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Positive Accounting: A Review Article

G. Whittington
Published online: 01 Mar 2012.

To cite this article: G. Whittington (1987): Positive Accounting: A Review Article, Accounting and Business
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 Accounfing and Business Research. Vol. 17, No. 68, pp. 321-336. 1987
Positive Accounting: A Review Article
G. Whittington
Introduction
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two papers in The Accounting Review (1978 and
1979) in the latter of which they described account-
ing theories as supplying ‘the market for excuses’.
Not content with this achievement, they are joint
founder-editors of The Journal of Accounting and
Economics, which has achieved international
recognition for its dissemination of the type of
empirical studies which they advocate.
It is also the case that Watts and Zimmerman’s
ideas are controversial. To some extent, this is the
inevitable consequence of innovation: those whose
intellectual capital is invested in the old ways do
not always take readily to new ideas. It is also
inevitable that novel approaches require time to
develop and will initially have the natural defects
of the prototype: this is readily conceded and the
early stages of development and improvement
are described frankly and clearly in Watts and
Zimmerman’s (1986) book. However, there is an
additional ingredient in the controversy sur-
rounding Watts and Zimmerman’s work. This is
the single-minded way in which they present their
own view of the subject, dismissing the a priori
theories of the 1960s as ‘excuses’. There may be a
natural tendency for the enthusiastic innovator to
be over-zealous in the advocacy of the new and
dismissive of the old, but the result is a view of
accounting theory which many would see as un-
balanced, and a presentation of the arguments and
evidence which some would see as tendentious. In
this respect, Watts and Zimmerman are firmly in
the tradition of the accounting theorists of the
1960s whom they attempt to dismiss as mere
providers of ‘excuses’. They too tended to cling
obsessively to their own views of the world, dis-
missing those who made alternative assumptions,
and ignoring the logical validity of the theories
derived from those assumptions, thus precluding
321
discussion of a whole range of theoretically poss-
An outline of ‘positive accounting theory’
Watts and Zimmerman start their book with a
fundamental statement of The Role of Theory
(Chapter 1). Their view is that:
The objective of accounting theory is to explain
and predict accounting practice. (p. 2)
This naturally precludes the theories of the 1960s
which tended to be normative in content:
. . .theory, as we describe it, yields no pre-
scriptions for accounting practice. It is con-
cerned with explaining accounting practice.
(P. 7)
The essence of positive theory is seen to be that it
explains and predicts behaviour, in contrast to
normative theory which is prescriptive. Thus the-
ories which say how accounting ought to be done
are excluded from Watts and Zimmerman’s view of
the economics-based accounting theory that
evolved from the use of the scientific concepts of
theory.
Subsequent chapters trace the historical evolution
of this approach to accounting theory. Chapter 2
describes the Efficient Markets Hypothesis (EMH)
and Capital Asset Pricing Model (CAPM) which
underly most empirical research of the post Ball
and Brown era, and Chapter 3 surveys the empir-
ical literature on the reaction of stock prices to
accounting earnings which was initiated by Ball
and Brown’s classic paper (1968), which intro-
duced the abnormal performance index (API), and
the equally important paper by Beaver (1968).
Chapter 4 discusses the literature on stock market
reaction to changes of accounting method, which
 328
was initiated by the Kaplan and Roll (1972) study,
and which was a natural extension of the API
studies of accounting earnings. Chapter 5 consid-
ers the empirical studies of accounting numbers as
predictors of business failure (e.g. Altman, 1968)
and of risk, as measured by fl in the CAPM model
(e.g. Beaver, Kettler and Scholes, 1970). Chapter 6
then turns to the time series properties of account-
ing earnings, completing the survey of the set of
empirical studies (or, as Watts and Zimmerman
(p. 156) describe it, ‘one line of positive accounting
theory’) whose primary interest is the relevance of
accounting data to the market value of shares.
The authors then embark on the ‘prelude to a
new theory’ (Chapter 7) which is developed in
Chapters 8 to 13: ‘This research emphasizes the
explanation of accounting practice variations
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across firms and industries, not accounting’s role in
providing valuation information’ (p. 156). The
‘prelude’ consists of a somewhat tendentious dis-
cussion of disclosure regulation rationales, the
main theme of which is to discredit the ‘public
interest’ view of regulation that it is intended to
increase social welfare, in favour of the view that
‘politicians and regulators are no different from.
anyone else: that is, they act in their own self-
interest’ (p. 176). It is suggested that managers’
choice of an accounting method may be deter-
mined by its consequences for the political process
(e.g. utility rate regulation), and also by its impli-
cations for various contracts which use accounting
data (such as debt covenants). The latter theme is
developed in the following two chapters, which
discuss the agency theory rationale of the firm and
the contracts with which management binds itself,
particularly debt contracts and management com-
pensation contracts. This is followed (Chapter 11)
by further discussion (again somewhat tenden-
tious) of the political process, in which the ‘size
hypothesis’ is discussed (i.e. the view that larger
firms incur potentially greater political costs), and
the general view is advanced that political costs
create an incentive to choose accounting methods
which diminish reported earnings. The account of
the new positive theory of accounting choice ends
with a survey of empirical tests of the explanation
of choice of accounting method by contract-related
variables (Chapter 11) and the effect on stock
prices of choice of accounting method, particularly
the hypothesis that mandatory restrictions on ac-
counting choice reduce stock prices (Chapter 12).
