Positive theories
Positive theories seek to explain and predict
particular phenomena.
They are often developed and supported on the
basis of observations (that is, they are
empirically based).
The view is that by making numerous
observations one will be in a better position to
predict what will happen in future.
For example, many managers within a particular
industry might be studied to predict what
accounting methods they will elect to use in
particular circunastamcesn Marboob Ho 2Positive Accounting Theory (PAT)
Seeks to explain and predict accounting practice.
It does not seek to prescribe particular actions.
According to Watts and Zimmerman:
“[PAT] is concerned with explaining [accounting] practice. It is designed to
explain and predict which firms will and which firms will not use a
particular [accounting] method....but it says nothing as to which method a
firm should use.”
Normative accounting theories have criticized
PAT because it does not provide practitioners
with guidance, even though it does attempt to
explain the economic implications that might
result from the selection of particular accounting
policies.
Prepared By: Dewan Mahboob Ho 3Positive Accounting Theory (PAT)
...contd..
Some examples of positive theories are:
legitimacy theory and stakeholder theory.
Watts and Zimmerman’s PAT focuses on
the relationship between the various
individuals involved in providing
resources to the organization.
This could be the relationship between the
owners and the managers, or between the
managers and the firm’s debt providers.
Prepared By: Dewan Mahboob HoPositive Accounting Theory (PAT)
...contd..
Many relationships involve the delegation of
decision making from one party (the principal)
to another party (the agent) — this is referred to
as an agency relationship.
Delegating decision making authority can lead
to loss of efficiency and, consequently, increased
costs. These costs are called agency costs.
PAT investigates how contractual arrangements-
many tied to accounting numbers- can be put in
place to minimize agency costs.
Prepared By: Dewan Mahboob Ho 5Positive Accounting Theory (PAT)
...contd..
PAT investigates how contractual arrangements-
many tied to accounting numbers- can be put in
place to minimize agency costs.
PAT is developed on the assumption that all
individual action is driven by self interest and
that individuals will act as an opportunistic
manner to increase their wealth.
Notions of loyalty and morality are not
accommodated within the theory.
Prepared By: Dewan Mahboob Ho 6Positive Accounting Theory (PAT)
...contd..
Organizations are considered as
collections of self-interested individuals
who have agreed to cooperate.
Such cooperation does not mean that they
have abandoned self-interest as an
objective; rather it means only that they
have entered into contracts that entail
sufficient incentives to secure their
cooperation.
Prepared By: Dewan Mahboob HoPositive Accounting Theory (PAT)
...contd..
PAT predicts that organizations will seek to put
in place mechanisms that align the interests of
the managers of the firm (the agents) with
interest of the owners of the firm (the
principals).
Some of these methods of aligning interests will
be based on the output of the accounting system,
such as, providing the managers with a share of
the organizations’ surpluses.
Where such accounting based alignment
mechanisms are in place, financial statements
will need to be praducedsranooos rio 8Positive Accounting Theory (PAT)
...contd..
Managers are required to bond themselves to
prepare these financial statements. This is costly
in itself and, in PAT, would be referred to as a
bonding cost.
This bonding cost is a cost incurred by agents
when they establish mechanisms to signal to
principals that they will behave in the interests
of the principal or will compensate the principal
if they fail to do so.
Prepared By: Dewan Mahboob HoPositive Accounting Theory (PAT)
...contd..
Assuming that managers will be responsible for
preparing financial statements, PAT would also
predict that there would be a demand for those
statements to be audited or monitored.
Otherwise, assuming self interest, agents would
make an attempt to overstate profits, thereby
increasing their absolute share of profits.
In PAT, costs of undertaking an audit is referred
to as a monitoring cost.
Prepared By: Dewan Mahboob Ho 10Positive Accounting Theory (PAT)
...contd..
PAT assumes that not all opportunistic
actions of agents can be controlled by
contractual arrangements or otherwise,
there will always be some residual costs
associated with appointing an agent.
