Positive Accounting Theory: Theoretical Perspectives on Accounting

Policy Choice

Shabrina Tri Asti Nasution

, Rizqy Fadhlina Putri

, Iskandar Muda

and Syafruddin Ginting

Student Postgraduate,Faculty of Economics and Business, Universitas Sumatera Utara, Medan –Indonesia

Lecture Faculty of Economics and Business, Universitas Sumatera Utara, Medan -Indonesia

Keywords: Positive Accounting Theory, Accounting Policy Choice

Abstract: This article reviews the positive accounting theory and its relation to accounting policy choice and identify

its broad contribution to the accounting research. By using literature reviews, there are researches that

discussing how management influenced by positive accounting theory before their decision of certain

accounting policy. The view from positive accounting theory that it can predict management’s choices

regarding accounting policies to maximizes their own best interests. The choices that firm makes are related

on what industry the firms are in, and the factors within that industry. Although three hypotheses from

positive accounting theory such as the bonus plan, the debt covenant and the political cost, has been

subjected to numerous criticism from different perspectives, positive accounting theory will continue to be

part of empirical research nowaday and the basic questions that related to accounting positive theory are still

relevant today.

1 INTRODUCTION

As a theory, a scientific accounting theory should be

able to explain the actual choices of accounting

standards. (Watts and Zimmerman, 1979)

stated the beginning of a positive theory of

accounting by exploring those factors influencing

management's attitudes on accounting standards that

are likely to affect a firm's cashflows and in turn are

affected by accounting standards. These factors are

taxes, regulation, management compensation plans,

bookkeeping costs and political costs, and they are

combined into a model that predicts that large firms

that experience reduced earnings due to changed

accounting standards favor the change. This theory

become generally known as positive accounting

theory (Watts and Zimmerman, 1986).

Positive accounting theory has been subject to

heated debate. (Zimmerman, 2001) said that a

unifying theory should emerge, but as a mater of

course it should be based on economics. (Ittner and

Larcker, 2002) address Zimmerman's criticisms that

managerial accounting studies are purely

descriptive, conducted without an underlying theory,

and unguided by research hypotheses. They also

discuss their views regarding the importance of

practice-orientated research for understanding

managerial accounting choices and for testing

economic and non-economic theories. (Hopwood,

2002), responded by said, although having some

sympathies with Zimmerman’s critique of Ittner and

Larcker’s review of the empirical management

accounting research literature, his analysis points out

how Zimmerman has too easily allowed his own

prejudices to influence both his assessment of the

empirical management accounting literature and his

recommendations for improvement. (Lukka and

Mouritsen, 2002), viewing Zimmerman’s accepting

the rule of a monolithic economics-based paradigm

would limit our abilities to develop a critical stance,

and threatens the ability ofmanagement accounting

research community for good scientific conversation

and progress. Hence, in contrast to Zimmerman,

they argue for remaining open for heterogeneity in

management accounting research.

It can be seen that the birth of positive

accounting theory has led to contradictions among

experts. This article discusses, that based on

literature studies, it is important to it is important to

understand positive accounting theory as part of part

1128

Nasution, S., Putri, R., Muda, I. and Ginting, S.

Positive Accounting Theory: Theoretical Perspectives on Accounting Policy Choice.

DOI: 10.5220/0009506011281133

In Proceedings of the 1st Unimed International Conference on Economics Education and Social Science (UNICEES 2018), pages 1128-1133

ISBN: 978-989-758-432-9

of empirical research nowaday and its relation to

accounting policy choice.

2 THEORICAL FRAMEWORK

Positive accounting theory in principle assumes that

the purpose of accounting theory is to explain and

predict accounting practices. Positive accounting

theory seeks to explain a process, which uses the

ability, understanding and knowledge of accounting

and the use of accounting policies that are most

suitable for dealing with certain conditions in the

future.

The development of positive theory cannot be

separated from dissatisfaction with normative theory

(Watts and Zimmerman, 1986). Furthermore it was

stated that the reason for analyzing accounting

theory in a normative approach were too simple and

did not provide a strong theoretical basis. \

There are three fundamental reasons for the

shifting of the normative to positive approach,

namely (Watts and Zimmerman, 1986) : The

inability of the normative approach to test theory

empirically, because it is based on premise or false

assumptions so that the validity cannot be tested

empirically. The normative approach focuses more

on the prosperity of individual investors than the

prosperity of the wider community. The normative

approach does not encourage or allow the optimal

allocation of economic resources in the capital

market. It is given that in an economic system based

on market mechanisms, accounting information can

be a controlling tool for the community in allocating

economic resources efficiently.

Furthermore, (Watts and Zimmerman,

1986)stated that the rationale for analyzing

accounting theory in a normative approach was too

simple and did not provide a strong theoretical basis.

To reduce the gap in the normative approach, Watts

and Zimmerman developed a positive approach that

was more oriented towards empirical research and

justified various accounting techniques or methods

that are now used or looking for new models for the

development of accounting theory in the future.

There are three hypotheses of Positive

Accounting Theory. Predictions made by Positive

Accounting Theory are widely organized on three

hypotheses formulated by Watts and Zimmerman

(Watts and Zimmerman, 1986). These three

hypotheses are intheir opportunistic form, because

according to Watts and Zimmerman (Watts and

Zimmerman, 1990), this is the method most often

used when they are interpreted:

Bonus Plan Hypothesis

In this hypothesis, all other things in a fixed state,

company managers with bonus plans tend to choose

accounting procedures with changes in reported

earnings from the future period to the present period

This hypothesis seems reasonable. Corporate

managers, like others, want high returns. If their

compensation depends, at least in part, on bonuses

reported on net income, then it is likely that they can

increase their bonus in that period by reporting as

high net income as possible. One way to do this is to

choose an accounting policy that increases reported

profits during that period. Of course, according to

the character of the accrual process, this will tend to

cause a decrease in profits and bonuses reported in

the future, with other factors remaining the same.