The empirical evidence is, for the most part, weak
and inconclusive, but the authors point out that
both theory and tests are at present crude. The
discussion of the new positive theory concludes
(Chapter 13) with an account of the application of
contracting theory to auditing, and some empirical
evidence relating to this.
Finally, Watts and Zimmerman present their
own, rather immodest, view of the importance of
A C C O U N T I N G A N D BUSINESS RESEARCH
the type of positive theory which they favour.
Chapter 14, on ‘The Role of Accounting Re-
search’, is taken from their controversial ‘market
for excuses’ paper (Watts and Zimmerman, 1979).
They start with the arrogant assertion:
Throughout this book, we use science’s concept
of theory (positive theory). Under that concept,
the object of accounting theory is to explain and
predict accounting practice (broadly defined)
(p. 338).
Presumably, we are being invited to believe that
any theory which does not ‘explain and predict
accounting practice’, in the sense implied by Watts
and Zimmerman’s brand of ‘positive theory’, is
unscientific, and therefore in some sense a bad
thing. This impression is reinforced by the sub-
sequent assault on ‘prescriptive theory’ which
seems to embrace most of what was written about
accounting before about 1966, and most of what
has since been written outside North America. This
type of ‘prescriptive theory’ serves the ‘market for
excuses’:
The excuses demand is primarily from the polit-
ical process and arises because of information
costs (p. 350).
Since the general thrust of earlier chapters has
been to assert (largely on the basis of assumption
rather than ‘positive’ empirical evidence) that the
political process is inefficient, expensive and, in
general, an obstruction to the efficient working of
the market place, it seems that we are being invited
to believe that the demand for excuses is not
something which should be satisfied. Indeed, the
market for excuses is the only market in which
Watts and Zimmerman seem possibly to be pre-
pared to contemplate regulation. However, when it
comes to summarising and evaluating their own
positive accounting theory (Chapter 1 9 , rather
than competing approaches, they offer a much
more balanced view. They readily concede that
empirical studies of accounting choice have, hith-
erto, lacked a coherent theoretical base, that the
evidence used has been inadequate in important
respects (e.g. the lack of attention given to the
details of the contracts which are believed to
determine accounting choice), and that there are
problems of statistical analysis (such as collinearity
among the contracting variables).
The methodology of positive accounting
Watts and Zimerman’s strident advocacy of the
methodology of positive accounting is the most
controversial aspect of their work in general and of
the present book in particular. It has already been
the subject of a most cogent and incisive critical
analysis by Christenson (1983), and it is unneces-
sary to repeat his philosophical critique. It is
 A U T U M N 1987
notable that Watts and Zimmerman’s book makes
no reference to Christenson’s paper (although it is
listed in the Bibliography) and makes no attempt
to answer his criticisms of their methodology. A
possible reason for this is that they were unable to
make a plausible answer, although an entertaining
alternative hypothesis is that, true to their positive
methodology, they do not consider that an answer
is necessary, since Christenson does not advance
empirically testable propositions by which his
(essentially, a priori logical) arguments can be
refuted.
It might perhaps be argued that Watts and
Zimmerman’s extreme methodological stance and
trenchant criticism of alternative approaches does
serve a useful purpose in drawing attention to their
views and in stimulating debate. They do, after all,
view accounting research ‘as an economic good’
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(p. 340) and marketing ability is a desirable skill in
purveyors of an economic good. However, market-
ing literature is not always the most reliable source
of information for those in search of a balanced
view, and, as has already been observed, lack of
respect for alternative views was, ironically, one of
the faults of the ‘normative’ theorists of the 1960s
who are criticised by Watts and Zimmerman.
Although it would not be appropriate (or, for
this author, possible) to restate or emulate Chris-
tenson’s critique of positive accounting meth-
odology, two practical aspects of the Watts and
Zimmerman approach deserve brief attention.
They are, firstly, their claim to prefer the positive
to the normative and, secondly, their emphasis on
empirical evidence rather than a priori theory.
The essence of the positive accounting meth-
odology seems to be that its objective ‘is to explain
and predict accounting practice’ (p. 2). This is
distinguished from ‘normative (i.e. prescriptive)
positions’ which seek ‘to prescribe the contents of
acounting reports’ (p. 7). The distinction depends
upon the view that ‘prescription requires the
specification of an objective and an objective func-
tion’ (p. 7 ) . This leads to the claim that positive
theory is ‘the economics-based accounting theory
that evolved from the use of the scientific concept
of theory’ (p. 13).
