Positive Accounting Theory

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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.

• “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...
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