Positive Accounting Theory
Accounting has evolved throughout human history from the single entry approach to more advanced methods such as the double-entry and documented bookkeeping methods. Accounting theories have developed in an effort to understand accounting practices and the basis of actions. In accounting research and practice, there are various approaches used in explaining the existing accounting practices and predicting accounting practices in business. In the early 1950 and 1960s, research on accounting involved a focus on what should be done rather than understanding and explain the already existing accounting practices (Wiratama and Asri, 2020). This formed the fundamentals of the normative accounting theory and focused on abstract principles and subjective characteristics on the structure of a company’s financial future.
In the early 1950s and 1960s, the Positive Accounting Theory (PAT) emerged as an alternative and marked a paradigm shift from the normative theories. As an accounting theory, PAT takes an objective approach into financial accounting by applying empirical finance techniques rather than subjective morality, policy recommendations, and value judgment. According to Wiratama and Asri (2020), while normative theories try to make recommendations on what to be done, PAT tends to create explanations and make predictions of real-world accounting practices. The normative theories were widely criticized as nothing more than definitional research and propositions. The positive accounting theory emerges as an alternative after the normative theories became questionable and increasingly criticized for their simple approach to the analysis of data and weak theoretical basis. The development of computing technologies such as IBM’s magnetic drum calculator in 1954 that allowed larger data storage and faster access, direct keyboard input by MIT in 1956, and development of FORTRAN computer programming language were major developments during this era(Wiratama and Asri, 2020).
The development of Random Access Memory and machine database inventions in the 1960s also increased demand in empirical accounting research. There were an increasing advancement and availability of facilities for calculating, processing, and analyzing a large amount of data. The emergence of the Efficiency Market Hypothesis (EMH) led to changes during the 1950s and 1960s in the US in the flow of businesses (Wallerstein et al., 2017). The Gordon-Howell report on business education commissioned by the Ford Foundation and published in 1959 championed for a research-based educational model in business schools (McLaren, 2018).
The dissatisfaction of the normative accounting theory that was influenced by government regulators including the Treasury Department Securities and the Exchange Commission that continued exert immense pressure on independent accounting standard regulatory bodies (Watts and Zimmerman, 1978). Ross Watts and Jerold Zimmerman published an article in 1979 titled “Towards a Positive Theory of Determination of Accounting Standards.” In the article, Watts and Zimmerman point out the self-interests of management to influence accounting standards on the assumption that it possesses similar interests with the shareholders. This however might not be the case. As highlighted by Jensen and Meckling (1976), there occurs a conflict of interest among managers (agents) appointed by shareholders which may result in agency costs.
In reality, the management can act on self-interests that are not in congruence with the interests of the shareholders due to other factors such as taxes, regulations, and political costs. As proved in the bonus hypothesis, management will choose an accounting procedure that will influence future incomes as well as the present period in order to get bonuses. There is also the possibility of managers shifting future incomes to the resent period in order to avoid technical errors and increase net income. Due to these factors, Watts and Zimmerman introduced the positive theory that will be used in determining reported earnings. The theory was initially developed as a prescription to the normative theorized by introducing a focus on the impact of accounting standards on various groups as well as the pressure subjected to accounting theories by these groups.
The positive theory uses an approach that balances the interests of both managers, investors, and the wider actors by using empirical research maximizing profits. The theory also seeks to answer accounting questions such as the effect of publishing financial statements on the prices of stock. The positive accounting theory seeks to answer this question by showing the relationship between accounting reports on earnings and the reaction to stock prices. This approach introduced the Capital Asset Pricing Models and the Efficiency Markets hypothesis which were developed in 1965 by Fama.
In this effect, the positive accounting theory introduced the historical cost methods which are used in the preparation of accounting reports with information that is critical in the valuation of the stock. In this approach, the capital market became efficient as the valuation of stock used only the relevant and unbiased information that is also available to the public. These changes formed the first stage of positive accounting theory development. Fama also introduced the three-stage EMH concept, which included strong, semi-strong, and weak form efficiencies in relation to stock prices. When the present stock prices of stock reflect past information, the market is assumed weak form efficiency. A semi-strong efficiency is assumed to occur when the present prices of stock are reflective of past information. On the other hand, when the present stock prices are reflective of all published and unpublished information, it is assumed that the market at strong efficiency.
In the second stage of positive theory development, accounting literature is emphasized in the research to explain and predict cross-company practices. The goal of the company was important in the development of the theory the shareholder’s interests being primal. The Capital market research was also by influenced Phillip Brown and Ray Ball who were critical contributors to the development of PAT. Their paper studied the association between financial report announcement and shifts in the prices of stock in capital markets.
As highlighted by Ball and Brown (1968), the prices of stock and the rate of return for the stock held tend to move proportionally. The research also revealed an association between stock prices and accounting earnings. The information in published financial reports was found to be useful in the determination of stock prices. It was found that by the month of the release, about 10-15% of the information in financial reports is usually new and not anticipated(Ball and Brown, 1968). On average, only 20% of the value of the information presented by the financial reports reaches the capital markets in the month of release.
The development of the positive accounting theory introduced the focus on the relationship between business agents and actors such as managers, shareholders, and government regulators and the pressure on accounting standards. Additionally, the theory has been critical in analyzing the effects of an accounting method and the costs of alternatives. As highlighted by Watts and Zimmerman (1990), these groups are always willing to spend resources in order to influence accounting standards for various reasons. In one of the reasons, managers are likely favoring an accounting procedure in an effort of getting bonuses and avoiding technical errors. Shareholders on the other hand might subject the accounting procedures to pressure in an effort of avoiding political costs.
References
Ball, R. and Brown, P. (1968), “An Empirical Evaluation of Accounting Income Numbers”, Journal of Accounting Research, [Accounting Research Center, Booth School of Business, University of Chicago, Wiley], Vol. 6 No. 2, pp. 159–178.
McLaren, P.G. (2018), “Stop Blaming Gordon and Howell: Unpacking the Complex History Behind the Research-Based Model of Education”, Academy of Management Learning & Education, Academy of Management, Vol. 18 No. 1, pp. 43–58.
Wallerstein, N., Gatti, L.L., Bógus, C.M., Akerman, M., Jacobi, P.R., de Toledo, R.F., Mendes, R., et al. (2017), “Shared Participatory Research Principles and Methodologies: Perspectives from the USA and Brazil—45 Years after Paulo Freire’s ‘Pedagogy of the Oppressed’”, Societies (Basel, Switzerland), Vol. 7 No. 2, available at:https://doi.org/10.3390/soc7020006.
Watts, R.L. and Zimmerman, J.L. (1978), “Towards a Positive Theory of the Determination of Accounting Standards”, The Accounting Review, American Accounting Association, Vol. 53 No. 1, pp. 112–134.
Watts, R.L. and Zimmerman, J.L. (1990), “Positive Accounting Theory: A Ten Year Perspective”, The Accounting Review, American Accounting Association, Vol. 65 No. 1, pp. 131–156.
Wiratama, R. and Asri, M. (2020), A Literature Review: Positive Accounting Theory (PAT), SSRN Scholarly Paper No. ID 3523571, Social Science Research Network, Rochester, NY, available at:https://doi.org/10.2139/ssrn.3523571.