Positive Accounting Theory

ACCOUNTING

ACCOUNTING

THEORY

THEORY AND P

AND PRACTICE

RACTICE

FAR 600

FAR 600

Positive Accounting

Positive Accounting

Theory

Theory

Prof Madya Dr Roshayani ArshRoshayani Arshadad Faculty of

Faculty of AccountancyAccountancy UiTM

UiTM

1

L

L

EARNING

EARNING

O

O

BJECTIVES

BJECTIVES





 At the end of this lesson, students should be able to

 At the end of this lesson, students should be able to

::



 Contracting theoryContracting theory



  Agency theory Agency theory



 Political processesPolitical processes

2

P

P

OSITIVE

OSITIVE

ACCOUNTING

ACCOUNTING

THEORY

THEORY

3

Concept of  PAT

To explain the reason for 

observed practice

Why the economic consequences

exist?

To predict the actions of the firm

Which accounting policy firm will

choose when some policies

available

What will the firm react to new acct

E

CONOMIC

C

ONSEQUENCES

Economic consequences is a concept that

asserts that, despite the implications of efficient

securities market theory, accounting policy

choice can affect firm value.

(Scott, W.R., 2003, p.259)

5

 Despite implications of efficient market theory, accounting

policy choice have economic consequences for various constituencies of financial statement users

 Standard setting bodies includes different constituencies in

their board in order to reach a consensus between accounting and political demands.

THE

RISE OF

ECONOMIC

CONSEQUENCES

 Economic consequences as defined by Zeff (1978) the

impact of accounting reports on the decision-making  behavior of business, government and creditors

.

 Third party interventions complicate the setting of 

accounting standards because they try to influence or  influenced the accounting the standard setting bodies

 Example: attempt by several US corporations to

implement replacement cost accounting during the period of high inflation (1947-1948)

T

HE

R

ISE OF

E

CONOMIC

C

ONSEQUENCES



Since there is no theory that clearly prescribes

what accounting policies should be used other 

than a vague requirement tradeoff between

relevance and reliability is necessary



This opens the door for various other 

constituencies to argue for their preferred

accounting policies



Hence standards setting requires both the

accounting theory domain as well as the

political domain

P

HILOSOPHY OF

PAT



 A science to predict unobservable phenomena and

seeks to explain observed accounting phenomena

by searching for the reasons events occur 

‘The objective of (positive) accounting theory is to explain and   predict accounting practice … Explanation means providing 

reasons for observed practice. For example, positive accounting theory seeks to explain why firms continue to use historical coat accounting and why certain firms switch between a number of  accounting techniques. Prediction of accounting practice

means that the theory predicts unobserved phenomena. (Watts & Zimmerman, 1986, p.2)

P

HILOSOPHY OF

PAT

 Economic focus

 i.e., focus on the costs and benefits of the alternative accounting methods, regulations & accounting std setting process & the

effects of reported FS on share prices.

 More scientific in methodology i.e., empirically explaining & predicting what occurs.

 Central idea is to develop hypotheses about factors that influence the world of accounting practices and to test the validity of these hypotheses empirically. ₉

N

 ATURE OF

NORMATIVE

THEORY

&

ITS

LIMITATIONS



Prescribes what should occur or the best way to

account



Limitations

 Normative presupposes PAT (Jensen, 1983)

 Normative not based on identified, empirical

observations & methods (Watts & Zimmerman , 1986)

 ‘Valid prescription requires specification of both an objective and 

an objective function.’ (p.7)

 Normative produces irrefutable prescriptions (Popper, 1968)

 ‘No amount of empirical testing can prove a theory to be correct 

 – i.e. tests of a theory against real-world data - but a theory  should be refutable or capable of falsification.’

Cop yrig ht@ 2004 by Roh ana Oth man. All

S

PAT

Model (CAPM)

Positive Accounting Theory

 Accounting Policy Choice (APC)

Opportunistic reasons Efficiency reasons

Cop yrig ht@ 2004 by Roh ana Oth man. All

S

PAT



PAT attempts to understand & predicts firm’s APC

PAT asserts that firms need APC to minimize

contracting costs



PAT implies it is more efficient for firm to have a

set of accounting policies (GAAP) from which

management can choose



However, this flexibility in APC opens the door to

Cop yrig ht@ 2004 by Roh ana Oth man. All

S

PAT

 Efficiency assume that internal control systems limit

opportunism and motivate managers to choose accounting policies that minimize contracting costs.

 Sweeney (1994) found that managers change accounting policies only when it was cost effective & Dechow (1994) further confirmed Sweeneys’ findings.

