Chapter 7 - Positive Theory
Positive Accounting Theory
Philosophy of PAT
Million Friedman championed positive theories in economics.
He stated that: (part 3 Empirical Research in Accounts of Accounting theory
from Jayne Godfrey)
The ultimate goal of positive science (i.e. INDUCTIVE) is
 The development of a ‘theory ‘ or ‘hypothesis’;
 that yields valid and meaningful “Predictions’
 about phenomena not yet “observed”.
Consistent with Friedman’s view, Watts and Zimmerman asserts that:
The objective of “positive accounting theory” is to “explain” and
“predict” accounting practice.

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“Explanation” means providing reasons for observed practice.
For example, positive accounting theory seeks to explain why firms
continue to use historical cost accounting and why certain firms switch
between a numbers of accounting techniques.
“Prediction” of accounting practice means that the theory predicts
“unobserved phenomena”.
“Unobserved phenomena” are not necessarily future phenomena; they
include phenomena that have occurred, but on which systematic evidence has
not been collected.
For example – Predicting the reaction of firms to a proposed accounting
standard and an explanation of why firms would lobby for and against such a
standard, even though the standard has already been released.
Testing these theories provides evidence that can be used to predict the
impact of accounting regulations before they are implemented.
PAT has an economic focus and seeks to answer such questions – what is the
effect of reported financial statements on share price, for example?
For the above issue, PAT is based on assumption about the behavior of
individuals: that is Manager, investors, lender and other individuals are
rational, evaluative utility maximize® (REM).
Chapter 7 - Positive Theory
Positive Accounting Theory
This theory attempts:
1. to explain manager’s choices of accounting methods in terms of
self-interest,
2. the relationships between stakeholders and,
3. how financial accounting can be used to minimize cost by aligning
competing interests.
Returning our fouces, PAT foucses on the “relationship” between
 the various individuals involved in providing resources to an
organization and

how accounting is used to assist in the functioning of these relationship
PAT, as developed by Watts and Zimmerman and others, is based on the
central economic-based assumption that all individuals’ action is derived by
self-interest and that individuals will act in an opportunistic manner to the
extent that the actions will increase their wealth.
Given an assumption that ‘self-interest” drives all individual actions, PAT
predicts that organization will seek to put in place mechanisms that aligns the
interests of the manages of the firm (agent) with the interests of the owners of
the firm (the principal).
EMH – Efficient market hypothesis
The genesis of positive accounting theory is the Efficient Market Hypothesis
(EMH). According to Fama, the EMH is based on the assumption that
capital markets react in an efficient and unbiased manner to publicly available
information.
The perspective taken is that security prices reflect the information content of
publicly available information and this information is not restricted to
accounting disclosures.
The capital market is considered to be highly competitive, and as a result,
newly released public information is expected to be quickly impound into
share prices.
Chapter 7 - Positive Theory
Positive Accounting Theory EMH – Efficient market hypothesis (cont’d)
A. The Efficient capital market vs. the accounting method
If accounting results are released by an organization, and these results were
already anticipated by the market (e.g. interim announcement), then the
expectation is that the prices of security will not react to the release of the
accounting results.
Consistent with traditional finance theory, the price of a security is
determined on the basis of belief about “The Present Value of Future Cash
Flows pertaining to that security and when these belief changes (as a result ot
particular information becoming available) the expectation is that the
security’s price will also change.
Because share prices are expected to reflect information from various sources
(as the information relates to predicting future cashflow), that was a view that
“ Management cannot manipulate share prices by changing accounting
methods in an opportunistic manner”. Page 207
B. The choices of manager under the efficient capital market
Because there are many sources of data used by the capital market, if
managers make less than truthful disclosures, which are not corroborated or
contradicts other available information, then, assuming that the market is
efficient, the market will question the integrity of the managers.
Consequently the market will tend to pay less attention to subsequent
accounting disclosures made by such managers.
While supportive of EMH, the literature was unable to explain “why”
particular accounting methods might have been selected in the first place.
For example, if an entity elected to switch its inventory cost flow assumptions
and this led to an increase in reported income, then the market was assumed
to be able to see through this change, and to the extent that there were no
apparent cash flow implications, there would be no share price reaction.
Hence, if the particular accounting method had no direct taxation
implications, there was an inability to explain why one method of accounting
was selected in preference to another. Page 210
Chapter 7 - Positive Theory
Positive Accounting Theory Agency Theory
A key to explaining manager’s choice of particular accounting method came
from Agency theory.
Agency theory provided a necessary explanation of why the selection of
particular accounting methods might matter, and focused on the relationships
between principals and agents, a relationship which, due to various
information asymmetries, created much uncertainty.
Agency theory accepted that transaction costs and information costs exist.
Relying upon traditional economic literature (i.e. maximize own wealth),
Jensen and Meckling considered the “relationship” and “conflicts” between
agents and principals and how efficient markets and various contractual
mechanisms can assist in minimizing the cost to the firm of these potential
conflicts. (Page 211)
It is assumed within Agency Theory that principles will assume that the agent
will be driven by self-interest, and therefore the principle will anticipate that
the manager, unless restricted from doing otherwise, will undertake
self-serving activities that could be detrimental to the economic welfare of the
principle. (Page 211)
In the absence of any “contractual mechanism” to restrict the agent’s
potentially opportunistic behavior, the principle will pay the agent a lower
salary in anticipation of the opportunistic actions. The agents are therefore
“assumed” to have an incentive to enter into contractual arrangements that
appear to be able to reduce their ability to undertake actions detrimental to
the interests of the principals.
That is, if it is assumed that managers would prefer higher salaries, then there
will be an incentive for them to agree to enter into contractual arrangement
that minimize their ability to undertake activities that might be detrimental to
the interests of the owners.
