Positive Accounting Theory - Essay Example

Positive Accounting Theory of Institute Positive Accounting Theory Introduction Since Watts and Zimmerman first wrote about The Positive Accounting Theory in 1978, there has been a debate on the how suitable the theory is in the prediction of how firms choose the accounting policies they use. However, one aspect quite evident is the ability of the theory to predict the behavior of managers when selecting accounting methods. It also predicts the responses of firms to new accounting policies and regulations. A look into the functionality of the Positive Accounting Policy and how it works in predicting accounting policy choice is necessary to aid understanding of operations in a firm. Positive Accounting Policy and its Use Positive Accounting Theory (PAT) involves predictions of choices of firms as pertains accounting policies and the response of firms to any new accounting policies. It also seeks to explain such decision-making actions by the management of different companies. Positive Accounting Theory makes use of theories to draw predictions on the choices management would likely make when selecting accounting policies to implement or use (Deegan, 2009, p.53). According to the theory, the conduct of any firm is in such a way that would maximize its best interests. In this regard, managers would likely do what they feel is best for the company at the expense of the interests of shareholders. In arriving at the choices to pursue, firms are guided by factors within the industry in which they operate. It is such factors on which the positive accounting theory lays a focus. Positive Accounting Theory’s focus is on the relationship that exists between different stakeholders in a business. The stakeholders provide resources to the firm in different capacities. Apart from this relationship, the theory also looks at how accounting would affect the functionality of such relationships. Through agency theory, positive accounting theory explains the possible motivations that guide managers in their choice of preferred accounting methods. In this light, the assumption is that managers, who are agents, would seemingly engage in activities that would create benefits for them at the expense of their principals (Deegan, 2009, p.54). The introduction of restrictive contracts, therefore, comes handy. However, managers still need some freedom to make decisions dependent on the situation. The positive accounting theory has two perspectives namely the efficiency perspective and the opportunistic perspective. The perspectives explain the conduct of managers in as much as choosing accounting policies is concerned. Under the efficiency perspective, the choice of accounting methods tries to keep in line with the firm’s objective to record a strong financial position. The management focuses on improving the performance of the firm and this reflects in the accounting policy in place. The efficiency perspective seeks portray the firm’s true financial position. The accounting policy a firm chooses would, therefore, be one that reflects the firm’s true image. The opportunistic perspective is all about the managers. Managers would seem to work towards satisfying their personal interests at the expense of all other stakeholders. The perspective is ex-post. Since the possibility of setting out all accounting rules applicable to all situations in advance and at no or limited cost is almost zero, it creates an opportunity for managers to act opportunistically in their selection of accounting methods. In their choice of accounting policies, they go for the policy that would guarantee them gains. They would also seek to have the firm gain through accounting policies but disregard other stakeholders who may have interests in the business. There is the use of hypothesis to explain this perspective and create an understanding of how managers arrive at their decisions on accounting policies. The debt, bonus plan and political cost hypothesis aid in this function (Watts and Zimmerman, 1990, p. 234). The Framework for Predicting Accounting Choices An organization enters into many contracts with many parties. Every organization would want to minimize contract costs to the lowest possible levels. PAT lays emphasis on the weight minimizing costs has on the choice of accounting policies. The theory avoids specifying the accounting policies that a firm may use as that may prove costly. The management needs some freedom to respond to different circumstances as best fit. There are several accounting policies from which managers may choose. The managers go through these policies before finally settling on the policies that benefit their firms most (AASB (a), 2014, p. 14). Accordingly, most managers favor accounting policies that have minimal costs while at the same time providing the management with flexibility to change the policies in case of changes in the external environment. The Positive Accounting Theory tries to explain why and how different companies operating in different industries arrive at the different accounting choices. The explanation is possible through the use of three theories. The theories are; the bonus plan hypothesis, the debt covenant