Prepared By: Dewan Mahboob Ho auAgency Relationship
delegation
Principal (owner)
ee
Agent (manager)
performance
Solutions:
*Bonding
*Monitoring
*Residual loss
(increase performance)
Problems:
Self interest
*Goal congruence
(reduce performance)
Prepared By: Dewan Mahboob HoEfficiency and the opportunistic
perspectives of PAT
Research that apply PAT
typically adopt either an
efficiency perspective or an
opportunistic perspective.
Prepared By: Dewan Mahboob HoEfficiency perspective of PAT
From the efficiency perspective, researchers
explain how various contracting mechanisms
can be put in place to minimize the agency costs
of the firm.
The efficiency perspective is often referred to as
an ex ante (before the fact) perspective. It
considers what mechanisms are put in place up
front with the objective of minimizing agency
cost.
Prepared By: Dewan Mahboob Ho 14Efficiency perspective of PAT
For example: preparing F/S though not
any regulation.
Researchers such as Jensen and Meckling
(1976) argue that the practice of providing
audited financial statements leads to real
cost savings as it enables organizations to
attract funds more cheaply (in other
words, it is efficient).
Prepared By: Dewan Mahboob Ho 15Efficiency perspective of PAT
From the efficiency perspective of PAT, it is also
argued that the accounting practices adopted by
firms are often explained on the basis that such
methods best reflect the underlying financial
performance of the entity.
Different organizational characteristics are used
to explain why firms adopt the accounting
methods they do.
For example: Goodwill.
Prepared By: Dewan Mahboob Ho 16Efficiency perspective of PAT
By providing measure of performance that
best reflect the underlying performance of
the firm, it is argued that investors and
other parties will not need to gather
additional information from other sources.
This will consequently lead to cost
savings. for example: Consolidated FS
prepared voluntarily.
Prepared By: Dewan Mahboob Ho 7Efficiency perspective of PAT
(contd..)
If it is assumed, consistent with the
efficiency perspective, that firms adopt
particular accounting methods because
they best reflect the underlying
performance of the entity, it is often
argued by the PAT theorists that the
regulation of financial accounting imposes
unwarranted costs on reporting entities.
Prepared By: Dewan Mahboob Ho 18Efficiency perspective of PAT
(contd..)
For example, if a new financial reporting standard is
released that bans accounting methods from being used
by a particular organization, this will lead to
inefficiencies as the resulting financial statements will no
longer provide the best reflection of the performance of
the organization.
Many PAT theorist would argue that management is
best able to select which accounting methods are
appropriate in given circumstances and government
should not intervene in the process (an anti-regulation
argument).
Prepared By: Dewan Mahboob Ho 19Opportunistic perspective of PAT
The opportunistic perspective of PAT takes as given the
negotiated contractual arrangements of the firm and
seeks to explain and predict certain opportunistic
behavior that will subsequently occur.
The opportunistic perspective is often referred to as ex
post (after the fact) perspective. Because it considers
opportunistic actions that could be undertaken once
various contractual arrangement have been put in place.
Prepared By: Dewan Mahboob Ho 20Opportunistic perspective of PAT
(contd..)
For example, in an endeavor to minimize agency costs, a
contractual arrangement might be negotiated that
provides managers with a bonus based on the profits
generated by the entity.
This will act to align the interests of the managers with
the interests of the owners.
Once the contractual arrangement is in place, the
managers could opportunistically elect to adopt
particular accounting methods that increase accounting
profits and therefore the size of the bonus. Managers
might elect to adopt a particular depreciation method
that increases income even though it might not reflect
the actual use of tress $etPewan Mahboob Ho aOpportunistic perspective of PAT
(contd..)
PAT assumes that principals predict that managers will
be opportunistic.
With this in mind principals often stipulate the
accounting methods to be used for particular purpose.
For example, a bonus plan agreement might stipulate
that a particular depreciation method such as straight
line depreciation be adopted to calculate income for
determination of bonus.
However, it is assumed to be too costly to stipulate in
advance all accounting rules to be used in all
circumstances.
