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This paper aims to critically examine Positive Accounting Theory (PAT) since its emergence in the 1970s. PAT has been one of the most influential accounting theories in the past four decades as it has attracted divergent opinions from accounting theorists and researchers. Watts and Zimmerman (1978), both were the advocates of PAT, propose that the objective of PAT is to predict accounting practices. What is more, PAT is an economics-based theory, since all individuals make decisions on the basis to maximise their own wealth (Watts & Zimmerman, 1978). The five factors affecting management wealth are taxes, information production costs, compensation plans, regulations and political costs, and the incentives for various groups of individuals to adjust accounting standards vary (Watts and Zimmerman, 1978). Despite owing some merits, this paper aims to identify the drawbacks of PAT based on the research and opinions sourced from various accounting theorists and researchers.
Introduction
For over decades, Positive Accounting Theory (PAT) has elicited a heated discussion among various groups of accounting theorists and researchers, which is not uncommon because each party has its own grounds and points of view. PAT was advocated and popularised by Watts and Zimmerman (1978) and such theory of accounting seeks to explain and predict the selection of particular accounting practices and their possible impacts. This contrasts with the Normative Accounting Theory (NAT), which aims to develop and prescribe optimal accounting standards for reporting entities to adopt (Kabir, 2011). Accordingly, PAT possesses a totally different emphasis from NAT. Since its emergence in the 1970s, PAT has been subject to numerous endorsements and criticisms from accounting theorists and practitioners, therefore it is essential to examine how far PAT has been successful in accounting world and what the limitations have been. Based on such reason, this paper aims to give a critical examination and evaluation on PAT. The paper is organised into several sections. First, the discussion will focus on the findings and theoretical arguments derived from the article written by Watts and Zimmerman (1978) Towards a
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Positive Theory of the Determination of Accounting Standards. Second, the articles research hypotheses will be discussed and analysed. Third, this section will identify and discuss the theoretical frameworks being applied. The forth section will look into the limitations of PAT, as well as its criticisms. This paper will finish up by briefly summarizing the main finding and conclusions.
managers are solely rewarded on a fixed salary, assuming self-interest, the central tenet of PAT, it is possible that they can be induced to manipulate the accounting numbers (e.g. augment reported earnings) to improve their apparent performance and contribution, and more importantly, their wealth and rewards (Healy, 1985). A research conducted by Lewellen, Loderer and Martin (1987) confirms such hypothesis because their studies show that a larger percentage of managers who are approaching retirement are less likely to undertake research and development expenses if their rewards are solely based on accounting-based performance measures. This is because incurring R&D costs will directly lead to a reduction in profits, and hence affecting their wealth negatively. As a consequence, Positive Accounting Theorists argue that it is more efficient and appropriate to reward managers with incentive compensation other than fixed salary, such as offering cash bonuses or stock options when the companys profits and shares increa se (Watts and Zimmerman, 1978). Therefore, both the owners (and shareholders) and managers will benefit, more importantly, the managers are given extra incentives to boost the value of the firm. Deegan (2012) also claims that under incentive based remuneration; it is highly possible to motivate managers to take actions and act in the best interests of the owners, thereby, aligning the interests of the managers and owners together. The last factor affecting management wealth is political costs. Whittington (1987) refers political costs to the costs that external groups or parties may impose on the company, such as increased taxes, product boycotts, and higher wages claims. Companies, especially those of large organisations, will directly or indirectly be affected by governments, unions, consumer groups and others (Deegan, 2012). Several studies indicate that a companys accounting results or reported earnings might affect the demands placed on firms by interest groups external to the firm (Watts & Zimmerman, 1978; Deegan & Hallam, 1991). Take the unions for example, if a company reports high profit, it is possible that the trade unions will use the reported accounting profit as a justification or excuse to take further actions in improving their members wealth in the form of higher wages (Deegan, 2012). Such wages increased, although it seems equitable, could be costly to the firms involved. Perhaps with a lower reported profit, there would be less chance for the demand of increased wages. Page 3 of 8
Watts and Zimmermans research in 1986 illustrates that US oil companies in the 1970s had drew unwanted attention from politicians and publics as they were making excessive reported earnings, therefore the companies were subject to the imposition of increased taxes and reduced subsidies. Similarly in Australia, Clarke (2011) claims that Australian mining companies such as Rio Tinto and BHP Billiton have been reporting high profits in recent years, and this has triggered the calls for mining resource tax by the governments. PAT theorists claim that politicians, similar to the managers and shareholders of a firm, are motivated to take action on the basis of self-interest, that is, to increase their power or wealth (Watts and Zimmerman, 1978). Therefore, targeting firms with excessive profits may help to boost their support from voters and thus increasing their chances of winning the election. Based on the discussion above, this paper has provided some insights on how various interest groups may use a firms reported earnings as a justification for particular actions. It can be seen that with a lower reported earnings, it may reduce the possibility of demands from interest groups, such as increased taxes or wages. Several studies shows that companies with high reported earnings choose to adopt income-decreasing accounting methods, in order to avoid great attention and scrutiny from the publics (Watts & Zimmerman, 1978; Jones, 1991). Similarly, Lim and Matolcsys research (1999) reveals that companies that are subject to price scrutiny are likely to apply accounting standards that reduce their reported profits significantly.
Research Question
Watts and Zimmerman (1978) outline three basic hypotheses underlying PAT which include bonus plan hypothesis, debt-equity hypothesis and political cost hypothesis. To begin with, the bonus plan hypothesis predicts managers in firms with incentive plans, have the tendency to adopt accounting standards that boost the reported income in current period. As for debt-equity hypothesis, it predicts that the higher the debt-equity ratio, the more likely that the managers of the firm will use reporting standards that increase the income. Next, political cost hypothesis forecasts larger firms rather than smaller firms have the incentives to use accounting methods that reduce incomes due to government
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and public scrutiny (Sinha, 2008). Watts and Zimmerman (1978) further state that the magnitude of political cost is greatly dependent on the size of the firm. Watts and Zimmerman (1978, pp. 118-121) develop a model of Firms Submission to the FASB regarding the selection of accounting standards. They further argue that the benefits and costs of proposed accounting standards are expected to vary with firm size. The research result demonstrates that larger firms are more likely to make favourable submission to FASB if their reported incomes are reduced by the proposed accounting methods. In contrast, smaller firms will either not submit or make unfavourable submissions. This is due to the fact that smaller firms are subject to less political pressure and public scrutiny; hence the managers do have incentives to oppose the proposed standards since their incentive compensation plan will be affected and adjusted, which is a costly process.
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Conclusion
This paper has critically examined PAT from the perspective of those advocates and opponents. Despite being bombarded by numerous criticisms for decades, PAT continues to be used by accounting researchers and theorists around the globe. One should consider the merits and usefulness of PAT, which is to predict and explain the selection of accounting practices made by individuals in particular circumstances. Such information is particularly important to the decision making process of management, owners, or even the groups external to the firms.
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Reference List
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Watts, RL & Zimmerman, JL 1978, Towards a Positive Theory of the Determination of Accounting Standards, The Accounting Review, vol. 53, no. 1, pp. 112-134. Watts, RL & Zimmerman, JL 1990, Positive Accounting Theory: A Ten Year Perspective, The Accounting Review, vol. 65, pp. 131-156. Whittington, G 1987, Positive accounting: A review article, Accounting and Business Research, vol. 17, pp. 327-336
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