It might be inferred from this that positive
theory is somehow value-free and ‘scientific’,
whereas normative theory was highly value-laden
(determined by the choice of objective function)
and therefore ‘unscientific’. Two objections can be
made to such an inference.
Firstly, positive theory is not free from value
judgements or prescriptive implications. At the
most basic level, the question asked (or hypothesis
tested) implies a prior view of what is an interesting
question, and at the level of empirical testing, value
judgements can influence the choice of maintained
hypothesis. Watts and Zimmerman’s own view of
the. world.
_. as
-7 - described in this book. is character-
329
ised by strong prior beliefs (or maintained hypoth-
eses), relating, for example, to the effectiveness of
the market system (e.g. ‘the single-period capital
asset pricing model (CAPM) is used throughout
the book as the valuation model’, P.x.), and indeed
they seem happy to call on ‘normative’ theoretical
welfare economics when it suits them, e.g. in the
use of Arrow’s impossibility theorem (p. 162).
Thus, even if they do not explicitly introduce an
objective function, their work is heavily con-
strained by prior beliefs, which determine their
assumptions and the hypotheses which they test.
Furthermore, they admit that positive accounting
research can, given the diversity of results, serve
the market for excuses (p. 346).
Secondly, it would be incorrect to assume that
all theory which is not positive, in the sense of
leading to empirically testable propositions, is nor-
mative in the sense of leading to prescriptions.
Mathematics, for example, is not usually thought
of as being prescriptive, despite the fact that its
essential method is deduction from assumptions,
rather than empirical testing, and empirical re-
searchers themselves make considerable use, in
assessing their results, of statistical techniques
founded on probability theory, which itself is a
body of theory based on deduction rather than
empirical testing. There seems to be no obvious
reason why accounting theory should not contain
a body of knowledge based on deduction from
axioms. Indeed, if this is not the case, accounting
theory will be constrained to analysing what is (i.e.
what can be empirically observed) rather than
what might be. Furthermore, it seems that such a
body of accounting theory exists in the work of
such authors as Ijiri (1967, listed in Watts and
Zimmerman’s bibliography but not discussed in
the text), Chambers (1966) and Edwards and
Bell (1961). The latter works are categorised as
prescriptive (p. 7), but they contain logical truths
which should not be dismissed because the authors
also try to apply them to policy issues, any more
than Watts and Zimmerman’s entire book should
be dismissed because it contains speculations about
the relative costs of accounting regulation and the
free market (Chapter 7).
This raises the issue of the second distinctive
feature of positive theory: its emphasis on predic-
tions rather than assumptions as a means of testing
the validity of theories. Students of the contro-
versies of the 1960s in accounting theory, which
were most effectively criticised in Nelson’s
influential paper (1973), will readily concede that
the infusion of empirical testing, as described in
Watts and Zimmerman’s book and Beaver’s book
(1981) in the same series, has been a most welcome
innovation. Nelson’s ‘golden age’ of accounting
theory was dominated by a priori reasoning from
assumDtions, and there was much unnecessary
contrdversy between opponents whose differences
 330
arose from their assumptions rather than errors of
logic. One obvious means of resolving such dis-
putes, if they concern the relevance of the com-
peting theories to the real world, is to test the
empirical validity of their predictions. However,
discriminating between alternative hypotheses by
means of empirical tests is not always easy (as
Watts and Zimmerman’s own account of the litera-
ture demonstrates), and not all hypotheses have
testable empirical predictions. Thus, total reliance
on empirical testing will not solve all the problems
of accounting theory.
Watts and Zimmerman’s book is, in fact, a good
illustration of the need for good a priori theory and
its complementarity to empirical testing. Their
earlier chapters, surveying the literature on the
stock market impact of accounting information,
are marked by a very loose and informal the-
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oretical framework, based on the idea that share-
holders are trying to estimate the future cash flows
of the firm (i.e. from the shareholders’ point of
view, dividends). The latter is, of course, a theor-
etical assumption, but no precise deductive theory,
on the lines of the income measurement theories
of the 1960s, is used, because:
. . . the EMH implies that if there is an empirical
association between earnings and stock prices,
earnings can be useful even if they are not
calculated consistently in terms of a formal
definition of income (p. 20).
This comes very close towards what Samuelson
(1963) (in a critique of Friedman (1953)) described
as the ‘F-twist’, the view that ‘A theory is vin-
dicable if (some of) its consequences are empiri-
cally valid to a useful degree of approximation; the
(empirical) unrealism of the theory ‘itself’, or of its
‘assumptions’, is quite irrelevant to its validity and
worth’. We would surely have more confidence in
the underlying hypothesis (that ‘earnings can be
useful’) if we had a more precise theory (based on
‘realistic’ assumptions) of why earnings measures
should be ‘useful’ to shareholders, rather than
simply observing an empirical correlation. Instead,
we are left with an extremely weak argument that
earnings are useful because:
If depreciation is approximately equal to the
investment each year then accounting earnings
would approximate cash flows and the market
value of the firm.. . would be approximately
equal to the present value of the firm’s expected
future earnings (p. 28).
