Friday, 9 December 2016

Positive Accounting Theory



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.

(Sethi, 1977) Further suggests that normally the budget spent on political costs (specifically the advocacy advertising) is minimal; however, it impacts the stakeholder in a huge way. Not only it addresses all their issues, concerns regarding the corporation practices, but it also enhances the image of the corporations in front of the stakeholders. According to Watts & Zimmerman, the political costs spent on such activities are actually a form of lobbying behavior just like that of maximization of wealth.

·         Social Responsibility Campaigns:

(Sethi, 1977), (Watts, 1978), (Patten, 1991) also suggest that along with the advocacy advertising, the corporations with the very high unexplainable profits or unethical business practices initiate the social responsibility campaigns. Since there is social contract between the society (stakeholders) and the firms itself, they tend to please the stakeholders.

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.

(Patten, 1991), for example, states:

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:

(Watts, 1978), have a stance, that not all the corporations are environment friendly. Some of the corporations are damaging the environment. Other researches who have put forward the stance i.e. Lemon & Cahan 1997, also state that corporations whose processes are not environment friendly, carry out various practices to hide out their unfriendly processes. For example Mobil Oil, which also started the advocacy advertising, they carry out different conferences, and spend money (i.e. Political Costs) in order to hide the bad name associated with them due to the unfriendly environmental processes these corporations carry out. 



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)

Author
Article
Study
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.
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.
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.
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.
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.
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.
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.
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.
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.
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. 
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.
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.
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.
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.
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.



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.