Positive Theories of Accounting - Literature review Example

Positive Theories of Accounting Name Tutor Course Institution Date Positive Theories of Accounting Introduction Accounting is regarded as both an art and science through which various financial phenomena are described and explained. It is through the use of these accounting theories that financial policies are chosen and its application made on the basis of either efficiency or the available opportunity. Theories of accounting play a very crucial part as far as accounting is concerned. Theories of accounting act as a form of abstractions of reality. Thus the choice of one theory over the other is founded on particular value judgments in relation to the selected accounting policies. The purpose of financial accounting is to enable any business to make sound economic decisions. Financial accounting therefore is more focused on the external factors that determine the kind decisions that are more favorable to the business. Intangible assets play a crucial role in the accounting process since they have an impact on the financial position, performance and adaptability of a firm. Intangible assets also influence economic decisions and the process of accounting. Some theories of accounting are preferred over others since they reflect closely human behavior more than other theories. The essay will seek to discuss two major accounting theories (positive and normative) and its application of the accounting policies to intangible assets. The paper also seeks to discuss how certain firms apply the use of ex ante and ex post in the formulation and application of particular accounting procedures (Watts & Zimmerman 1990). Positive theories of Accounting Positive accounting theory practices are usually objective and based on facts. Thus its main focus is based on analyzing economic statistics and available data so as to obtain conclusions. Positive accounting theory is founded on the basis of explaining reasons behind the social disclosure of any business firm. According to Watts & Zimmerman (1990) positive accounting theory aims at explaining predictions and provides answers to the practice of accounting. Thus the theory predicts certain accounting phenomena while describing its interactions in the real world situation. In many larger firms for instance those concerned with gas and oil social responsibility is regarded as a useful intangible asset. Social responsibility generally contributes to the public image of a particular firm. It leads to public acceptance and in the end avoidance of such issues as strikes and boycotts. It is therefore due to a firm’s mode of efficacy that will enable it to gain public confidence and good political will. Thus accounting theories are crucial in enabling a firm to adopt an efficient social responsibility and disclosure policies that will not only enable these firms to gain more profits but also gain public confidence and increase its economic opportunities and efficiency. Positive theory of accounting enables such business firms to be able to predict phenomenon that will greatly affect the running and operation of their activities so as to determine whether they will make profits or losses. Furthermore positive accounting theory (PAT) has enhanced the understanding of variety of accounting phenomena and concerns. For instance it has produced fundamental approaches in linking accounting numbers and stock returns and reporting motivation (Watts & Zimmerman 1990). Positive accounting theory has the sole objective of understanding and predicting managerial accounting policy choices across different firms. This will enable managers to choose a certain accounting policy that will benefit the firm as opposed to others in relation to efficiency and availability of opportunities at a given period of time. On the other hand normative accounting theory is applied as a guide to managers on what policies they should or should not implement in regards to their firms and operations. In relation to accounting practice firms generally organize themselves in the most proficient approach in order to exploit their prediction for continued existence in a competitive market. This entirely depends on factors such as legal and institutional ecological setting, machinery, level of competition among others. Thus firms can be observed as nexus of conventions. Many of these contracts usually involve a lot of accounting information. Therefore Positive accounting theories (PAT) is of the opinion that the selection of accounting policies by a particular firm is with the aim of reducing contracting costs while at the same time enhancing the firm’s efficiency (Markus 2002). Managers necessitate flexibility in accounting policies in order to adapt to upcoming or unpredicted conditions. There is need for flexibility to enable managers to select from a series of accounting policies that will unlock up the likelihood of opportunistic kind of behavior. Ali & Hwang (2000) argue that Positive accounting theories make an assumption that managers of different firms are rational. The sense of rationality will enable them to select accounting policies in their personal most excellent awareness that may not be necessarily lead to turnover maximization; opportunistic. The managers will also be in a position to choose accounting policies for the purpose of attaining corporate governance goals and aims of the firm that will eventually lead to competent contracting. According to PAT there are different ways through which managers are able to manage earnings. This involves alteration of accounting policies, managing