What this seems to mean is that in some (unlikely)
circumstances, earnings can equal dividends. This
raises two questions:
(i) Why is it not sufficient to report merely
dividends rather than earnings?
A C C O U N T I N G A N D BUSINESS RESEARCH
(ii) Are current earnings good predictions of
future dividends (a question requiring both
an underlying theory and empirical testing)?
The latter question is crucial but is left as an
informal, untested belief
Underlying the tests of association. . . is the
notion that earnings are measures of current
and future cash flows (p. 65).
To be fair to Watts and Zimmerman, once they
leave the area of income measurement, where they
are reacting against the excessive a priori theorising
of the 1960s, they do recognise the need for better
theory, although they tend to maintain the Fried-
manite positive view that accuracy of empirical
prediction is more important than realism of as-
sumptions. For example, they bemoan ‘the lack of
an economic theory of volume’ (p. 64), and they do
acknowledge the lack of a theory of how cash flows
and earnings are generated and are related to one
another (p. 136). Equally, when they discuss their
own positive theory of choice of accounting
method, they are prepared to acknowledge the
need for greater theoretical refinement, e.g.
The lack of a well-developed positive account-
ing theory results from the lack of rich economic
theories of the firm (including the contracting
process) and of the political process (p. 357).
Thus, in practice, Watts and Zimmerman’s work
is entirely consistent with a sensible combination of
a priori reasoning and empirical testing. They may
lay relatively more emphasis on empirical tests
than realistic assumptions, whereas the theorists of
the 1960s tended to neglect empirical testing, but
the reader who is more interested in accounting
than philosophy might well be led to the conclu-
sion that much of the rhetoric about positive
accounting methodology is unnecessary, except as
a device for discrediting potential competitors.
After all, ‘theories evolve through competition
among researchers’ (p. 362).
Equally, we have already seen that it is some-
what unfair to label a priori theories as necessarily
prescriptive or value laden, or to imply that the
positive approach is exempt from these character-
istics. We now turn to an important area which
illustrates the latter proposition, the market as-
sumptions made in Watts and Zimmerman’s book.
The market assumption
The Rochester School of accounting, to which
Watts and Zimmerman belong, is an intellectual
offshoot of the Chicago School of Economics. The
latter has been perceptively analysed by Reder
(1982), who described its central assumption as
follows:
 AUTUMN 1987
In essence the Chicago View, or what I term
‘Tight Prior Equilibrium’ theory (TP), is rooted
in the hypothesis that decision makers so allo-
cate the resources under their control that there
is no alternative allocation such that any one
decision maker could have his expected utility
increased without a reduction occurring in the
expected utility of at least one other decision
maker. (Reder, 1982, p. 11)
Reder points out that this is essentially a definition
of Pareto optimality, and that further assumptions
are typically made by Chicago economists to derive
testable hypotheses:
The further assumptions may be summarized as
follows: (1) most individual transactors treat the
prices of all goods and services they buy or sell,
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as independent of the quantities that they trans-
act; (2) the prices at which individuals currently
agree to transact are market clearing prices that
are consistent with optimization by all decision
makers; (3) information bearing on prices and
qualities of all things bought and sold, present
and future, is acquired in the quantity that
makes its marginal cost equal to its price, i.e.
information is treated like any other com-
modity; (4) neither monopoly nor governmental
action (through taxation or otherwise) affects
relative prices or quantities sufficiently to pre-
vent either marginal products or compensation
of identical resources from being approximately
equal in all uses.
These assumptions are essentially those of perfectly
competitive equilibrium, and may be found un-
acceptable by many as a description of how the
world actually operates. However, objections to
the realism of assumptions are precluded by ‘the
F-twist’ which, in the extreme, asserts that:
Truly important and significant hypotheses will
be found to have ‘assumptions’ that are wildly
inaccurate descriptive representations of real-
ity.. . (Friedman, 1953, p. 14).
Watts and Zimmerman’s assumed economic set-
ting is consistent with this outline of the ‘Chicago
view’ and the philosophy of ‘positive accounting’
clearly owes much to Friedman’s ‘positive eco-
nomics’. For example, throughout their book the
CAPM and the EMH are assumed to be the basis
of share valuation. On the EMH they say:
Today, the acceptance of the EMH is such
that empirical regularities apparently inconsis-
tent with the hypothesis are called anomalies
(p. 158).
We can again compare this with Reder’s account
of ‘the Chicago View’:
33 1
Any apparent inconsistency of empirical
findings with implications of the theory, or
report of behaviour not implied by the theory,
is interpreted as anomalous.. . (Reder, 1982,
p. 13).
