Theories of Accounting and Organisational Tradeoffs - Essay Example

?Critical Module Report: Positive Theory of Accounting Standards [ID Introduction Accounting theory often focuses on the economic to the detriment of other forces: Which elements should be accounted for, what data signals are salient to investors and to the economy, how managers react to accounting protocols, etc. It often fails to analyse the political, economic and cultural. Watts and Zimmermann (1978) was a major change in this regard, as it focused on how firms with reduced earnings theoretically should and empirically did resist accounting policy change. Watts and Zimmermann (1978)'s research was the opening salvo of a growing body of literature focusing on the intersection between political and economic calculuses in the field of accounting, as well as creating interest in positive accounting. A critical review of its content is thus relevant even now. Watts and Zimmermann The impact of Watts and Zimmermann's paper is immense: A Google Scholar search finds 1035 citations of it, and Watts' (1990) ten year retrospective article has 3041! Published in The Accounting Review, a major journal, the paper not only introduced positive accounting as a concept but began to focus on the role of regulatory boards and politics. The papers' primary research question is simple: Why would firms spend valuable assets resisting accounting standards (Watts and Zimmermann, 1978, 131)? Empirically, they had done so numerous times. A superficial analysis might point to corruption or to trying to protect against malfeasance, but Watts and Zimmermann's research indicates that there is a more complex structural reason. Their research indicated several trends: 1. Larger companies, ceterus paribus, will support less complex accounting measures like General Price Level Accounting more often than smaller companies: This is theoretically supported by the notion that a large company would be more likely to be a target of government interference or auditing and thus has more of a stake, proportional to their size. Firm size is the largest factor in their analysis. 2. Direction of change in earning is vital: Companies that are earning less than in previous years and thus experiencing negative growth or at risk of reporting losses unsurprisingly resist accounting changes that might a) further depress their costs by requiring more administrative overhead and paperwork and b) might require more complex reporting of the firms' difficulties. The paper also pointed to complex government-economic interaction forces. Even the mere effect of requiring different accounting standards could have multiple impacts on firm behavior. “Investment-production” decisions could end up changing as firms' accounting overhead increases, with firms picking either less costly or less risky investments to shield them from the risk (Watts and Zimmermann, 1978, 131). This would be indicated by a lower beta on common stock, which was found in those firms supporting GPLA. They also found that there was a “decline in systematic risk as firm size increases and as government intervention costs rise”. The benefits of improved accounting might be eclipsed by the cost for larger and larger companies. This in turn begs a question: Might larger firms have larger accounting overhead in general due to the number and complexity of their transactions? There are implications for policy as well, both for NGO accounting standards boards like the FASB and for national and provincial governmental regulation like the SEC. Corporate lobbying has historically had a major freezing effect on actions taken by regulators, including the SEC arguably having chosen the AICPA as their “scapegoat” so as to avoid the difficult task of crafting regulatory standards themselves (Watts and Zimmermann, 1978, 132). To avoid resisting corporate lobbying, regulators may wish to choose accounting standards that improve firms' fidelity of financial information without incurring substantial overhead. Of course, in light of recent events in the global economy, regulation under forces like the Basel II and III accords might seem likely to become more expansive, not less. Watts and Zimmermann's work guided the creation of a new theory of positive accounting. Positive accounting theory in general is positivist: It tries to describe how accounting is actually done rather than laying out optimal accounting standards; thus, it varies from normative accounting. In Watts and Zimmermann's (1990) Positive Accounting Theory: A Ten Year Perspective, they note that positive accounting theory has attracted much criticism. Positive accounting theory preceded their work: Researchers like Ball, Brown and Beaver in the late 1960s had begun to implement “empirical finance methods to financial accounting” (Watts and Zimmermann, 1990, 132). However, the early work looked only at the interrelation between accounting numbers and stock prices, two economic effects. Watts and Zimmermann's work codified the positive accounting movement by not only adding in effects from outside institutions like NGO and political regulation but also rectifying the failure to predict major changes like an entire industry switch from accelerated to straight-line depreciation that was not accompanied by a change of tax depreciation methods, which appears to be a transparent tax dodge, and looking at how accounting itself was done, not merely accounting's impact elsewhere (Watts and Zimmermann, 1978; Watts and Zimmermann, 1990, 132). Watts and Zimmermann's theory differed from earlier positive accounting theories which were informational in scope and assumption by arguing that accounting was not merely information, which is costless, but process, which has administrative cost (Watts and Zimmermann, 1990, 132-133). Information and transaction costs were the only way to explain why firms would spend money resisting the expansion of accounting standards through lobbying, or would ever choose any accounting standard that wasn't the optimal one for communicating information to shareholders. Further Analysis It is impossible to do anything but look at a cursory analysis of the growing positive accounting theory that Watts and Zimmermann helped codify, but some examples are illustrative and will be offered. Kwok and Sharp (2005) used positive accounting assumptions to analyse the behavior