Positive Accounting Theory

Lesson Six

Reference:
Chapter Seven, Recommended Text Book

Dr. Isuru Manawadu

PhD in Accounting, B.Sc. in Accounting (Sp) Sjp, FCA 1
 Learning Outcomes
At the end of this course the students should be able to:
– Explain how a positive theory differs from a
normative theory;
– Describe the origins of Positive Accounting Theory
(PAT);
– Describe the perceived role of accounting in
minimising the transaction costs of an organisation;
– Discuss how accounting can be used to reduce the
costs associated with various political processes;
– Assess how particular accounting-based
agreements can provide incentives for managers to
manipulate accounting numbers; and
– Assess the criticisms of PAT.

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 Lesson Outline
 Difference between a positive theory and a
normative theory

 Origins and Development of Positive

Accounting Theory (PAT)

 Key Hypotheses used in PAT Literature

 Two Perspectives of PAT Research

 Criticisms of PAT
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 Normative
Positive theories
theories
seek to explain
prescribe how a
and predict
particular
particular
practice should
phenomena.
be undertaken.

Theories

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 Positive Accounting Theory (PAT)
– (Pages 272-274)
• ‘… 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.’ (Watts and
Zimmerman 1986, p. 7)
 Explain – Providing reasons for observed
practice
 Predict – Refers to theory predicting
unobserved accounting phenomena.

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 Positive Accounting Theory
(PAT) (Contd.)
• Focuses on relationships between various
individuals involved in providing resources to
an organisation and how accounting is used to
assist in the functioning of these
relationships.
– Between owners and managers
– Between lenders and managers

Assumptions underlying PAT

• All individuals’ action is driven by self-interest
and individuals will act opportunistically to
increase their wealth.
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 Origins and Development of PAT
– (Pages 274-287)
Came to prominence in mid-1960s as a paradigm shift from
normative theories - changes in USA Business Schools in the
late 1950s and early 1960s.

Dominant research paradigm in 1970s and 1980s.

Development of Efficient Market Hypothesis (EMH) by Fama

and others
Capital markets - react in an efficient and unbiased manner to
publicly available information.

Capital Market Research

Ball and Brown (1968) paper - crucial to the acceptance of the
positive research paradigm
Unexpected changes in accounting earnings lead to abnormal
returns on an organisation’s shares.
Historical cost information is useful to the market

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Origins and Development of PAT
(Contd.)

Share prices reflect information from various sources.

Thus, the mgt. cannot manipulate share prices by
changing accounting methods in an opportunistic
manner.

No need for extensive accounting regulation

However, Capital Market Research could not explain

why the selection of particular accounting methods
might matter.

Agency Theory, focuses on the relationships between

principals and agents.

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Agency Relationship and Costs –(Page 278)

• Defined by Jensen and Meckling (1976)

– ‘a contract 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.’

• Agency Costs:
– Monitoring costs: costs of monitoring agents’
behaviour
– Bonding costs: costs involved in agents
bonding their behaviour to expectations of
principals
– Residual loss: too costly to remove all
opportunistic behaviour

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 The Perspective of the Firm as a
‘Nexus of Contracts’ –(Pages 281-283)
• In Agency Theory literature, the firm itself is
considered as a ‘nexus of contracts.’

• These contracts (monitoring and bonding

mechanisms) ensure that all parties, acting in
their own self-interest, are at the same time
motivated to maximise firm value. (Internal
Control Mechanisms)

• External Control Mechanisms such as market

for corporate control and market for
managers.
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 The Emergence of PAT
–(Pages 283-287)
Contractual
arrangements
Markets were
for controlling
efficient (Capital
the efforts of
Market
self-interested
Research)
agents (Agency
Theory)
PAT
Emphasized the
role of
accounting in
reducing the
agency costs of
an organization.

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 The Emergence of PAT (Contd.)

• Watts and Zimmerman Paper (1978) - the key

paper in the development and acceptance of PAT.
– Assumes that individuals act to maximize their
own utility. In doing so they are resourceful
and innovative. The obvious implication of this
assumption is that management lobbies on
accounting standards based on its own self-
interest.

• Considered how particular organizational

attributes might affect management acceptance
or rejection of a particular accounting method.

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Key Hypotheses (Watts and Zimmerman, 1990 –
Positive Accounting Theory : Ten year perspective)

Debt
Bonus
plan Political
cost

Three
Hypotheses

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 Bonus Plan Hypothesis
(Management Compensation Hypothesis)

• Managers of firms with bonus plans

are more likely to use accounting
methods that increase current period
reported income.

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 Owner/Manager Contracting
(Page 291 -301)

• Assumes self-interest, owners expect

managers (agent) to undertake activities
not always in the interest of owners
(principal).