 Both the above studies confirmed that managers choose accounting policies more for efficiency reasons rather than opportunistic reasons.

Cop yrig ht@ 2004 by Roh ana Oth man. All

S

PAT

 PAT developed in two stages

 First-stage literature did not explain accounting practice. The

earlier of the two stages involved research into accounting and the behaviour of capital markets

 Second-stage literature sought to explain and predict

T

HE DIFFERENCE BETWEEN NORMATIVE

THEORY AND POSITIVE THEORY

 Normative theory:

what they should do

 What is a good normative theory:

it is judged by its logical consistency with underlying assumptions of how rational individuals should

behave

 Positive theory:

to predict which acct policy firms will choose

T

HE RELATION BETWEEN NORMATIVE

THEORY AND POSITIVE

 Both are valuable to theory development and testing  Positive theory helps to keep the normative research

on track by empirical testing

S

TRENGTH OF PAT

Perceived that theory should be able to generate hypotheses capable of 

falsification through empirical testing

Deemed desirable that theory aim was to explain and predict accounting practices rather than supply prescriptions

Necessary to rationalize existing

accounting principles, which normative theory didn’t attempt to do

PAT attempt to model connection between accounting, firms, & markets & analyze problems within an economic network

W

HY

PAT?

 What was? What is? What ought to be?

 A theory that is consistent with the existence of 

economic consequences

 explain or predict real world phenomenon and are tested

empirically

 Based on scientific methodology using economic based

empirical literature

 Enable theories to be refuted, to explain & predict, to

rationalize accounting principles and to model connection between accounting, firms & markets

 Attempt to understand why accounting policies matter 

PAT H

YPOTHESES

 Predictions made by PAT largely organized around 3

hypotheses formulated by Watts & Zimmerman (1996), all other things being equal:

 The Bonus Plan Hypothesis

 Choose accounting policy that shift reported earnings from future

periods to the current period

 The Debt Covenant Hypothesis

 Firm with prospect of violating accounting-based debt covenants (e.g.

going below the agreed specified level of debt equity ratio) would shift reported earnings from future periods to current periods

 The Political Cost Hypothesis

 Choose accounting policy that defer reported earnings from current to

future periods.

PAT H

YPOTHESES



Managers of firms with bonus plan predicted to

 choose less conservative accounting policy & oppose accounting

standards that may lower reported net income than managers of  firms without such plan



Managers of firms with high debt-to-equity ratio

 Choose less conservative accounting policy & oppose new

standards that may lower reported net income. 

Managers of large firms

 Choose more conservative accounting policies & less likely to

oppose new standards that may lower reported net income.

P

OSITIVE THEORIES

 ‘Experiences’ or ‘facts’ of the real world  explaining reasons for current practice

 predicting how accounting information is used in

economic decision-making

N

 ATURE OF

P

OSITIVE

T

HEORIES



Provide description of what accounting is

Descriptive, inferential & objective



Objective of PAT is to explain & predict

accounting practice



 A science to predict unobserved phenomena

Observable & verifiable



Derived inductively from specific set of 

observation



 Analytic (logic), semantic & pragmatic

N

 ATURE OF

P

OSITIVE

T

HEORIES

 Based on scientific empirical methodology, relating or 

testing accounting hypothesis to experience or facts of  real world e.g., efficient market hypothesis

 Focus on

  Accounting policy choice  Capital market research

 Assumptions

 Efficient capital market

  A firm is a nexus of contracts

  Accounting is important in contract enforcement   Accounting information is an economic good

 Managers, investors, lenders & others are assumed to be

rational & evaluative utility maximizer 

 Discretion to choose accounting policies that maximize their 

utility and value of firm

C

RITICISMS ON

PAT

 Positive theory are not value free

 VALUE FREE IS NOT ALTERED OR

INFLUENCED BY VALUE JUDGMENT

 Value judgment of the rightness or wrongness or 

usefulness of something base on persona; view.

 The theories use large-scale statistical research,

remote from practitioners and their concerns

DIFFERENCE

BETWEEN

NORMATIVE

&

POSITIVE

ACCOUNTING

THEORIES

Normative



Prescriptive

 Prescribed how people should behave

Positive



Descriptive, explanatory or predictive

 Describe how people behave

 Explain why people behave in a certain manner   Predict what people have done or will do



Suggestion: can coexist & complement each

other 

C

ONTRACTING

T

HEORY

 Firm is a legal nexus (connection) of contractual relationships amongst suppliers and consumers of factors of production  Rationale for the firm:

‘it costs less to transact (or contract) through central organization than to do so individually’ 

‘firm is an efficient means of organizing economic activity because they reduce contracting costs’

Hence firm exists to reduce transaction costs

 PAT-APC focuses on two main types of agency contracts to explain accounting practices:

 Management contracts (shareholders & managers)

 Debt contracts (lenders & managers who is acting on behalf of the shareholders)

 A

T

 Developed to explain & predict the actions of agents

(e.g. managers) & principals (e.g. shareholders or  lenders).