Of course, Watts and Zimmerman are not
unique in owing intellectual allegiance to the
Chicago View or in regarding the EMH as a
maintained hypothesis. The majority of North
American empirical accounting researchers would
fall into this category, and their collective achieve-
ments are formidable. However, it is important to
point out that this represents a constrained view of
accounting research, and that prior beliefs (or
maintained hypotheses) play an important part in
it, despite the claims to ‘scientific’ and value-free
status. It is particularly important to do this in the
case of the present pair of authors, because they
are inclined to be so dismissive of alternative
approaches (particularly the a priori theorists of
the 1960s) and to imply that they have a monopoly
of the truth.
In order to illustrate the possible limitations of
this type of research, derived from the Chicago
View, we shall briefly consider two issues, the
EMH assumption and the role of regulation, as
discussed by Watts and Zimmerman.
(i) The EMH Assumption
The EMH assumption is fundamental to most of
the empirical studies described in the book, or, at
least, to the inferences drawn from them. We are
told that:
On average, in an efficient market, stock prices
adjusted for the market’s expected rate of return
are correct estimates of future stock values.
(Watts and Zimmerman, 1986, p. 21)
This is correct only if we equate prices with values.
The EMH asserts that the market is fair game
efficient, i.e. that present market prices reflect, on
average, correct estimates of future returns (typi-
cally tested over a short time horizon), where
returns are measured as changes in market price
(i.e. capital appreciation of share price) plus divi-
dends. Changes in price usually dominate divi-
dends in the return measure, so that the EMH is
really asserting a relationship between present
prices and future prices (not values). If, in some
fundamental sense, the market undervalues or
overvalues certain shares at all of the times when
market price is observed, the EMH may be seen to
hold (the market may be fair game efficient over
the period observed), but the market will be
inefficient in the fundamental sense described by
Keynes (1936, pp. 150-64), i.e. share prices will not
necessarily reflect the best current estimates of the
long-run returns (potential dividends) of individual
filTlS.
 332
Keynes’ celebrated ‘beauty contest’ stylisation of
the market was one in which market transactors
were trying to guess one another’s future actions
rather than the fundamental characteristics (i.e.
future dividend-paying potential) of the shares.
King (1977) suggests that this can be modelled
theoretically as a temporary equilibrium. Of
course, it has been argued by some proponents of
the EMH, such as Beaver (1981), that the ‘intrinsic
value’ of a share is a meaningless concept, and
‘fundamental value’ is certainly a better term to
use, implying valuation based on the fundamental
characteristics of the firm rather than on short-
term prospective changes in share prices. However,
fundamental analysis has a long and continuing
history, which requires some explanation if the
information market is competitive and the market
does not take account of fundamental character-
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istics, and it is interesting to note that Beaver
himself in his studies of the effects of FAS 33
(Beaver and Landsman, 1983, Chapter 4) appears
to assume that, in a competitive equilibrium,
Tobin’s ‘q’ for current cost accounts should be
unity, i.e. the current cost book value of equity
should equal the stock market value. This seems to
amount to using current cost value as a form of
fundamental value in the specific market setting
which is being assumed.
The relevance of this to accounting should be
clear. If, as Beaver (1981) correctly points out,
market efficiency is defined with respect to a
specific information set, then, if we are concerned
with fundamental characteristics, it is possible to
improve the market’s valuation process by widen-
ing the information set. By making possible better
forecasts of the long-run returns of individual
firms, such information might improve the deci-
sions of investors who were interested in long-run
income rather than short-term capital gains, and
lead to a better allocation of resources (in the sense
of a Pareto improvement, by channelling funds to
areas with the best returns on investment) both
between individual firms and between the equity of
firms and other forms of investment.
This type of argument is the justification for the amenable to improvements such as might be sug-
theoretical work of such writers as Chambers
(1966) and Edwards and Bell (1961), who are
summarily dismissed by Watts and Zimmerman:
. . . if accounting earnings are related to stock EMH and the single period CAPM, the authors
prices, the EMH suggests that earnings can be have the audacity to reject market failure argu-
useful measures or indices of value contrary to ments on the ground that:
the 1960’s argument that earnings numbers are
useless because they are not measured using a
single concept of income. (Watts and Zimmer-
man, 1985, p. 37)
The concept of ‘uselessness’ or ‘usefulness’ here is,
of course, confined to the narrow bounds of the
EMH, i.e. does the information enable the investor
to ‘beat the market’ (as determined by other in- cost accounting.
ACCOUNTING A N D BUSINESS RESEARCH
vestors)? It rules out the broader issues of use-
fulness, as, for example, in Modigliani and Cohn’s
(1979) study which claims that the equity market
did not allow correctly for inflation, a situation
which might have been remedied by some method
of inflation accounting.’ It also rules out the
type of theoretical analysis which has been carried
out recently by such economists as Fisher and
McGowan (1983) and Kay and Mayer (1986), and
by the UK Treasury Working Party in the Byatt
Report (1986). This literature is concerned cen-
trally with the control of state-regulated or state-
owned enterprises, but it also has implications for
the private unregulated sector (discussed explicitly
in the Byatt Report) since an efficient allocation of
resources across the whole economy requires com-
parison of the rates of return in different sectors
and therefore, presumably, the availability of com-
parable information.