Therefore, PAT proposes that there will always be scope
for agents to opportunistically select particular
accounting methéde in prefereeesto'o thers. 2Owner/manager contracting
A manager that owns a firm bears the costs associated
with their own perquisite consumption (consumption by
employees of non-salary benefits), which could include
consumption of the firm’s resources for private purposes
— acquiring an overly expensive company car or
luxurious offices or staying in overly expensive hotel
accommodation.
As the percentage of ownership held by managers
decreases, managers bear less and less of the cost of their
own perquisite consumption.
The costs begin to be absorbed by other owners of the
firm.
Prepared By: Dewan Mahboob Ho 23Owner/manager contracting
(contd..)
PAT adopts as a central adoption that all action
by individuals is driven by self-interest, and the
major interest of all individuals is to maximize
their own wealth. Such assumption is often
referred to as the “rational economic person
assumption”.
Tf all individuals are assumed to act in their own
self-interest, owners would expect managers
(their agents) to undertake their activities that
might not always be in the interests of the
owners (the principals).
Prepared By: Dewan Mahboob Ho 24Owner/manager contracting
(contd..)
Further, because of their position within
the firm, managers will have access to
information that is not available to
principals — a problem referred to as
“information asymmetry” .
It increases the scope for managers to
undertake actions that are beneficial to
themselves at the expense of the owners.
Prepared By: Dewan Mahboob HoOwner/manager contracting
(contd..)
It is assumed in PAT that principals expect their agents
to undertake activities that might be advantageous to
themselves but disadvantageous to the value of the firm.
Asa result, principals will price this into the amounts
they are prepared to pay the managers.
That is, in the absence of controls to reduce the ability of
managers to act opportunistically, principals expect such
actions, and as a result, will pay their managers a lower
salary.
It is often referred to as price protection. Managers,
therefore, bear some of the agency costs of the potential
opportunistic behaviors that they might, or might not
undertake.
Prepared By: Dewan Mahboob Ho 26Owner/manager contracting
(contd..)
Before agreeing to increase the amount
paid to managers, the owners of a firm
would need to ensure that any
contractual commitments can be
monitored for compliance.
Managers may be rewarded:
In a fixed basis;
On the basis of results achieved, or,
On the basis. of.a,.cambination of the two,Owner/manager contracting
(contd..)
If managers are rewarded on a fixed basis:
They will not want to take great risks as they
will not share potential gains.
Will not adopt strategies that will increase the
value of the firm;
They will be reluctant to take on optimum level
of debt as the claims of the debt holders would
compete the manager's own fixed income.
Like debt holders, managers with a fixed income
claim want to protect their fixed income stream. |
Prepared By: Dewan Mahboob HoOwner/manager contracting
(contd..)
Assuming self interest drives actions of
managers, PAT theorist argue that it can be
necessary to put into place remuneration
schemes that reward the managers in a way that
is, at least in part, tied to the performance of the
firm.
Thus, if the performance of the firm improves,
the rewards paid to managers increase
correspondingly. If the firm performs well both
the parties will benefit
repared By: Le 29Owner/manager contracting
(contd..)
Bonus schemes:
A scheme where the manager receives a bonus that
is ties to the performance of the organization.
Managers are commonly rewarded in terms of the
market price of the firm’s shares.
This might be through holding an equity interest
in the firm, or perhaps by receiving a cash bonus
explicitly tied to movements in the market value
of the firm’s securities.
Prepared By: Dewan Mahboob Ho 30Accounting based bonus plans
The amount paid to managers may be tied
directly to accounting numbers- such as
profits/sales/assets.
In this case any changes in the accounting
methods used by organization will affect
the bonuses paid.
Contracts that rely on accounting numbers
might rely on ‘floating’ generally
accepted accounting principles.
Prepared By: Dewan Mahboob Ho 31Incentives to manipulate
accounting numbers
There are a number of costs that might arise if incentive schemes are
based on accounting outputs.
Healy (1985) found that under schemes that rewarded managers
after a pre-specified level of earnings had been reached, managers
would adopt accounting methods consistent with maximizing that
bonus.