• Managers have access to information not

always available to principals.
– information asymmetry
– further increases managers’ ability to
undertake activities beneficial to themselves

• Costs of divergent behaviour are agency

costs.
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 Owner/Manager Contracting
(Contd.)
• In the absence of controls to reduce opportunistic
behaviour, agents (managers) expected to undertake
activities disadvantageous to the value of the firm.

• Principals price this into the amounts they are

prepared to pay the manager (Price protection).

• Managers may contract themselves not to consume

perks so will receive higher salary (known as bonding).

• Bonus Schemes : Accounting-based as well as Market-

based.

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 Debt Hypothesis
(debt/equity hypothesis)

• The higher the firm’s debt/equity ratio, the

more likely managers use accounting
methods that increase income.
– 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.

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Debt Contracting - Agency Costs
of Debt – (Pages 302-308)
• Agency costs of debt include:
– excessive dividend payments, which
leave fewer assets to service debt.
– the organisation may take on additional
debt, with new debtholders competing
with original debtholders for repayment.
– investment in high-risk projects may not
be beneficial to debt holders as they
have a fixed claim.

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 Use of Debt Contracts
• In the absence of safeguards to protect
the interests of debtholders, it is assumed
they will require the firm to pay higher
costs of interest to compensate.

• If firms contract not to pay excess

dividends, take on high levels of debt or
invest in risky projects, then they can
attract debt at lower cost.

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 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
hypothesized to reduce the possibility
that people will argue that the
organisation is exploiting other parties.

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 Political Costs (Pages 308-314)

• Costs resulting from political attention

from government, lobby groups etc.

• Commonly directed at larger firms

– indication of market power

• May result in increased taxes, increased

wage claims, product boycotts etc.

• Firms likely to adopt accounting methods

to reduce profits to lower political scrutiny.
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 Two Perspectives (Pages 287-290)
Explains how
Opportunistic Seeks to explain
Efficiency various contracting Perspective managers’ actions
Perspective mechanisms
minimise agency once contracts are
costs of the firm. already in place.

Ex ante Ex post
perspective perspective
mechanisms - Put considers
in place up front opportunistic
to minimise future actions after the
agency and fact
contracting costs

Managers select Managers are

accounting assumed to
methods most opportunistically
efficiently reflect act to maximise
underlying firm own wealth.
performance. 22
 Some Criticisms of PAT
(Pages 319-323)

• Does not provide prescription

• PAT is not value-free as it asserts
assumption that all action is driven by
self-interest
• Argued to be too negative and simplistic a
perspective of humankind
• Issues have not shown great development
• In undertaking large-scale empirical
research, researchers ignore
organisational-specific relationships
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Diagrammatic Summary of PAT
 Case study 01
The United Way of America, a nonprofit organization that provides funding and support to
local charities across the United States. In the 1990s, the United Way of America was
embroiled in a scandal over its financial practices. An investigation by the U.S. Senate found
that the organization had engaged in financial improprieties, including using donor funds to
pay for lavish salaries and expenses for its executives. The scandal led to a decline in public
trust and a drop in donations to the organization. To address these issues, the United Way of
America turned to develop new financial reporting practices that would promote transparency
and accountability. The organization worked with the Financial Accounting Standards Board
(FASB) to develop specific accounting standards for nonprofit organizations, which require
nonprofits to disclose information about their finances and operations, including information
on their sources of revenue, expenses, and investments. The United Way of America also
adopted best practices for financial reporting, such as providing regular financial reports to its
donors and stakeholders and appointing an independent auditor to review its financial
statements. These practices helped to restore public trust in the organization and improve its
financial performance.

What is the most appropriate theory for the above case? (PAT or NAT)

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 Case study 02
There is a study in the retail industry to analyze the impact of financial reporting quality on firm
performance. The title of this study was "Financial Reporting Quality and Firm Performance:
Evidence from the Retail Industry" by Robert J. Bloomfield, John H. Evans III, and Lawrence D.
Brown, published in the Journal of Accounting Research in 2016. The study analyze the
relationship between financial reporting quality and firm performance in the retail industry. The
researchers hypothesized that firms with higher financial reporting quality would have better
financial performance, because they would be better able to communicate their financial position
and prospects to investors and other stakeholders.

To test this hypothesis, the researchers collected data on financial reporting quality and financial
performance for a sample of 182 retail firms over a 10-year period. They used a statistical model
to control for other factors that could influence firm performance, such as size and industry. They
found that firms with higher financial reporting quality had better financial performance,
consistent with the predictions. The study provides empirical support for the predictions and
demonstrates its usefulness in analyzing the relationship between financial reporting quality and
firm performance in the retail industry. It also has implications for accounting standard-setters and
regulators, who may want to encourage higher financial reporting quality to promote better firm
performance.
What is the theory that the researcher has used for the above study? (PAT or NAT)
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