POSITIVE

ACCOUNTING
THEORY
Positive compared to normative
theories
 A positive theory seeks to explain and
predict particular phenomena
 normative theories prescribe how a
particular practice should be undertaken
 the
prescription might depart from existing
practice
Positive Accounting Theory
defined
 PAT is concerned with predicting such actions
as the choices of accounting policies by firm
managers and how managers will respond to
proposed new accounting standards

 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 method…but it says nothing as to
which method a firm should use
PAT defined—continued
 Focuses on relationships between various
individuals and how accounting is used to
assist in the functioning of these
relationships
 examples of relationships:
 ownersand managers
 managers and the firm’s debt providers
 Firms organize themselves in the most efficient
manner  to maximize prospects of survival
 Firms  nexus of contracts  organization
can be described by the set of contracts it
enters into
 Firms want to minimize various contracting
costs i.e. negotiation costs, monitoring,
contract violation, etc.
 Contracts involve accounting variables 
employee promotion/remuneration based on
accounting measures
 Firms may choose accounting policies to be
used in preparing financial statements
 Flexibility of choice  opportunistic behavior of
managers
 PAT assumes that managers are rational and
choose acctg policies in their own best interest
 All individuals’ action is driven by self-interest
and individuals will act in an opportunistic
manner to the extent that the actions will
increase their wealth
 does not incorporate notions of loyalty or morality
Origins of PAT—capital markets
research
 Development of Efficient Markets
Hypothesis (EMH) by Fama and others
 capitalmarkets react in an efficient and
unbiased manner to publicly available
information
 Ball and Brown (1968) paper was crucial to
the acceptance of the positive research
paradigm
 investigatedstock market reaction to accounting
earnings announcements
Origins of PAT— Agency theory
 Explained why the selection of particular
accounting methods might matter
 focused on the relationships between
principals and agents
 eg. shareholders and managers
 information asymmetries create much
uncertainty
 transaction costs and information costs exist
Agency Relationship
 Defined by Jensen and Meckling (1976)
 ‘acontract under which one or more (principals)
engage another person (the agent) to perform some
service on their behalf which involves delegating
some decision-making authority to the agent’
 relies upon traditional economics literature
 assumptions of self-interest and wealth
maximisation
Agency costs
 Monitoring costs
 costs of monitoring agents behaviour
 eg. auditing financial statements
 bonding costs
 costs involved in agents bonding their
behaviour to expectations of principals
 eg. preparing financial statements
 residual loss
 toocostly to remove all opportunistic
behaviour
Role of accounting in contracts
 Accounting information used to reduce
agency costs
 used as monitoring and bonding
mechanisms to control the efforts of self-
interested agents
Key Hypotheses of PAT
 Three key hypotheses frequently used in
PAT literature to explain and predict
support or opposition to an accounting
method:
 bonus plan hypothesis
 debt hypothesis
 political cost hypothesis
 research assumes managers will act
opportunistically when selecting methods
Bonus plan hypothesis
 Managers of firms with bonus plans are
more likely to use accounting methods that
increase current period reported income
 also called management compensation
hypothesis
 action increases the present value of bonuses
paid to management
Debt hypothesis
 The higher the firm’s debt/equity ratio, the
more likely managers use accounting
methods that increase income
 also called debt/equity hypothesis
 the higher the debt/equity ratio, the closer the
firm is to the constraints in debt covenants
 covenant violation results in costs of technical
default
Political cost hypothesis
 Large firms rather than small firms are
more likely to use accounting choices that
reduce reported profits
 size is a proxy variable for political attention
 reduction of reported income is hypothesised
to reduce the possibility that people will argue
that the organisation is exploiting other parties