Where profits were not expected to reach the minimum level
required by the plan, managers appeared to adopt strategies that
further reduced income in that period (taking a bath).
This leads to higher income in subsequent periods when profits
might be above the requires threshold.
For example, a manager might write off an asset in one period when.
bonus was not going to be earned anyway so that there would be
nothing further to depreciate in future periods when profit-related
bonuses might be paid.
Prepared By: Dewan Mahboob Ho 32Incentives to manipulate
accounting numbers (contd..)
Investment strategies that maximize the present value
of a firm’s resources will not necessarily produce
uniform periodic cash flows or accounting profits.
It is possible that some strategies might generate
minimal accounting returns in the early years, yet still
represent the best alternatives available to the firm.
Rewarding managers on the basis of accounting
profits might discourage them from adopting such
strategies and might encourage them, instead, to
adopt a short term, as opposed to a long-term focus.
Prepared By: Dewan Mahboob Ho 33Incentives to manipulate
accounting numbers (contd..)
Lewellen, Loderer and Martin (1987):
US managers approaching retirement are less likely to undertake
research and development expenditure if their rewards are
based on accounting based performance measures, such as
profits.
Incurring R&D costs leads directly to a reduction in profits.
Also R&D expenditures would be expected to lead to benefits in
subsequent years, retiring managers might not be there to
share that gain.
Predictably, the self-interested manager who ts rewarded on the
basis of accounting profits will not undertake research and
development in periods close to the point of their retirement.
Prepared By: Dewan Mahboob Ho aMarket based bonus schemes
Firms involved in mining or high-technology R&D might
have accounting earnings that fluctuate greatly. Successful
strategies might be employed that will not provide accounting
earnings for a number of periods.
In such industries, positive accounting theorists might argue
that itis more appropriate and efficient to reward managers
in terms of the market value of the firm’s securities, which are
assumed to be influenced by expectations about the net
present value of expected future cash flows.
This can be done either by basing a cash bonus on any
increases in share prices or by providing managers with
shares or options to shares in the firm.
If value of the firm’s share increases, both managers and
owners will benefit and managers will be given an incentive
to increase the valye.of the FEE: stahboob Ho 35Concluding remarks
PAT assumes that if a manager is rewarded on
the basis of accounting numbers, the manager
will have an incentive to manipulate the
accounting numbers in an effort to increase their
own personal wealth.
Rewarding managers in terms of accounting
numbers might not be appropriate if
management is solely responsible for compiling
those numbers.
The auditor will act to arbitrate on the
reasonableness of the accounting methods
adopted. Prepared By: Dewan Mahboob Ho 36Concluding remarks
It must be remembered that there will always be
scope for opportunism.
It would be too expensive and impossible to pre-
specify a complete set of accounting methods to
cover all circumstances.
It should be remembered that the existing
accounting standards (IAS and IFRS) do not
cover all types of transactions and, as a result,
significant discretion can be employed when
compiling financial statements.
Prepared By: Dewan Mahboob Ho 37Debt Contracting
When a party lends fund to another organization, the
recipient of funds might undertake activities that reduce
or even eliminate any likelihood of the funds being
repaid.
These costs, which relate to divergent behavior of the
borrower, are referred to in PAT as the agency costs of
the debts.
For example, the recipient of funds might pay excessive
dividends, leaving few assets in the organization to
service debts.
Alternatively, the organization might take on additional,
and perhaps excessive levels of debt. The new debt
holders would then compete with the original debt
holders for repayragiat.sy: Dewan Mahboob Ho 38
Smith and Warner (1979) refer to this practice as claimDebt contracting (contd..)
The firm may also invest in very high-risky
projects. The strategy would not be beneficial for
the debt holders.
They have a fixed claim and therefore if the
project generates high profits they will receive
no greater return, unlike owners who will share
the increased value of the firm.
If the project fails, which is more likely if it is
risky, the debt holders might receive nothing.