 Assumption: no ‘ a priori’ reason to believe that agent

will act in the best interest of the principal

 Jensen & Meckling (1976) describe an agency

relationship arises when there is a contract under which one party (the principal) engages another party (the

agent) to perform some service on the principal’s behalf.

 Under the contract the principal delegates some

 A

GENCY

T

HEORY

 – P

ROBLEM

 No reason to believe that the agent will always act in

the principal’s best interests.

 Agency problem is the problem of inducing an agent to

behave as if he or she were maximizing the principal welfare, resulting in agency cost

 A

GENCY

T

HEORY

- C

OSTS

 Agency costs are costs that arises from agency

relationships (because of the separation of  ownership from control of an entity)

 Three types of agency costs identified are:

 Monitoring costs

 Bonding costs

 Residual loss

 AGENCY

THEORY

- MONITORING

COSTS



Costs of monitoring the agent’s behavior 



Expenditure by principal to measure, observe &

control agent’s behavior 



Examples: mandatory audit costs, cost to

establish management compensation plan, &

budget restrictions among others



Price protection is the way the principal protects

against agency costs by paying according to the

level of costs expected.



Price protection is borne by agents

 A

GENCY

T

HEORY

- B

ONDING

C

OSTS



Costs of establishing & complying with

mechanisms (bonding agent’s interest with

the principal’s interest)



Borne by agents - Price protection resulted in

agents ultimately having to bear monitoring

costs associated with contracts



Examples: frequent quarterly financial

statements



Costs to managers includes: time & effort,

constraints, & income forgone

 A

GENCY

T

HEORY

 – R

ESIDUAL

L

OSS

 Residual loss occur when the net value of the agents’

output is less, when they make decisions that are not entirely in the principal’s interest (deadweight loss)

 When the agent make decisions that do not keep the best

interest of the principal, it results in residual loss

 Strong form efficient market provide information on

incentives & opportunities that will trigger the agent to act contrary to the interest of a principal

 The agent would then use information to set their 

remuneration level i.e., the principal will remunerate the agent to the point that the principal expects the agent to likely become contrary to the interest of the principal

 A

GENCY

T

HEORY

 – S

ETTLING

U

P

 Settling up means the principal review the remuneration

package given to the agent base on the principle that the remuneration level has to tally with the agent’s effort.

 If the agent is deemed to have acted more in favor of 

the interest of the principal the it is likely that the remuneration will be revised upwards

 In contrary, remuneration will revise downwards if the

agent is deemed to have acted more in contrary to the interest of the principal

 If the contract is to be continued then it should start with

 AGENCY

THEORY – RESIDUAL

OPPORTUNISM

 Residual opportunism – cost borne by agent due loss

of reputation & potential loss of long-term returns to them

 With incomplete price protection & settling up,

residual loss is borne partly by agent & partly by principal

 A

GENCY

C

OSTS

 Monitoring costs

 Cost of monitoring agents behaviour and expenditure by principal to

measure, observe and control the agent’s behaviour.

 Examples: audit costs, operating rules, budget restrictions

 Bonding costs

 Costs of establishing and complying with these mechanism (bond’s

agents interest to match principal’s interest).

 These costs are borne by agents

 Examples: frequent (weekly, quarterly, semi-annually) reporting to

shareholders

 Residual costs

  Also known as deadweight loss is when the net value of the agent’s

output is less than if the agent’s interest were completely aligned to the principal

 Not reduced by monitoring or binding costs

 However, under strong-form efficient market, it is assumed that the

 A

GENCY

P

ROBLEM AND

C

OST

 Agent problem and cost arise from the opportunistic

behaviour of management

 Opportunistic tendencies increase with decrease

proportionate share (ownership) which increases residual loss.

 Shareholders are prepared to bear agency costs as long

as marginal benefits to shareholders exceed marginal cost

 Price protection of shareholders could be in two forms:

 Share price adjustments to reflect opportunistic behaviour 

 Share price exclude monitoring and binding cost

 Limitation of price protection is that share price is not always

available due to thin trading and when manager’s efforts can be directly related to earnings performance

S

UMMARY

 A number of conflicting theories have developed  A theory generally consists of 

three parts

 There are several criteria for judging a theory  Persuasiveness of evidence