unrestricted accumulation, timing the implementation of fresh accounting standards, alteration of real variables among other issues. Hence an excellent selection of accounting policies on time will enable a firm to decrease opportunistic accounting policy selections while at the same time sustain cost of deficiency of accounting flexibility to varying situations. PAT allows managers to select from a wide range of accounting policies that will enhance the reduction of accounting expenses while exposing the firm to the expenditure of opportunistic manager behavior (Ali & Hwang 2000). Therefore in regards to PAT managers posses a superior motivation to select accounting standards that record lesser earnings as a result of taxes, political and regulatory deliberations than to select accounting principles that posts elevated earnings and in the process enhanced incomes and enlarged incentive reparations to the business/firms. Markus (2002) argues that political pressure highly affects the operations of any business. Low political costs will lead to enhanced business operations that will in turn enable the business to record higher rates of income while experiencing low expenditures. In regards to unregulated firms, it is common for managers to select accounting principles that record higher earnings and give up anticipated tax outcomes. This will enable the firms to operate at a minimum expenditure and in the end be able to maximize their earnings. Thus the system is most preferred by managers due to its advantageous nature and the firm will be able to expand and bring in the expected returns (Markus 2002). Opportunistic and efficiency Approach In regards to efficiency perspective PAT makes an effort to explain and understand the ways through which various contracting mechanisms can be used in its application with the purpose of minimizing the costs of the business that is usually associated with decision making process and power within a particular business enterprise. The efficiency approach is generally referred to as an ex ante point of view. According to Bantas (2012) Ex-ante is used to refer to prior to the reality. This is due to the fact that it considers the mechanisms that are applied before hand with a sole objective of lessening prospective agency and contracting expenditure. In regards to ex ante the firm makes a choice of policies to be applied prior to the reality of the situation experienced by the firm. This is usually done with a purpose of the firm reducing its contractual expenditure and minimizes costs. Thus the firm enacts efficient policies in order to ensure that the contracting expenditures are reduced while at the same time helping the firm not to incur losses. In Ex-ante approach the necessary policies are enacted beforehand so as to minimize costs and project profits. Most managers prefer to enact the accounting policies before hand as it will be able to act as guidance in meeting the firm’s goals and objectives clearly. When accounting policies are enacted beforehand it will make it possible for the business operations to run smoothly and in cases where the policies fail to work efficiently alterations may be done promptly (Bantas, 2012). PAT also has an opportunistic approach that seeks out to enlighten and forecast certain opportunistic behavior. This is due to the fact that human behavior does not remain static and changes over a period of time. Thus the opportunistic approach explains and predicts such behaviors so as to enable the business to plan and prepare itself for the upcoming future prevailing conditions. In the initial stages a firms contractual agreements could have been discussed due to the fact that they were believed to be more resourceful at the time in relation to interests of particular individuals within the firm. For the fact that it may not be proficient to undertake on complete contracts for the firm that generates direction on accounting techniques to be applied in different situations thus there will be several capacity for managers to be opportunistic. The opportunistic approach in PAT is generally regarded to as an ex post approach. Ex post meaning after the fact. This is due to the fact that after contractual agreements some alterations may be necessitated. Ex post takes into consideration opportunistic procedures that may be embarked on after various contractual agreements have been put into situation by the firm. Stipulating in advance all accounting regulations to be applied in all anticipated circumstances is a costly affair to the firm as a business entity. PAT recommends that in regards to accounting procedures and issues there is constantly a scope for the firm managers to be opportunistic while selecting a particular accounting policy and procedure in regards to others. Thus the firm applies the ex post approach in seizing opportunity to alter certain accounting policies and procedures in order to meet the goals and objectives of the firm as far as accounting procedures are concerned (Rowbottom, 1998). PAT argues that majority of accounting choices use the application of various sets of variables in the process of formulating accounting policies. The aspect representing the manager’s authority in the selection of accounting procedure in relation to bonus strategy and political process. Thus as a result of equity prediction on a higher debt/equity ratio, managers are more likely to apply accounting procedures that will increase income to the firm. In relation to political costs it is predicted that multinational firms are more likely to select accounting policies that reduce profits recorded