Prepared By: Dewan Mahboob Ho 39Debt contracting (contd..)
Where covenants restrict the total level of debt
that may be issued, this is assumed to lead to a
reduction in the risk to existing debt holders.
This is further assumed to translate into lower
interest rates being charged by the protected
debt holders.
Debt covenants are restrictions within a trust
deed on the operations of a borrowing entity.
Prepared By: Dewan Mahboob Ho 40Debt contracting (contd..)
In the absence of contractual safeguards, it is
assume that the debt holders will require the
firm to pay higher costs of interest to
compensate high risk exposure.
Ifa firm contractually agrees that it will not
pay excessive dividends, not take on high
levels of debt and not invest in projects of an
excessively risky nature, it is assumed that
the firm will be able to attract debt capital at a
lower cost than would otherwise be possible.
Prepared By: Dewan Mahboob Ho
a1Debt contracting (contd..)
As with management compensation
contracts, PAT assumes that the existence
of debt contracts provides management
with subsequent (ex-post) incentives to
manipulate accounting numbers — an
incentive that increases as the accounting
based constraint approaches violation.
Prepared By: Dewan Mahboob Ho 42Debt contracting (contd..)
If the firm contractually agreed that the ratio of
debt to total tangible assets should be kept
below a certain figure, if the figure was likely to
be exceeded, management might have an
incentive either to inflate assets or deflate
liabilities.
Debt agreements typically require that financial
statements be audited.
Prepared By: Dewan Mahboob Ho 43,Debt contracting (contd..)
Debt holders are external parties with a claim
against the organization for repayment of funds
previously advanced.
Within accounting, management usually has
available a number of alternative ways to
account for particular items and thus, to
minimize the effects of existing accounting
based restrictions.
Therefore, it might appear optimal for debt
holders to specify in advance all accounting
methods management must use.
Prepared By: Dewan Mahboob Ho 44Debt contracting (contd..)
However, as noted previously, it would be
too costly and impractical to write
‘complete’ contracts upfront.
As a consequence, management will
always have some discretionary ability
that might enable it to lessen the effects of
restrictions negotiated by debt holders.
Prepared By: Dewan Mahboob Ho 45Debt contracting (contd..)
The role of the external auditors, if appointed,
would be to arbitrate on the reasonableness of
accounting methods chosen.
There will be a particular demand for financial
statement audit when: a) management is
rewarded on the basis of numbers generated by
accounting systems; and, b) the firm has
borrowed funds and accounting based
covenants are in force to protect the investment
of debt holders.
Prepared By: Dewan Mahboob Ho 46Debt contracting (contd..)
It could also be argued that as managers’
share of equity in a business decreases and
the proportion of debt to total assets
increases, there will be a corresponding
increase in the demand for auditing.
Prepared By: Dewan Mahboob Ho 7Political costs
The term political costs is used to refer to the
costs that particular groups external to the firm
might be able to impose on the firm, such as the
costs associated with increased taxes, increased
wage claims or product boycott.
Government, trade unions, environmental lobby
groups or particular consumer groups affect
organizations.
Prepared By: Dewan Mahboob Ho 48Political costs (contd.)
The demands placed on firms by particular
interest groups might be affected by the
accounting results of the firm.
For example, if a firm were to record high
profits, this might be used as an excuse for the
trade unions to take action to increase their
members’ share of profits in the form of higher
wages.
Prepared By: Dewan Mahboob Ho 49Political costs (contd.)
High profits might also be used by particular groups that
lobby for increased taxes or decreased subsidies on
grounds of the firm’s ability to pay.
For example, Watts and Zimmerman (1986) examined the
highly publicized claims about US oil companies made by
consumers, unions and government within the USA in late
1970s.
These claims were that oil companies were making excessive
reported profits and were in effect exploiting the nation.
It is considered that such claims could have led to the
imposition of additional taxes in the form of ‘excess profits’
taxes.
Prepared By: Dewan Mahboob Ho 50Political costs (contd.)
Governments seeking re-election could be motivated to
take action against unpopular firms if it was felt that
they would secure a net increase in electoral support.