Unlike most of the leading contributors to
efficient markets accounting research (such as Bea-
ver, 1981 and 1981a, and Foster, 1986, both of
whom give very thoughtful consideration to the
limitations of the EMH assumptions), Watts and
Zimmerman appear repeatedly to imply that the
EMH has value implications beyond fair-game
efficiency of the market. For example:
Further, given the EMH, the evidence presented
in Chapter 3 suggests that the market can
discriminate between efficient and less efficient
firms, at least to some degree. (p. 159)
and, as a response to the ‘meaningless numbers’
criticism of conventional accounts:
Positive stock price changes are associated with
positive unexpected earnings and negative stock
prices (sic) with negative unexpected earnings.
Therefore, since the stock price is an unbiased
estimate of value, earnings changes are mea-
sures of value changes. (p. 161)
Thus, because stock prices reflect (to some extent)
reported earnings, we are invited to believe that
earnings must reflect ‘value’ and are therefore not
geted by a priori theorising. Having derived such
strong inferences from empirical studies based on
the strong joint maintained hypotheses of the
First, they are generated in very stylized worlds
and then it is assumed that they also occur in
practice. (p. 167)
‘Kennedy (1976) makes an argument of this type for current
 A U T U M N 1987
However, this is, at least, a welcome relaxation of
the hold of the ‘F-twist’.
It is also notable that Watts and Zimmerman do
not have a serious discussion of the evidence
contradicting the EMH. In particular, they do not
refer at all to the very balanced and thorough
survey by Dyckman and Morse (1986), which is
published in the same series and listed on the cover
of their book. This reaches a much less decisive
view of the evidence:
Theory must become more global and testing
more precise and complete before broad ac-
counting policy solutions can stand adequately
on the resulting foundation. (Dyckman and
Morse, 1986, p. 90)
and
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Proponents of the EMH and its implications
often claim too much while its detractors give it
too little. As with most innovations, the truth
lies nearer the middle ground. (p. 91)
Of course, the Dyckman and Morse book was not
published when Watts and Zimmerman were writ-
ing theirs, but the first edition (Dyckman, Downs
and Magee, 1975) was available and, more im-
portantly, so was the considerable published litera-
ture on which their conclusions are based. Another
notable omission from Watts and Zimmerman’s
bibliography is the excellent survey of market-
based accounting research by Lev and Ohlson
(1982). It is perhaps no coincidence that the Lev
and Ohlson paper contains a powerful plea for
widening the range of accounting research to con-
sider welfare implications and for a re-examination
of fundamental valuation models.
(ii) Disclosure Regulation
The discussion of disclosure regulation (concen-
trated mainly in Chapters 7 and 10, but developed
and referred to elsewhere in the book) is one where
Watts and Zimmerman’s ‘Chicago View’ is partic-
ularly apparent, to such an extent that they can and, on the signalling problem:
hardly claim that their own work is free of pre-
scriptions: they clearly have a general view that
regulation is a bad thing and the free market
provides the best solution for the supply of ac-
counting information.
The basis of the criticism of regulation in Chap-
ter 7 is the authors’ adherence to the EMH. Their The method chosen to adduce ‘positive’ evidence
use of EMH-based arguments is tendentious in the on these issues is as follows:
following three respects. Firstly, they ignore the
considerable body of evidence that the EMH may
not hold, even within its own terms (e.g. in the
‘anomalies’ quotation on p. 158, which has already
been quoted). Secondly, they repeatedly suggest
that the EMH implies that the stock market can
identify ‘efficient’ firms rather than merely antici- accounting disclosure are briefly considered.
pating future market gains efficiently: again,
333
examples of this have already been quoted.
Thirdly, they extrapolate the rather limited aspects
of the EMH which have been tested to an assump-
tion that the information market is in a state of
competitive equilibrium in all respects, so that
naive investors are ‘price protected’, i.e. ‘They buy
at a price that is ‘fair’ in the sense that on average
they earn a normal rate of return’ (p. 160), for
example ‘the manager’s equilibrium compensation
is reduced by the amount of profits he is expected
to earn from insider trading’ (p. 159).
The latter scenario is, of course, derived from
strong assumptions about the world and no empir-
ical evidence is offered for extending the scope of
the EMH so far. Thus, the subsequent discussion
of ‘Alleged Market Failures’ (p. 163 et. seq.: note
that the authors do not have a section on ‘Alleged
Market Efficiency’) may be regarded as a piece
of ‘normative’ theorising comparable with that of
Chambers (1966) (although Chambers would
probably claim that his theoretical argument was
better developed), and the other theorists of
the earlier generation criticised by Watts and
Zimmerman. The comparison is particularly apt
on p. 167, where the authors imitate the less
appealing aspects of some of the previous gener-
ations by claiming that there are ‘Fallacies in the
Market Failure Rationales’, when what they are
referring to are differences of assumption or lack of
empirical evidence rather than the existence of
logical errors or other positive evidence of error.
