Chapter 7 - Positive Theory

Positive Accounting Theory

Philosophy of PAT
Million Friedman championed positive theories in economics.
He stated that: (part 3 Empirical Research in Accounts of Accounting
theory from Jayne Godfrey)
The ultimate goal of positive science (i.e. INDUCTIVE) is
The development of a theory or hypothesis;
that yields valid and meaningful Predictions
about phenomena not yet observed.
Consistent with Friedmans view, Watts and Zimmerman asserts
that:
The objective of positive accounting theory is to explain and
predict accounting practice.

Explanation means providing reasons for observed practice.

For example, positive accounting theory seeks to explain why
firms continue to use historical cost accounting and why certain
firms switch between a numbers of accounting techniques.
Prediction of accounting practice means that the theory
predicts unobserved phenomena.

Unobserved phenomena are not necessarily future phenomena;

they include phenomena that have occurred, but on which
systematic evidence has not been collected.
For example Predicting the reaction of firms to a proposed
accounting standard and an explanation of why firms would lobby
for and against such a standard, even though the standard has
already been released.
Testing these theories provides evidence that can be used to
predict the impact of accounting regulations before they are
implemented.
PAT has an economic focus and seeks to answer such questions
what is the effect of reported financial statements on share price,
for example?

For the above issue, PAT is based on assumption about the

behavior of individuals: that is Manager, investors, lender and
other individuals are rational, evaluative utility maximize (REM).
Chapter 7 - Positive Theory
Positive Accounting Theory
This theory attempts:
1. to explain managers choices of accounting methods in
terms of self-interest,
2. the relationships between stakeholders and,
3. how financial accounting can be used to minimize cost by
aligning competing interests.
Returning our fouces, PAT foucses on the relationship between
the various individuals involved in providing resources to an
organization and
how accounting is used to assist in the functioning of these
relationship
PAT, as developed by Watts and Zimmerman and others, is
based on the central economic-based assumption that all
individuals action is derived by self-interest and that individuals will
act in an opportunistic manner to the extent that the actions will
increase their wealth.
Given an assumption that self-interest drives all individual actions,
PAT predicts that organization will seek to put in place mechanisms
that aligns the interests of the manages of the firm (agent) with the
interests of the owners of the firm (the principal).
EMH Efficient market hypothesis
The genesis of positive accounting theory is the Efficient Market
Hypothesis (EMH). According to Fama, the EMH is based on the
assumption that capital markets react in an efficient and unbiased
manner to publicly available information.
The perspective taken is that security prices reflect the

information content of publicly available information and this

information is not restricted to accounting disclosures.
The capital market is considered to be highly competitive, and as a
result, newly released public information is expected to be quickly
impound into share prices.
Chapter 7 - Positive Theory
Positive Accounting Theory EMH Efficient market hypothesis (contd)
A. The Efficient capital market vs. the accounting method
If accounting results are released by an organization, and these
results were already anticipated by the market (e.g. interim
announcement), then the expectation is that the prices of security
will not react to the release of the accounting results.
Consistent with traditional finance theory, the price of a security is
determined on the basis of belief about The Present Value of Future
Cash Flows pertaining to that security and when these belief
changes (as a result ot particular information becoming available)
the expectation is that the securitys price will also change.
Because share prices are expected to reflect information from
various sources (as the information relates to predicting future
cashflow), that was a view that Management cannot manipulate
share prices by changing accounting methods in an opportunistic
manner. Page 207
B. The choices of manager under the efficient capital market
Because there are many sources of data used by the capital market,
if managers make less than truthful disclosures, which are not
corroborated or contradicts other available information, then,
assuming that the market is efficient, the market will question the
integrity of the managers.
Consequently the market will tend to pay less attention to
subsequent accounting disclosures made by such managers.
While supportive of EMH, the literature was unable to explain
why particular accounting methods might have been

selected in the first place.

For example, if an entity elected to switch its inventory cost flow
assumptions and this led to an increase in reported income, then
the market was assumed to be able to see through this change, and
to the extent that there were no apparent cash flow implications,
there would be no share price reaction. Hence, if the particular
accounting method had no direct taxation implications, there was an
inability to explain why one method of accounting was selected in
preference to another. Page 210
Chapter 7 - Positive Theory
Positive Accounting Theory Agency Theory
A key to explaining managers choice of particular accounting
method came from Agency theory.
Agency theory provided a necessary explanation of why the
selection of particular accounting methods might matter, and
focused on the relationships between principals and agents, a
relationship which, due to various information asymmetries, created
much uncertainty.
Agency theory accepted that transaction costs and information
costs exist.
Relying upon traditional economic literature (i.e. maximize own
wealth), Jensen and Meckling considered the relationship and
conflicts between agents and principals and how efficient
markets and various contractual mechanisms can assist in
minimizing the cost to the firm of these potential conflicts. (Page
211)
It is assumed within Agency Theory that principles will assume that
the agent will be driven by self-interest, and therefore the principle
will anticipate that the manager, unless restricted from doing
otherwise, will undertake self-serving activities that could be

detrimental to the economic welfare of the principle. (Page 211)

In the absence of any contractual mechanism to restrict the
agents potentially opportunistic behavior, the principle will pay the
agent a lower salary in anticipation of the opportunistic actions. The
agents are therefore assumed to have an incentive to enter into
contractual arrangements that appear to be able to reduce their
ability to undertake actions detrimental to the interests of the
principals.
That is, if it is assumed that managers would prefer higher salaries,
then there will be an incentive for them to agree to enter into
contractual arrangement that minimize their ability to undertake
activities that might be detrimental to the interests of the owners.
Chapter 7 - Positive Theory
Positive Accounting Theory
Contracting theory
Agency Theory does not assume that individual will ever act other
than in self-interest, and the key to a well functioning organization is
to put in place mechanism (Contracting theory) that ensure that
actions that benefit the individual also benefit the organization.
By the mid to late 1970s, theory had therefore been developed that
proposed
Markets were efficient and that
Contractual arrangements were used
as a basis for controlling the efforts of self-interested agents.
It is also emphasis that efficiently written contracts, with many
being tied to the output of the accounting system, were a crucial
component of an efficient corporate governance structure.
PAT development and Accounting method
In 1990 Watts The accounting Review identified three key
hypothesis that had become frequently used in the PAT literature to
Explain and Predict whether an organization would support or

oppose a particular accounting method.