This obviously assumes that the actions of most
politicians are motivated by a desire to be re-elected -
perhaps not an unrealistic assumption and certainly
consistent with the PAT contention that actions of all
individuals can best be explained by the assumption of
self interest.
It is argued within PAT that accounting numbers can be
used as a means of providing ‘excuses’ for effecting
wealth transfers in the political process.
Prepared By: Dewan Mahboob Ho 51Political costs (contd.)
High profits might also be used by
consumer groups to justify assuming a
position that prices are too high.
Media reports of high corporate
profitability trigger political costs of a
firm.
Prepared By: Dewan Mahboob Ho 52Political costs (contd.)
Ina sense, the reported accounting profits of particular
organizations are used as an excuse to push for higher
wages, which could be costly for these organizations.
However, if reported profits were not so high, perhaps this
would reduce the likelihood of demands for increased
wages.
Therefore, if managers consider that there might be claims
for increased wages in particular years, those managers
might elect to adopt income-decreasing accounting
methods.
For example, they might depreciate assets over fewer
years, thereby increasing depreciation expenses and
consequently reducing profits.
Prepared By: Dewan Mahboob Ho 53Accounting policy selection and
disclosure
A firm might be involved in many
agreements that use accounting numbers
relating to profits and assets.
As a result, the decision to expense or
capitalize an item can have important
financial implications for the organization
and, potentially, for management.
Prepared By: Dewan Mahboob Ho a4Accounting policy selection and
disclosure (contd..)
Asa result of the choices that face the accountant, it is
imperative that financial report users be aware of the
accounting policies adopted by the reporting entity.
Comparing the financial results and positions of
reporting entities that use different accounting methods
can be a misleading exercise unless notional adjustments
are made to counter the effects of these different
methods and policies.
For such adjustments, knowledge of each firm’s
accounting policies is necessary.
Prepared By: Dewan Mahboob Ho 55Accounting policy notes
Notes showing accounting principles,
based on recognition and measurement
rules adopted in preparing and presenting
financial statements.
Prepared By: Dewan Mahboob Ho 56Management of Income
Common labels for the financial numbers game:
Label Definition
Aggressive A forcefull and intentional choice and application of accounting principles done in an
accounting effort to achieve desired results, typically higher current eamings, whether the practices
followed are in accordance with GAAP or not.
Earnings The active manipulation of eamings toward a predetermined target, which may be set
management by management, a forecast made by analysts, or an amount that is consistent with a
smoother, more sustainable earnings stream.
Income A form of earnings management designed to remove peaks and valleys from the
smoothing normal earning series, including steps to reduce and store profits in good years for use
during the slower years.
Fraudulent Intentional misstatements or omissions of amounts or disclosures in financial
financial statements, done to deceive financial statement users, that are determined to be
reporting fraudulent by an administrative, civil or criminal proceedings.
Creative
accounting
Any and all steps used to play the financial numbers game, including the aggressive
choice and application of accountin; anak te udulent financial reporting, and. au
Steps taken towal {SEANSOY PSUEEATENI Lathe smoothingRewards of the Game
The rewards of the financial numbers game are as follows:
Category
rewards
Share price effects
Higher share prices;
Reduced share price volatility;
Increased corporate valuation;
Lower cost of equity capital;
Increased value of stock options.
Borrowing cost
effects
Improved credit quality;
Higher debt rating;
Lower borrowing costs;
Less stringent financial covenants.
Bonus plan effects
Political cost effects
Increased profit-based bonuses.
Decreased regulations;
Avoidance of higher taxes.
Prepared By: Dewan Mahboob HoCreative accounting
Where those responsible for preparing accounts select
accounting methods not objectively but according to the
results desired by the preparers.
Accounts preparers can be creative, yet at the same time
follow financial reporting standards.
Although they might not be objective, it might be
difficult for parties such as auditors, with an oversight
function, to claim that the financial report preparers are
doing anything wrong.
Prepared By: Dewan Mahboob Ho 59Creative accounting (contd..)