as opposed to smaller firms. This is due to the fact that size is considered as a variable for political concentration. Large firms attract a lot of public interest and political attention due to their size. In some cases political attention usually leads to political interference leading to the collapse of such firms. Thus there is need for the larger firms to invest more on the intangible assets in order to counteract the political attention and use it for their own benefits and for the interest of achieving the goals and objectives of the firm (Markus, 2002). PAT emerged in order to solve the problems and shortcomings of normative approach in accounting. However, PAT view that a policy o accounting procedure is replaced when another procedure does not aid in resolving a problem rationally is faulted by critics. PAT fails to explain when to consider a new accounting procedure, at what stages will the procedure is applied and the eventual choice from two competing theories on explanation of a certain phenomenon or occurrence. A normative theory on the other hand expresses whether an economic decision or policy is desirable or not. Thus in accounting a normative theory offers judgment on economic policies and decisions whether they will be beneficial to the firm or not. Normative theory does not offer and explanation or understanding of a given economic policy but rather it gives only judgment in regards to the desirability of a given policy on a business enterprise. Therefore it is due to the weakness of the normative theory of offering only judgments that positive accounting theory emerged. Positive accounting theory was aimed at giving explanations and description in regards to a particular economic policy or decision that a firm intends to undertake at present or in the future as a result of the prevailing economic circumstances. Hence PAT was meant to cover up for the weakness that was being experienced in the normative theoretical approach. The main difference between the normative and positive accounting theory is the approaches each theory takes (Gaffikin, 2006). Whereas normative theory engages in the process of judging whether a particular economic decision is desirable or not PAT explains and attempts to describe a certain economic decision or policy that the firm intends to apply whether at the present or in the prevailing circumstances. One major weakness of the normative theory of accounting is the fact that the judgments of the policies and accounting theories made are not always correct. This is due to the fact that human behavior is not always static and it keeps on changing with time. A policy that may be deemed desirable today may not be desirable in the future leading to jeopardy of the activities of the firm. However, most accounting statements are difficult to classify whether they are positive or normative giving way for firms to rely on making assumptions. These assumptions may in turn be very costly to the firm and lead to the firm making huge losses that could be avoided by use of an efficient theory and accounting procedure (Gaffikin, 2006). Conclusion Positive Accounting Theory attempts to explain and predict the accounting practice. This is in the sense that PAT provides reasons for the observed accounting practice. Thus PAT seeks to give an explanation for the reasons behind firms continue application of historical cost accounting and the reasons for certain firms to embrace a variation of different accounting methods. In the sense of prediction, PAT predicts overlooked occurrences. Unobserved circumstances do not essentially refer to future occurrences since they include already what has transpired but methodical substantiation has not been gathered by the firm. The contrasting argument is evident in both the positive and normative theories of accounting. Whereas the positive theory describes and explains the reasons behind the application of particular accounting procedures as opposed to the other, normative theory of accounting offers judgments on why certain policies are more desirable than others. Thus positive theory is the most preferable among economic for the fact that it offers more insight on the policies and accounting procedures that need to be applied. It also gives managers a sense of prediction on what policies to use in future prevailing circumstances. It enables mangers to alter certain policy that they feel does not suit either their interests or the interests of their firms. Hence in general accounting practice positive accounting theory is the most preferred in comparison to other accounting theories. List of References Ali, A., & Hwang, L., 200, Country-specific factors related to financial reporting and the value relevance of accounting data. Journal of Accounting Research, 38, 1-21 http://www.smashwords.com/extreader/read/247871/1/positive-accounting-theory-and-policy-selection Watts, L. R. & Zimmerman L. J 1990, Positive Accounting Theory: A ten Year Perspective. The Accounting Review. Vol. 65. No. 1. Pp 131-156. Markus J. M 2002, Positive Accounting Theory, Political Costs and Social Disclosure Analyses: A Critical Look: Accountancy and Business Law, Dunedin, New Zealand. < http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.199.7620&rep=rep1&type=pdf> Bantas, H, 2012, Positive Accounting Theory and Policy Selection, Reluctant Geek. Retrieved on August 14, 2013 from Rowbottom, N1998, Intangible Asset Accounting and Accounting policy Selection in the football industry, The University of Birmingham. Gaffikin, M 2006, The Critique of Accounting Theory, Rtrieved on August 15, 2013 from Read More