It transpires that most of the arguments hinge on
the relative costs of government regulation and
private contracting, with the authors clearly as-
suming that the latter is cheaper, e.g. on the public
good problem:
If private contracting costs are greater than the
private benefits to be captured, there is only a
market failure if government’s contracting costs
are lower than private costs. No evidence
has been presented to support that condition.
(P. 167)
To be optimal, the signaling problem has to
assume high contracting costs. However, as we
have argued, if those costs are the same for the
individuals and the government, there is no
market failure. (p. 168)
If the government’s costs are substantial, it is
not apparent that there is any market failure in
the private production of information in cor-
porate accounting reports. To illustrate this
point, the costs of government regulation of
(P. 169)
 334
What is not considered is the cost of private
contracting. The subsequent pages add up the costs
of the SEC and compliance with its regulations,
but make no attempt to identify the benefits, or the
additional costs of private regulation which are
avoided by public regulation. Thus, the burden of
proof is put on those who wish to justify public
regulation, and the relative cheapness of private
regulation emerges as the maintained hypothesis
because ‘it is not apparent that government regu-
lation of financial disclosure improves social wel-
fare’ (p. 172).
No attempt is made to consider why voluntary
standards emerge (such as GAAP) without the
direct intervention of the state, and whether this
suggests1that there is some perceived benefit to the
participants. This is a weakness also of the dis-
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cussion of contracting in later chapters, where it is
conceded that GAAP is often found to be a
convenient basis for contracts, presumably because
it is cheaper than negotiating detailed ‘one-off’
information systems appropriate to each individ-
ual contract. The authors are also silent on the
framework of law which is assumed, and its
benefits. Presumably, they are assuming that there
will be a government created and enforced law of
contracts to support their market system, and
possibly also a framework of company law, but
accounting regulation is a natural outgrowth of
company law. It would be instructive to know
where, and why, the authors believe that govern-
ment created laws should be confined, e.g. we are
assured that:
Theft is also encompassed by the Jensen and
Meckling analysis. Stealing by the owner-
manager is analogous to the owner-manager’s
overconsumption of perks. (p. 185)
It might be inferred from this that areas of the
criminal law are also unnecessary.
It seems likely that the authors’ view would be
that government intervention should always be
minimised, subject to the need to provide basic
support for the enforcement of contracts. Certainly
their view of the political process (Chapter 10) is
predictably sceptical. ‘The political process is a
competition for wealth transfers’ (p. 222), poli-
ticians and bureaucrats are ‘seeking to make them-
selves better off’ and propose solutions artificially
to generate crises based on spurious evidence to
voters ‘who rationally choose to remain ignorant’
(p. 223). Thus, the market and political processes
‘are hypothesized to differ in terms of the costs’
(p. 229), the market system being assumed to be
cheaper. This may or may not be true, but the
evidence offered is mainly a priori theorising from
(controversial) assumptions, which Watts and
Zimmerman affect to despise, spiced with the
occasional anecdote.
A C C O U N T I N G A N D BUSINESS R E S E A RCH
The positive theory of accounting choice
Watts and Zimmerman describe the development
of ‘a new accounting theory’ (P.x.) in Chapters 8
to 14 of their book. This is essentially a theory of
accounting choice, whose central concern is why
managements choose various accounting tech-
niques.
Christenson (1983, pp. 5-6) has already made
the fundamental criticism of this approach, that it
is really a ‘sociology of accounting’ rather than
accounting theory, since it ‘is concerned with de-
scribing, predicting and explaining the behaviour
of accountants and managers, not that of account-
ing entities’. Of course, the sociology of accounting
is a perfectly legitimate and interesting area of
intellectual endeavour. What is disturbing is the
possible implication that it might be pursued to the
total exclusion of other studies concerned with the
fundamental problems of reporting the financial
transactions and states of accounting entities.
Christenson draws an analogy with chemistry:
Chemical theory consists of propositions about
the behaviour of chemical entities (molecules
and atoms), not about the behaviour of chem-
ists. (Christenson, 1983, p. 6)
If we ignore Watts and Zimmerman’s tendency
to rule out other approaches to accounting theory
in their enthusiasm for their own, we can accept
that their theory of accounting choice is interesting
and potentially fruitful, but it is also, at present,
rudimentary. On this point, the authors tend to
disarm criticism by admitting the limitations of the
theory and the ambiguity of the empirical results
achieved so far. They also suggest future exten-
sions and improvements (particularly in Chapter
15). The reader’s main regret may be that they do
not adopt a similarly sympathetic approach to
alternative approaches.
The discussion of the empirical results (Chapter
11) is perhaps the most balanced. Although the
authors occasionally commit themselves to over-
enthusiastic interpretation (e.g. in their claim that
‘Zmijewski and Hagerman’s results provide strong
evidence’, p. 256) and even error (Table 11.5
contains a numerical error which makes it inconsis-
tent with the text, and the title of the paper is
incorrectly quoted, despite the fact that it was
published in Watts and Zimmerman’s own jour-
nal), they provide a useful critical survey of recent
literature. They also seem to have accepted some of
the strong criticisms made of their own work
(Watts and Zimmerman, 1978) by Ball and Foster
(1982), especially in the interpretation of the size
variable.
