Positive Accounting Theory - Coursework Example

POSITIVE ACCOUNTING THEORY Name Institution Course Date Positive Accounting Theory In regard to the positive accounting theory (PAT), accounting numbers forms an essential aspect of a company’s effective contracting technology. Majority of the covenants, conditions and terms that are contained in contracts makes use of accounting variables. As such, the theory positive accounting theory suggests that contractual arrangements and related costs are the main determinants of the choice of an accounting method (Watts and Zimmerman, 1986). In this regard, by making use of proposals of contracting theory, it is possible to forecast and choice of accounting as suggested by positive theory of accounting. Managers of a company are capable of obtaining different accounting numbers by using distinct accounting methods that are within the accepted principles of accounting. As a result, it is prudent to argue hypothesize that the choice of accounting method is affected by contractual arrangements. There are three kinds of contracts that are related to choice of accounting method; contracts between owners and management, debt holders and management, and political parties and management. In this regard, there are three hypothetical arguments based on positive accounting theory that explains the choice of accounting method; management compensation plan hypothesis, debt hypothesis and political cost hypothesis. As such, researchers in the accounting discipline have over the years been empirically testing the positive accounting theory as proposed by Watts and Zimmerman (1990). According to Watts and Zimmerman (1990), tests of accounting choice method provides evidence that the political process, debt and bonus variables are statistically significant in regard to positive accounting theory. At the time they instituted the positive accounting theory Watts and Zimmerman suggested that it lacks strong support. This is evidenced by flaws in research methodology (Watts and Zimmerman, 1990). On the other hand, the dependent variable, which is accounting choice variable, has not yet been sufficiently specified. In that case, the net accruals are the most encouraging measure because they reflect comparative impacts on earnings generated by different accounting choices. However, such a measure consists of a non-discretionary element; therefore, it is considered a noisy amount of the net accrual amount that managers can manipulate (Watts and Zimmerman, 1990). In that aspect, positive accounting is deficient in some way leading to Watts and Zimmerman recommending the following need: that it is necessary to measure net accruals relative to what they would amount to without manipulation in order to exclude the variations from dependent variables. In that case, it would call for the use of a specific model that is non-existent at the moment (Martens and Stevens, 1993). Consequently, it is also relevant to criticize the explanatory variables for instance the employment of a zero-one variable to amount a bonus plan which is considered simplistic. Additionally, the use of firms’ size to measure the level of political sensitivity it wholly inadequate. Consequently, using the debt-to-equity ratio may, on the other hand, fail to capture its exact relation with debt covenant itself according to Watts and Zimmerman (1990). It is worth noting that a lot of models have as well ignored the probable impacts of interaction among explanatory variables. In the same note, variables that have been omitted can cause biased coefficients for explanatory variables and thereby hamper correlated interactions. A notable aspect of accounting is the information perspective in which case it is perceived that accounting data should provide information to creditors, investors and other interested stakeholders. The main objective of positive accounting theories as argue by Hansen and Pourjalali (2012) is to explain and forecast particular phenomena. As earlier mentioned, positive accounting theories are developed and reinforced by observations and that is why they are based on empirical studies. The theories of positive accounting assume that by making a lot of observations, a person is put in a better position to forecast future happenings. For instance, a large number of managers in an industry may be studied in order to forecast the accounting methods that they may use in specific circumstances. On a critique aspect, positive accounting theory is mainly concerned with explaining and predicting accounting practices of various organizations, as opposed to prescribing particular actions. On the other hand, normative accounting theories have criticized positive accounting theories because the former do not provide guidance to practitioners. This is in consideration that they attempt to elucidate economic effects that may result from the selection of specific accounting policies. In addition to the earlier mentioned theories that positive accounting theory may be based on, other include stakeholder theory and legitimacy theory (Hansen and Pourjalali, 2012). As proposed by positive accounting theory, most of the relationships involve delegating the function of decision making from one person (principal) to the other (agent) which is commonly referred to as agency relationship. As such, delegating the authority of decision making can hamper the efficiency besides increasing the costs involved referred to as agency costs. It is worth noting that positive accounting theory makes an effort to investigate how contractual engagements, in which case most of them are tied to accounting numbers, can be utilized in order to reduce agency costs. On the other hand, in contrast to what may be the norm, positive accounting theories are based on the assumption that individual actions are propagated by self-interest that renders them to act in