of the International Accounting Standards Board, or IASB. Their work argued that there were four stakeholder groups whose varying needs and interests would determine the shape and outcome of International Accounting Standards (IAS): Users, preparers, accountants and regulators. Using a sociological concept and theory of power, they found that, while each party had substantial power making it a mixed-power system, certainly preparers of accounting information had substantial influence, exerting their power to avoid costly accounting standards on the international stage. Zmijewski and Hagerman (1981) added an income strategy analysis to the positive accounting model. They found that, in line with positive accounting theory, small firms behaved differently from large firms, and that firms' income strategy determined by their size, management compensation, concentration ratio and total debt to asset ratio (but not systematic risk or capital intensity) determined their choice of individual accounting principles. There are critics of positive accounting, of course (Milne, 2002). An obvious point is that positive accounting, while useful, ignores what should be done: This is a strength as it allows hard-nosed analysis of the real world, but it is a weakness because it means that the theory can't provide policy predictions to move forward. However, Milne (2002) in line with others argues that the social disclosures literature aspect of the positive accounting movement, for example, provides little empirical analysis, “fails to provide distinct arguments for self-interested managers’ wealth maximizing” and misreads Watt and Zimmermann's (1978) original text. A thirty-year-old article is thus still guiding modern debates on elements of accounting as diverse as corporate social responsibility, reportage of debt and assets, and the behavior of the IASB. Similarly, Whitley (1988) argues that positive accounting theory research doesn't and in theory can't follow “empiricist philosophies of science” and notes that methodological rules that Watts and Zimmermann apply may be incoherent or inapplicable thanks in no small part to the complexity of sociological forces and analysis. Indeed, it does seem that trying to analyse how firms adopt accounting procedures in practice is a difficult exercise at best given that the way that firms choose their behavior is likely to be based on secret internal discussion and data not easily available to researchers as well as such diverse factors as corporate culture, corporate social responsibility (CSR) policies, race, national culture, gender, sexual orientation, the role of the national government, the role of provincial and local governments, etc. Critical Review Watts and Zimmermann's original article was a major contribution to accounting, but there are clearly two problems with the approach they ushered in. The first is that it is very difficult to do research in this vein. Normative theories of accounting can discuss organisational tradeoffs, values of various approaches, and guide firm behaviour. But looking at the way organisations account and how they relate their accounting structure and preferences to polity, economy, culture, etc. enters the realm of sociology. This not only dilutes the focus of accounting research, but also requires the explosion of variables, the use of experiments, more advanced case studies, deep knowledge of corporate behaviour that is not easily available... The exercise becomes mathematically quixotic. Conventional accounting research can help predict behaviour by determining upcoming cash flow problems for a company or detecting malfeasance; the value of Watts and Zimmermann's approach is much more dilute. Researchers know so little about the behaviour of social variables that it seems absurd to want to embark on examining accounting through this lens. The second disadvantage of this approach is that the conclusions enter into highly controversial territory. It attempts to predict what companies want to do, and presumably should do, in the political system, as regards donations or lobbying initiatives. It thus imperils the potential objectivity of accounting research. Conclusion Nonetheless, it is unquestionable that, despite controversy and questions of applicability, positive accounting theory is an established force, guiding present research of accounting in a new direction. Indeed, accounting should, from a sociological perspective, be far more willing to incorporate analysis from different institutional forces. Watts and Zimmermann's original article took accounting into an exciting new direction, with consequences still to be discovered. References Christenson, C. 1983, The Methodology of Positive Accounting” The Accounting Review (January), pp1-22. Deegan, C. M. 2009, In Financial accounting theory. North Ryde, N.S.W: McGraw-Hill. Demski, JS. 1988, “Positive accounting theory: A review”, Accounting, Organizations and Society, Vol. 13 No. 6, 623-629. Kwok, WCC and Sharp, D. 2005, "Power and international accounting standard setting: Evidence from segment reporting and intangible assets projects", Accounting, Auditing & Accountability Journal, Vol. 18 Iss: 1, pp.74 – 99. Milne, MJ. 2002, “Positive accounting theory, political costs And social disclosure analyses: a critical look”, Critical Perspectives on Accounting, vol. 13 no. 2, June, 369-395. Tinker, T, B. Merino, and M. Neimark. 1982, “The Normative Origins of Positive Theories: Ideology and Accounting Thought,” Accounting, Organizations and Society 2, pp167- 200. Watts, RL. and J. Supreme. 1986, Positive Accounting Theory, Edgewood Cliffs, NJ: Prentice Hall. Watts, RL and Zimmermann, JL. 1978, “Towards a Positive Theory of the Determination of Accounting Standards”, The Accounting Review, Vol. LIII No. 1. Watts, RL and Zimmermann, JL. 1986, Positive Accounting Theory, Edgewood Cliffs, NJ: Prentice Hall. Watts, RL and Zimmermann, JL. 1990, “Positive Accounting Theory: A Ten Year Perspective”, The Accounting Review, Vol. 65 No. 1 131-156, January. Whitley, RD. 1988, “The possibility and utility of positive accounting theory”, Accounting, Organizations and Society. Vol. 13 No. 6, 631-645. Zmijewski, ME and Hagerman, RL. 1981, “An income strategy approach to the positive theory of accounting standard setting/choice”, Journal of Accounting and Economics, Vol. 3 No. 2, August, 129-149. Read More