However, it must be said that much of this
empirical literature really does need to be reported
critically, because there is a great deal of ad hoc
empiricism. This involves the use of variables
 A U T U M N 1987
which are at best proxies for the likely true expla-
natory variables and are at worst merely things
which might work (in the sense of correlating
with the dependent variable). Moreover, the speci-
fications of the models commend themselves for
their simplicity rather than their theoretical plausi-
bility, e.g. linear additivity is a popular specifi-
cation (and, to be fair to the authors, this is
acknowledged on p. 358). The latter may be a
natural consequence of the ‘positive’ approach if it
emphasises empirical predictions (i.e. obtaining
high coefficients of determination) rather than a
priori theoretical reasoning (i.e. estimating models
which have theoretical specifications derived from
plausible assumptions).
With regard to the positive theory of accounting
choice, its narrowness has already been mentioned,
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but it seems that even within its narrow confines it
could be developed further than the authors sug-
gest (e.g. in their final chapter). This might, how-
ever, involve dropping some of the authors’ most
treasured assumptions. For example, as indicated
earlier, the issue of why many contracts voluntarily
adopt GAAP is worthy of further exploration.
This does suggest that some form of widely agreed
standard accounting information is considered
cost-effective relative to ‘bespoke’ information
unique to each contract and each firm. This could
be due to preparation costs but might well also be
due to information processing costs of the user. At
an empirical level, it might be possible to identify
different types of contracts or firm (e.g. classified
by industry) where these costs would be expected
to be high, and it would then be possible to test
whether these firms (or contracts) tended to have
a higher incidence of using GAAP (although it may
well be that all firms use GAAP). The result of such
a study might be a vindication of some degree of
standardisation of accounting, although not neces-
sarily by the government.
Two other issues, lurking underneath Watts and
Zimmerman’s discussion of the theory of account-
ing choice, deserve some discussion. First, if, as
some of the empirical evidence suggests, account-
ing standards which restrict accounting choice
reduce firm value, why, in a world of efficient
markets, does this occur? The assumption seems to
be that the reduction in firm value is a deadweight
loss (i.e. there are no gainers) so surely the con-
tracts should be drawn up in such a way as to avoid
such losses (i.e. the contracts should be flexible
enough to avoid the effects of future changes in
accounting standards) or they should be renego-
tiated when the prospect of an unanticipated loss
appears. Of course, some of the losses may be due
to external factors which cannot be dealt with by
negotiation (notably the political threat) but this is
not true of debt contracts and compensation con-
tracts which feature strongly in current theories.
Secondly, is there also a ‘fundamental’ rationale
335
in the terms of these contracts and, in particular,
their choice of accounting variables? After all,
management compensation contracts are intended
to provide incentives for managers to act in share-
holders’ interests, and debt contracts are designed
to protect debt holders from the consequences of
insolvency. Presumably if such contracts use profit
measures, they are using them as proxies for the
future cash flow earning potential of the firm,
which in turn can be related to the long-run
profitability or the net present value of the firm.
This leads back into the theoretical debates of the
1960s which Watts and Zimmerman reject as ‘nor-
mative’, but in doing so they are also rejecting a
whole area of possibly interesting and useful em-
pirical research, e.g. does the form of contract or
form of accounting information which it uses have
any bearing on the future success of the firm (e.g.
future growth of share price, in response to mana-
gerial compensation, or future solvency, in re-
sponse to debt contracts)? This is particularly
unfortunate because Watts and Zimmerman them-
selves, despite their efficient markets rhetoric,
clearly have a fundamental valuation model at the
backs of their minds:
Using the theory, investors or analysts do not
interpret balance sheets and earnings numbers
as unbiased estimates of firm value and changes
in firm value. . . (p. 356).
and (later in the same paragraph):
. . . an investor or analyst could adjust the earn-
ings number for expected management manipu-
lations in deriving cash flow estimates. This
would help the investor or analyst better predict
the market value of nontraded stocks and
bonds.
Conclusion
Watts and Zimmerman have written a stimulating
account of an important line of accounting re-
search to which they themselves have made a major
contribution. The principal deficiency of their
book is that, in their enthusiasm for their own
preferred type of work they denigrate the work of
earlier accounting theorists and other contem-
porary researchers who adopt a different ap-
proach. This is unfortunate because it is unneces-
sary and tends to divert attention from the central
issue, that all approaches to accounting theory are,
at the present time, in a fairly rudimentary stage of
evolution and desperately need further construc-
tive development. Moreover, in their enthusiasm,
they tend to ignore or forget the restrictive assump-
tions and relatively narrow focus of their own
work. This creates the danger that they may never
explore the full potential of studies of choice of
accounting method.
 336
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