According to Griffiths (1987):
“Every company in the country (the UK) is fiddling its
profits. Every set of public accounts is based on books
which have been gently cooked or completely roasted.
The figures which are fed twice a year to the investing
public have all been changed in order to protect the
guilty....it is totally legitimate. It is creative
accounting”.
Source: Creative accounting: how to make your
profits what you want them to be.
Prepared By: Dewan Mahboob Ho 60Creative accounting (contd..)
While it must be acknowledged that
creative accounting does occur, it is
reasonable to argue that, with the
increased number of financial standards
being issued, the scope for being ‘creative’
should decrease.
Prepared By: Dewan Mahboob Ho 61Some criticisms of PAT
Normative theorists see PAT as Description not
Prescription. The normative theorists see the role
of accounting as prescription.
But there are many researchers and research
departments that still favor PAT.
One widespread criticism of PAT is that it fails
to provide prescription and, therefore, any
means of improving accounting practice. It is
argued that simply explaining and predicting
accounting practice is not enough.
Prepared By: Dewan Mahboob Ho 2Some criticisms of PAT (contd..)
There is no guidance as to what people should
do.
This is normally justified by PAT theorists on the
basis that they do not want to impose their own
views on others.
They would prefer to provide information about
the expected implications of particular actions
and let people decide for themselves what they
should do.
Prepared By: Dewan Mahboob Ho 63.Some criticisms of PAT (contd.)
The fundamental assumption of PAT is that ALL
action is driven by a desire to maximize wealth.
To many researchers such an assumption
represents a perspective of humankind that is far
too negative.
Gray, Owen and Adams (1996) state that PAT
promotes a morally bankrupt view of the world.
Prepared By: Dewan Mahboob Ho otSome criticisms of PAT (contd.)
Another criticism of PAT is that since its
general inception in the 1970s the issue
being addressed have not shown any
great development.
Prepared By: Dewan Mahboob Ho 65Some criticisms of PAT (contd.)
In Watts and Zimmerman (1987) there were three key
hypotheses:
The debt hypothesis: Organizations that are close to
breaching accounting based debt covenants will select
accounting methods that lead to an increase in profits
and assets.
The bonus plan hypothesis: Managers on accounting
based bonus schemes will select accounting methods
that lead to an increase in profits.
The political cost hypothesis: Firms subject to political
scrutiny will adopt accounting methods that reduce
reported income.
Prepared By: Dewan Mahboob Ho 66Some criticisms of PAT (contd.)
A review of the recent PAT literature
indicates that these hypotheses continue
to be tested in different environments and
in relation to different accounting policy
issues- even 25 years after Watts and
Zimmerman formulated them.
Prepared By: Dewan Mahboob Ho oFSome criticisms of PAT (contd.)
Sterling (1990):
“what are the potential accomplishments [of
PAT]? I forecast more of the same: twenty
years from now we will have been inundated
with research reports that managers and
others tend to manipulate accounting
numerals when it is to their advantage to do
u”
so.
Prepared By: Dewan Mahboob HoSome criticisms of PAT (contd.)
Christenson (1983):
We are told, for example, that ‘we can only expect a positive
theory to hold on average’. We are also advised ‘to
remember that as in all empirical theories we are
concerned with general trends’, where ‘general’ is used in
the weak sense of ‘true or applicable in most instances but
not all’ rather than a strong sense of ‘relating to,
concerned with, or applicable to every member of a
class’.....a law that admits exceptions has no significance,
and the knowledge of it s not of the slightest use. By
arguing that their theories admit exception, Watts and
Zimmerman condemn them as insignificant and useless.
Prepared By: Dewan Mahboob Ho 9Concluding remarks
While the criticisms do, arguably, have some
merit, PAT continues to be used.
A number of accounting research journals
continue to publish PAT research.
A number of the leading accounting research
schools throughout the world continue to teach
it.
What must be remembered is that all theories of
accounting will have limitations.
Prepared By: Dewan Mahboob Ho 70