positive accounting theory

What is Positive Accounting Theory?

Positive Accounting Theory is the branch of academic research in accounting that tries to make good predictions of real world events and translate them to accounting transactions. This contrasts with normative accounting theory, which that tries to recommend what should be done. Positive Theories try to explain and predicts actions such as which accounting policies firms will choose and how firms will react to newly proposed accounting standards.

Positive Accounting theory's basic goal is to understand and predict the choice of accounting policies across differing firms. It acknowledges that economic outcomes happens. Under PAT, firms want to increase their chance for survival, so they co-ordinate themselves efficiently. Firms are seen as the total collection of the contracts they have entered into. In relation to PAT, because there is a need to be efficient, the firm will want to reduce the costs linked with contracts. Some examples of contract costs are negotiation, renegotiation, and monitoring costs. Contract costs involve accounting variables as contracts can be stipulated in terms of accounting information such as net income, and financial ratios.

The firm will choose the accounting policies that best acknowledge the need for minimization of contract costs. PAT recognizes that changing circumstances require managers to have flexibility in choosing accounting policies. This brings forward the problem of “opportunistic behaviour”. This occurs when the actions of management are to better their own personal interests. With this in mind, the optimal set of accounting policies are described as a compromise between fixing accounting policies to minimize contract costs and providing flexibility in times of changing circumstances (considering the effects of opportunistic behaviour).

The Three Hypotheses of Positive Accounting Theory

Positive Accounting Theory has three hypotheses around which its predictions are organized.

1. Bonus plan hypothesis

The bonus plan hypothesis states that managers of firms with bonus plans will tend manipulate accounting method and figures to show the accounting performance better than it should be. By doing so, they can increase their bonuses for the current year.

2. Debt covenant hypothesis

The debt covenant hypothesis states that managers will tend to show better profits in the goal of having a better performance and liquidity position to pay the interest and principal of the debt they have built up in the business. By increasing current earnings, the company is less likely to violate debt covenants, and management has minimized its constraints in running the company.

3. Political cost hypothesis

The political cost hypothesis assumes that firms will tend to show their profits are lower by using different accounting methods and procedures so that the firm does not attract the attention of politicians, who will have an eye on high profit industries. High profitability can lead to increased political “heat”, and can lead to new taxes or regulations esp. for large firms which may be held to higher reporting standards.

How to Achieve Positive Accounting Theory

You can achieve positive accounting theory by changing accounting policies, Managing discretionary accruals. You can also achieve PAT by the timing of adoption of new accounting standards, Changing real variables--R&D, advertising, repairs & maintenance, SPEs (Enron), and try to capitalize operating expenses (WorldCom).