Chapter 7 - Positive Theory
Positive Accounting Theory
Contracting theory
Agency Theory does not assume that individual will ever act other than in
self-interest, and the key to a well functioning organization is to put in place
mechanism (Contracting theory) that ensure that actions that benefit the
individual also benefit the organization.
By the mid to late 1970s, theory had therefore been developed that proposed “
Markets were efficient and that
Contractual arrangements were used
as a basis for controlling the efforts of self-interested agents.
It is also emphasis that efficiently written contracts, with many being tied to
the output of the accounting system, were a crucial component of an efficient
corporate governance structure.
PAT development and Accounting method
In 1990 Watts – The accounting Review identified three key hypothesis that
had become frequently used in the PAT literature to “Explain” and “Predict”
whether an organization would support or oppose a particular accounting
method.
These hypotheses as follow:
1. The “ bonus plan hypothesis”
2. The “debt / equity hypothesis”; and
3. The political cost hypothesis”
The bonus plan hypothesis assumes that managers with bouns plan as more
likely to use accounting methods that increase current period reported income.
It predicts that if a manager is rewarded in terms of a measure of performance
such as accounting profits, the manager will attempts to increase profits..
The debt/ equity hypothesis predicts that the higher the firm’s debt/equity
ratio, the more likely managers use accounting methods that increase income.
Managers exercising discretion by choosing income increasing accounting
method, relaz debt constraints and reduce the costs of technical default.
Chapter 7 - Positive Theory
Positive Accounting Theory
Opportunistic and efficiency perspectives
Within the efficiency perspective, researchers explain how various
contracting mechanisms can be put in place to minimize the agency costs of
the firm, that is, the costs associated with assigning decision making authority
to the agent.
The efficiency perspective is often referred to as an ex ante perspective.
Ex-ante means before the fact – as it considers what mechanisms are put in
place up front, with the objective of minimizing future agency and
contracting costs.
The opportunistic perspective of PAT, takes as given the negotiated
contractual arrangements of the firm and seeks to explain and predict certain
opportunistic behaviors that will subsequently occur. Initially, the particular
contractual arrangements might have been negotiated because they were
considered to be most efficient in aligning the interests of the various
individuals within the firm. However, it is not possible or efficient to write
complete contracts that provide guidance on all accounting methods to be
used in all circumstances – hence there will always be some scope for
managers to opportunistic.
The opportunistic perspective is often referred to as an ex post perspective- ex
post meaning after the fact – because it considers opportunistic action that
could be undertaken once various contractual arrangements have been put in
place.
As noted previously, it is assumed to be too costly to stipulate in advance all
accounting rules to be used in all circumstances. Hence, PAT proposes that
there will be always be scope for agents to opportunistically select particular
accounting methods in preference to others.
Chapter 7 - Positive Theory
Positive Accounting Theory
How PAT attempt to explain in part the revaluation of assets under AASB116?
It is the choice of accounting method between cost model and revaluation
model.
Given that AASB 116 (IAS 16) allows entities a choice between the cost model
and the revaluation model, it is of interest to consider what may motivate
entities to choose between the two measurement models.
Cost-benefit basis - cost incurred to provide relevant information
In most arguments relating to the choice between the two models, there are
the general propositions that a “Current Price”, namely a fair value, will
provide more relevant information than a past price, namely the original cost,
while the costs associated with continuously determining the present price
reduce the incentive, on a cost-benefit basis, to move to current values.
Certainly, the requirement under AASB 116 to continuously adjust the
carrying amounts of assets measured at fair value so that they are not
materially different from current fair values provides a cost dis-incentive to
management to adopt the revaluation model.
The bonus plan hypothesis
Another factor that entities have to consider when choosing their
measurement bases for class of property, plant and equipment is the effect of
the model on the income statement.
Where assets are measured on a fair value basis, the depreciation each year
would be expected to be higher as the depreciable amount is higher.
Besides the effect of depreciation, there will be an effect on disposal of the
assets.
When an asset is measured at fair value, there is expected to be an immaterial
amount of profit/loss on sale, as the recorded amount of the asset at time of
sale should be close to that of the market price at time of sale.
For an asset measured at cost, any gain on sale will be reported in the income
statement – the income is recognized upon disposal of assets which is
determined by the management decision.
Chapter 7 - Positive Theory
Positive Accounting Theory
Apart from increased relevance and reliability argument, what are the
incentive for management to use revaluation model?
The Debt / Assets hypothesis
The effect of adopting the revaluation model is to increase the entity’s assets
and equities. Hence, entities which need to report higher amounts in these
areas would consider adoption of the revaluation model.
For example, entities which have debt covenants generally have constraints
relating to their debt-asset ratio e.g. the debt-asset ratio must not exceed 50%.
Hence, for an entity with increasing debt, adoption of the revaluation model
for a class of assets which is increasing in value will ease pressure on the
debt-asset ratio by increasing the asset base of the entity, providing, of course,
that the debt covenant allows revaluations to be taken into account in
measuring assets.
The political cost hypothesis
The incentives for entities to adopt fair value measures, then, tend to be
entity-specific because of pressures placed on the entities relating to external
circumstances.
For example: an entity’s reported profit figure may be under scrutiny from a
specific source, such as a trade union seeking reasons to support claims for
higher pay, or regulators looking at monopoly control within an industry.
Conclusion
Where there are pressures to report lower profits, adoption of the revaluation
model provides scope of higher depreciation charges with increases in the
value of non-current assts not affecting the income statement. With lower
reported profit and a higher asset/equity base, any judgment made by
reviewing ratio such as rate of return on assets or equity will result in the
entity being seen in a less favorable light. (Company Accounting – Ken Leo,
John Hoggett – Page 189 and 190)