient Contracting Versions of PAT

Positive accounting theory can be classified as opportunistic and efficient versions. The three hypotheses of PAT are presented in opportunistic form. Managers choose accounting policies to maximize their own expected utility relative to their bonus plan, debt covenants, and political costs. Management chooses accounting policies that minimize their contract costs. These

policies can also be chosen on an efficiency criterion. Quite often, these two theories make similar forecasts. It is difficult to determine whether opportunism or efficiency is driving the policy changes.

Research has addressed this problem. Christie and Zimmerman investigated the frequency of firms that faced takeover, to use income-increasing accounting policies to maximize reported net income and financial position. They found that these policy changes were not used to avoid possible takeover, and that were not as opportunistic as originally thought.

Sweeney discovered that managers would change accounting policies in response to debt covenant problems, only when it was cost-effective. In another study, Sweeney found that firms that would benefit opportunistically through substantial tax costs from switching accounting policies, chose not to do so in favour of a more efficient alternative. Her results show support for both the opportunistic and efficient views of hypotheses, and firm specific analysis is required to distinguish between the two. Dechow did research that found net income to be more highly associated with net returns than cash flow. Subramanyam that managers choices of discretionary accruals served to improve the predictive value of current earnings to predict future earnings. These findings support the efficient contracting version of PAT, as opposed to the opportunistic.

Conclusion

Positive accounting theory is used to predict and comprehend the accounting policy choices that firms make. It is introduced as a way to merge market theory with economic consequences. Where there are pressures to report lower profits, adoption of the revaluation model provides scope of higher depreciation charges with increases in the value of non-current assts not affecting the income statement. With lower reported profit and a higher asset/equity base, any judgment made by reviewing ratio such as rate of return on assets or equity will result in the entity being seen in a less favorable light. (Company Accounting Ken Leo, John Hoggett Page 189 and 190)

1. What is the difference between normative and positive accounting theory? y Normative theory tries to argue what accounting policies firms should adopt. Normative theory answers questions about how the world should be, and how people and firms should behave.

Positive theory tries to explain accounting practice and the relation between accounting and other variables (e.g., earnings and stock prices). Positive theory answers questions about why the world is the way it is, and what will happen if one decides to act one way or another, given certain conditions. Positive theory also offers testable predictions about what will happen if certain accounting practices are adopted, or what accounting practices one should expect to see under certain contractual arrangements with creditors, etc. This might help managers and others decide on what accounting policies to adopt and lobby for, and it might help policy makers decide what accounting policies to promulgate. o Why do some firms use straight line and others use accelerated depreciation? o Why do some firms use LIFO and others FIFO? o Why do some firms choose Big4 auditors while others choose smaller auditors?