These hypotheses as follow:
1. The bonus plan hypothesis
2. The debt / equity hypothesis; and
3. The political cost hypothesis
The bonus plan hypothesis assumes that managers with bouns plan
as more likely to use accounting methods that increase current
period reported income. It predicts that if a manager is rewarded in
terms of a measure of performance such as accounting profits, the
manager will attempts to increase profits..
The debt/ equity hypothesis predicts that the higher the firms
debt/equity ratio, the more likely managers use accounting methods
that increase income.
Managers exercising discretion by choosing income increasing
accounting method, relaz debt constraints and reduce the costs of
technical default.
Chapter 7 - Positive Theory
Positive Accounting Theory
Opportunistic and efficiency perspectives
Within the efficiency perspective, researchers explain how
various contracting mechanisms can be put in place to minimize the
agency costs of the firm, that is, the costs associated with assigning
decision making authority to the agent.
The efficiency perspective is often referred to as an ex ante
perspective.
Ex-ante means before the fact as it considers what mechanisms
are put in place up front, with the objective of minimizing future
agency and contracting costs.
The opportunistic perspective of PAT, takes as given the
negotiated contractual arrangements of the firm and seeks to
explain and predict certain opportunistic behaviors that will

subsequently occur. Initially, the particular contractual

arrangements might have been negotiated because they were
considered to be most efficient in aligning the interests of the
various individuals within the firm. However, it is not possible or
efficient to write complete contracts that provide guidance on all
accounting methods to be used in all circumstances hence there
will always be some scope for managers to opportunistic.
The opportunistic perspective is often referred to as an ex post
perspective- ex post meaning after the fact because it considers
opportunistic action that could be undertaken once various
contractual arrangements have been put in place.
As noted previously, it is assumed to be too costly to stipulate in
advance all accounting rules to be used in all circumstances.
Hence, PAT proposes that there will be always be scope for agents to
opportunistically select particular accounting methods in preference
to others.

Chapter 7 - Positive Theory

Positive Accounting Theory
How PAT attempt to explain in part the revaluation of assets under
AASB116? It is the choice of accounting method between cost
model and revaluation model.
Given that AASB 116 (IAS 16) allows entities a choice between the
cost model and the revaluation model, it is of interest to consider
what may motivate entities to choose between the two
measurement models.
Cost-benefit basis - cost incurred to provide relevant
information
In most arguments relating to the choice between the two models,
there are the general propositions that a Current Price, namely a

fair value, will provide more relevant information than a past price,
namely the original cost, while the costs associated with
continuously determining the present price reduce the incentive, on
a cost-benefit basis, to move to current values.
Certainly, the requirement under AASB 116 to continuously adjust
the carrying amounts of assets measured at fair value so that they
are not materially different from current fair values provides a cost
dis-incentive to management to adopt the revaluation model.
The bonus plan hypothesis
Another factor that entities have to consider when choosing their
measurement bases for class of property, plant and equipment is
the effect of the model on the income statement.
Where assets are measured on a fair value basis, the depreciation
each year would be expected to be higher as the depreciable
amount is higher.
Besides the effect of depreciation, there will be an effect on disposal
of the assets.
When an asset is measured at fair value, there is expected to be an
immaterial amount of profit/loss on sale, as the recorded amount of
the asset at time of sale should be close to that of the market price
at time of sale.
For an asset measured at cost, any gain on sale will be reported in
the income statement the income is recognized upon disposal of
assets which is determined by the management decision.
Chapter 7 - Positive Theory
Positive Accounting Theory
Apart from increased relevance and reliability argument, what are
the incentive for management to use revaluation model?
The Debt / Assets hypothesis
The effect of adopting the revaluation model is to increase the
entitys assets and equities. Hence, entities which need to report
higher amounts in these areas would consider adoption of the
revaluation model.

For example, entities which have debt covenants generally have

constraints relating to their debt-asset ratio e.g. the debt-asset ratio
must not exceed 50%. Hence, for an entity with increasing debt,
adoption of the revaluation model for a class of assets which is
increasing in value will ease pressure on the debt-asset ratio by
increasing the asset base of the entity, providing, of course, that the
debt covenant allows revaluations to be taken into account in
measuring assets.
The political cost hypothesis
The incentives for entities to adopt fair value measures, then, tend
to be entity-specific because of pressures placed on the entities
relating to external circumstances.
For example: an entitys reported profit figure may be under scrutiny
from a specific source, such as a trade union seeking reasons to
support claims for higher pay, or regulators looking at monopoly
control within an industry.
Conclusion
Where there are pressures to report lower profits, adoption of the
revaluation model provides scope of higher depreciation charges
with increases in the value of non-current assts not affecting the
income statement. With lower reported profit and a higher
asset/equity base, any judgment made by reviewing ratio such as
rate of return on assets or equity will result in the entity being seen
in a less favorable light. (Company Accounting Ken Leo, John
Hoggett Page 189 and 190)