Historical Context
Positive Accounting Theory (PAT) emerged in the late 20th century as a response to the dominance of normative accounting theories that prescribed how accounting should be done. Key figures like Ross Watts and Jerold Zimmerman significantly contributed to PAT’s development with their 1978 paper “Towards a Positive Theory of the Determination of Accounting Standards.” The objective of PAT is to explain and predict accounting practices based on empirical evidence and economic relationships.
Key Concepts
Types and Categories
- Descriptive Approach: Focuses on describing actual accounting practices and the reasons behind them.
- Predictive Approach: Predicts the effects of accounting policies and the choices of accounting methods based on economic and contractual considerations.
Core Assumptions
- Economic Rationality: Assumes that individuals (including managers and accountants) act in their self-interest, often economically motivated.
- Contractual Relationships: Emphasizes the role of contracts in shaping accounting practices, as they represent the economic consequences of financial reporting.
- Agency Theory: Central to PAT, it explores conflicts of interest between different stakeholders (e.g., managers, shareholders, creditors) and how these conflicts influence accounting choices.
Key Events in PAT Development
- 1978: Publication of the influential paper “Towards a Positive Theory of the Determination of Accounting Standards” by Watts and Zimmerman.
- 1986: Further elaboration on the theory in Watts and Zimmerman’s book “Positive Accounting Theory”.
Detailed Explanations
Agency Theory and PAT
At its core, Positive Accounting Theory is grounded in agency theory, which examines conflicts of interest between managers (agents) and shareholders (principals). These conflicts arise because agents may not always act in the best interest of principals. PAT predicts that managers will choose accounting policies that benefit them, such as those that maximize their compensation or minimize the risk of covenant violations.
Mathematical Models
PAT employs various mathematical models to predict and explain accounting behaviors. One simple example is the Bonus Plan Hypothesis:
Managers might choose accounting policies that increase reported earnings if their bonuses are tied to these figures.
Charts and Diagrams
Example: Decision Influence Chart (Hugo-compatible Mermaid format)
graph TD;
A[Stakeholders] -->|Agency Relationship| B[Managers];
B -->|Choose Accounting Policies| C[Financial Reports];
C -->|Impact on| D[Stakeholders];
D -->|Feedback Loop| A;
Importance and Applicability
Positive Accounting Theory is crucial for understanding why managers choose specific accounting methods and policies. This understanding can:
- Help investors and regulators predict management behaviors.
- Improve corporate governance practices.
- Inform the development of accounting standards based on empirical observations.
Examples
- Example 1: A firm close to violating a debt covenant may adopt aggressive revenue recognition policies to avoid breaches.
- Example 2: A company with a bonus plan linked to net income might capitalize expenses rather than expensing them immediately to boost short-term earnings.
Considerations
- Limitations: PAT may not fully account for all variables influencing accounting choices, such as cultural or ethical considerations.
- Ethical Implications: The focus on self-interest and economic rationality might lead to practices that are ethically questionable.
Related Terms and Comparisons
- Normative Accounting Theory: Prescribes how accounting should be done, in contrast to PAT which describes and predicts current practices.
- A Priori Theories of Accounting: These are theories developed through logical deduction before empirical observation, differing from PAT’s empirical approach.
Interesting Facts
- Positive Accounting Theory has influenced the development of many modern financial reporting regulations and practices, making it a cornerstone of contemporary accounting theory.
Inspirational Stories
- Story of Enron: The Enron scandal exemplifies the consequences of managerial self-interest predicted by PAT, where management manipulated accounting policies to inflate earnings and hide debt.
Famous Quotes
- “Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.” – Diane Garnick
Proverbs and Clichés
- “Follow the money.” – This cliché underscores the importance of financial incentives in driving managerial behaviors, a key tenet of PAT.
Expressions, Jargon, and Slang
- Big Bath: A strategy where companies take large write-offs in bad years, making future earnings look better, often predicted by PAT.
FAQs
-
What is Positive Accounting Theory?
- Positive Accounting Theory is a theory that explains why firms use certain accounting practices based on economic incentives and empirical evidence.
-
How does PAT differ from normative theories?
- Unlike normative theories which prescribe how accounting should be done, PAT seeks to explain and predict accounting practices.
-
What is the role of agency theory in PAT?
- Agency theory in PAT examines conflicts of interest between managers and shareholders and predicts how these conflicts influence accounting choices.
References
- Watts, R. L., & Zimmerman, J. L. (1986). Positive Accounting Theory. Prentice Hall.
- Deegan, C. (2013). Financial Accounting Theory. McGraw-Hill Education.
Summary
Positive Accounting Theory offers a pragmatic approach to understanding accounting practices by focusing on economic motivations and empirical evidence. By applying PAT, stakeholders can gain insights into managerial behaviors and predict the impact of various accounting policies, contributing to improved decision-making and regulatory frameworks.