hypothesis, and the political cost Hypothesis. The bonus plan hypothesis purports that managers are spurred by their personal compensation when choosing the accounting policies to use. They will, therefore, go for accounting policies whose effect is to bring forward earnings from the future into the current period. That would cause a higher net income in the present period. The result would be that the management would receive bonuses and other incentives due to the higher net income. It would mean that there is maximization of personal compensation on the manager’s part. The use of different methods to depreciate assets is one example of how managers can manipulate accounting policies so as to record higher earnings for their benefit (AASB (b), 2014, p.49). Another way would be to ignore research and development costs. That would have the effect of showing higher profits, and hence managers get better remuneration for the good performance of the firm. The debt covenant hypothesis or debt/equity hypothesis suggests that the motivation for the selection of accounting policies is the firm’s debt covenants. The management would, therefore, want to use accounting policies that make them look good in the eyes of their creditors. Accounting policies that bring forward future earnings to the present are, therefore, more favorable in this respect. That is because they tend to make the financial position of the firm look stronger than what it is in reality. In so doing, they help the management avoid trouble with lenders. Creditors want to have some assurance that the company is in a position to pay both the interest and principal on existing loans. Managers tend to use accounting policies that present better performance especially where the debt/equity ratio is high. According to AASB 116 (IAS 16), an entity may choose between the cost and revaluation models when accounting for assets. Choosing between the two models is dependent on the results the management seeks. Revaluation may have the effect of increasing the value of assets (IASB, 2003). That would raise the asset base and, therefore, improve the debt-asset-ratio. As a result, the firm would be able to keep to debt covenants. On its part, the political cost hypothesis proposes that the political environment forms a basis for the choice of accounting policies by large companies. Political decisions have an impact on firms as the may bring about some material costs. The management, therefore, would have to choose an accounting policy that would reduce the political cost. Most firms prefer to apply accounting policies that push into the future, current earnings (Watts and Zimmerman, 1990, p.139). That helps them reduce their tax liability as well as avoid other regulations. Most of the regulations would come about if, in the eyes of the public, a firm seems to enjoy monopoly power. Regulations may come into place to control such monopoly power. That makes managers want to record lower earnings to avoid much attention that may lead to many regulations. Accounting policies affect the wealth of other stakeholders to the business. The extent of effects of the accounting policies would vary depending on the amount of costs involved. Where the costs are high, then the effects would be more. Some contractual relationships rely on accounting values. Such contracts fail to unify the interests of managers and stakeholders (Watts and Zimmerman, 1990, p.135). Managers may need some discretion on the accounting policies as they are in a better position to know what policy would best suit the company and its employees. The managers may opt to exercise this discretion where they feel that decision maximizes wealth for everyone or where such a move would place them in a better position. Conclusion The Positive Accounting Theory tries to put into perspective the choices of managers as regards accounting policies. Different accounting policies have different effects on the financial position of a company. While some accounting policies reduce earnings, others increase the amount of earnings. Whether earnings increase or decrease, it would depend on the objectives the management of a firm would wish to meet. That would also steer the accounting policy the company chooses. While people may assume that the choice of accounting policies is dependent on the management’s personal interests, there are many instances where the choice aims at achieving what is best for the company. The policy, therefore, would lead to efficiency and ensure survival of the business. The positive accounting theory, therefore, becomes an important tool to predict such motivations to the choice of an accounting policy. References AASB (a), 2014. AASB 108: Accounting Policies, Changes in Accounting Estimates and Errors. Melbourne: Government of Australia. AASB (b), 2014. AASB 116: Property, Plant and Equipment. Melbourne: Government of Australia. Deegan, C. M., 2009. Financial Accounting Theory. North Ryde, N.S.W: McGraw-Hill. IASB, 2003. IAS 8: Accounting Policies, Changes in Accounting Estimates and Errors. London: IASB. Watts R.L. and Zimmerman J.L., 1990. Positive Accounting Theory: A Ten Year Perspective. The Accounting Review, 63(1), p. 131-156. Read More