an opportunistic in order to increase their wealth. As such, one deficiency of the positive accounting theories is that do not accommodate notions of morality and loyalty (Hansen and Pourjalali, 2012). Consequently, the positive accounting theories regard organizations as a pool of the self-interested group of individuals working in cooperation. However, such cooperation does not imply abandonment of their objective on self-interest. This means that such individuals enter into contracts that involve adequate incentives to protect their cooperation. Consequently, positive accounting theory forecasts majority of organizations aims at putting mechanisms in place that are in alignment with the interests of firms’ managers, the agents, and the interest of firms’ owners, the principals. In that case, the various methods applied in aligning distinct interests is based on the production of the accounting system for instance offering the managers with a share of the organization’s surpluses. In such instances where accounting practices are based on alignment mechanisms, there are no financial statements that are produced. However, firm managers are supposed to bond themselves in preparation of financial statements, which is rather costly, is commonly referred to as bonding costs in positive accounting theory. It is worth noting that bonding costs are borne by the agents in instances where they establish mechanisms for signalling principals that they will conduct themselves in their interests. In case they fail to do so, the agents are required to compensate the principals (Hansen and Pourjalali, 2012). Another theoretical underpinning of positive accounting theory is that in case managers are to prepare financial statements themselves, the theory forecast that there would be increased demand for the financial statements to be monitored or audited. On the other hand, by making an assumption of self-interest of the principals, then agents would make efforts to overstate profits in order to increase the entire share of profits. This leads to the organization incurring monitoring costs which is in other words costs of undertaking an audit. In such a case, positive accounting theory assumes that it is not all unscrupulous actions of the agents that can be influenced by contractual obligations or otherwise it results in residual costs that are associated with the appointment of an agent. According to Watts and Zimmerman (1986), the opportunistic and efficiency perspectives are applied by researches that apply positive accounting theory. In an efficiency perspective, contracting mechanisms can be employed to reduce agency costs. In another aspect, efficiency perspective of positive accounting theory alleges that accounting practices that are adopted by various firms are exemplified based on underlying financial performance of an organization (Milne, 2002). In consistent with efficiency perspective of accounting theory, adoption of accounting methods by various organizations implies they do so in order to reflect the underlying performance of a firm. As such, regulating financial accounting leads to incurring unwarranted costs for reporting entities. Release of new reporting standards that bans organizations’ preferred accounting methods results in inefficiencies thereby failing to reflect an organization’s performance. In that case, positive accounting theory argues that management is best capable of selecting appropriate accounting methods in specific circumstances only and, therefore, regulatory authorities, for instance government, should not intervene. On the other hand, opportunistic perspectives of positive accounting theory considers as given the negotiated contractual obligations of an organization. As such, it seeks to expound and forecast specific opportunistic behaviour that may likely occur in the future. By instituting contractual arrangements that align managers’ interests with those of the owners, managers may opportunistically decide to adopt specific accounting methods in order to increase their bonus and accounting profits. For instance, managers may decide to make use of a depreciation method in order to increase their income strategically (Collin et al., 2009). In conclusion, therefore, as explained on the above discourses, it is quite evident that positive accounting theory assumes that managers manipulate accounting numbers. This is especially in instances where manager are rewarded based on the status of the accounting numbers which acts as an incentive for manipulation. Therefore, it is not appropriate for managers to reward managers based on accounting numbers. Based on the positive theory of accounting, it calls for other monitoring methods for instance financial auditing, in order to ascertain reasonableness of chosen accounting method. References Collin S-O Y, Tagesson T, Andersson A, Cato J, Hansson K, 2009. Explaining the choice of accounting standards in municipal corporations: Positive accounting theory and institutional theory as competitive or concurrent theories, Critical Perspectives on Accounting, vol. 20, no. 2, pp. 141-174. Hansen D, and Pourjalali H, 2012, Positive accounting theory: Background, criticism, & answers. The Iranian accounting and auditing review, vol. 2, no. 3, pp. 1-37. Martens S, and Stevens, K T, 1993, Positive Accounting Theory and the Obligation for Post-Retirement Benefits, Critical Perspectives on Accounting, vol. 4, no. 3, pp. 275–295. Milne M J, 2002. Positive accounting theory, political costs and social disclosure analyses: A critical look. Critical Perspectives on Accounting, vol. 13, no. 3, pp.369-395. Watts, R. L., and Zimmerman, J. L. 1990, Positive Accounting Theory: A Ten Year Perspective, The Accounting Review, pp. 131-156. Watts RL, and Zimmerman, JL, 1986, Positive accounting theory Contemporary topics in accounting series, Prentice-Hall, New York. Read More