However, the present value of the usefulness of the

manager from the line of his future bonuses will

increase by giving changes to the present.

Debt Contract Hypothesis

In this hypothesis, all other things are in a fixed

state, the closer a company is to a violation of

accounting based on a debt agreement, the tendency

is the more likely the company manager chooses

accounting procedures with changes in reported

earnings from the future period to the present period.

The reason is that the reported profits that are

increasing will reduce technical negligence. Most of

the debt agreements agree that the lender must meet

during the agreement period. For example, a

company that gets a loan may agree to maintain a

certain level of debt to assets, interest reports,

working capital, and assets of shareholders. If such

an agreement is betrayed, the debt agreement can

provide / issue a penalty, such as limiting dividends

or additional loans. Clearly, the prospect of violating

the agreement limits the company's activities in the

operations of the company itself. To prevent, or at

least delay, such violations, companies can choose

certain accounting policies that can increase current

profits. Based on the hypothesis the debt agreement,

when the company approaches negligence, or is

already in default / defective, is more likely to do

this.

Political Cost Hypothesis

In this hypothesis all other things are in a fixed state,

the greater the political costs that must be borne by

the company, managers tend to prefer accounting

procedures that give up on reported earnings from

the present to the future. The political cost

hypothesis introduces a political dimension to the

selection of accounting policies. Companies of very

Positive Accounting Theory: Theoretical Perspectives on Accounting Policy Choice

1129

large size may be subject to higher standards of

performance, with respect for environmental

responsibility, simply because they feel that they are

big and powerful. If large companies also have the

ability to gain high profits, then political costs can

be increased. Companies may also face political

costs at certain points of time. Foreign competition

may lead to a decline in profitability unless the

affected companies can influence the political

process in order to protect imports as a whole. One

way to do this is to adopt income-decreasing

accounting policies (decreasing income) in order to

convince the government that profits are falling.

The different approaches and the basis of

accounting theory cause two accounting perspectives

: positive accounting theory approaches produce

perspectives of accounting as science. While the

normative accounting theory approach produces

perspective of accounting as an art. Which both are

equally recognized as a means of accounting theory

approach.

Normative Accounting Theory in the form of

General Acceptable Accounting Practices is a

theoretical reference in providing the best way to

predict various accounting phenomena and

illustrates how the interaction between accounting

variables in the real world is a function of the

Positive Accounting Theory approach. It does not

rule out the possibility that facts in the real world

(accounting practices) will influence Normative

Accounting Theory.

After we understand positive accounting theory,

the question arises, "what underlies many

researchers criticize positive accounting theory?".

This article tries to answer this question by using a

comparison of reviews from previous literatures.

3 RESEARCH METHOD

This article uses literature reviews to identify gaps in

the literatures about positive accounting theory and

its relation to accounting policy choice and identify

its broad contribution to the accounting research.

4 ANALYSIS AND RESULTS

At the beginning of its development, accounting

theory produced a normative theory which was

defined as a theory that requires and uses value

policy that contains a minimum of a premise.

Normative theory at first did not use a formal

investigative approach, only in later developments

began the use of a formal structured investigative

approach, namely a deductive approach (starting

from basic accounting propositions to rational

accounting principles), as a basis for developing

accounting techniques. In addition, accounting

developments also leads to positive or descriptive

accounting theory whose investigation is more

structured using an inductive approach (based on

conclusions that are generalized based on). Detailed

observation and measurement results. Various

positive or descriptive theories develop rapidly in

accounting. Theoretical developments lead to

positive theory (descriptive). This is accompanied by

changes in the focus of accounting theory used by

accounting institutions, for example FASB, which

emphasizes usability in decision making and is no

longer focused on postulate.

Accounting theory is sometimes confused with

normative and positive terms. Watts and

Zimmerman (Watts and Zimmerman, 1986) explain

normative theory as follows: normative theory seeks

to explain what information should be

communicated to users of accounting information

and how the accounting will be presented. So

normative theory tries to explain what accountants

should do in the process of presenting financial

information to users rather than explaining what

financial information is and why it occurs.

Normative theory is often called a priori theory

(from cause to effect and deductive). Normative

theory is not generated from empirical research but

is generated from semi research activities.

The development of positive accounting theory

cannot be separated from dissatisfaction with

normative theory (Watts and Zimmerman, 1986).

Furthermore it was stated that the rationale for

analyzing accounting theory in a normative

approach was too simple and did not provide a

strong theoretical basis. There are three fundamental

reasons for the shifting of the normative to positive

approach, namely: 1. The inability of the normative

approach to test the theory empirically, because it is

based on the premise or wrong assumption so that its

validity cannot be tested empirically. 2. The

normative approach focuses more on the prosperity

of individual investors than the prosperity of the

wider community. 3. The normative approach does

not encourage or allow the optimal allocation of

economic resources in the capital market. This is

considering that in an economic system based on

market mechanisms, accounting information can be

a controlling tool for the community in efficiently

allocating economic resources.

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(BOLAND and GORDON, 1992) said that one

theoretical approach emphasized in the accounting

literature is positive accounting theory. Synonymous

with this theoretical view are the 1978 and 1979

articles published by Ross Watts and Jerold

Zimmerman. These two articles prompted criticism

from three different perspectives. There are critiques

that refer to technical research methods problems,

critiques concerned with philosophy of science

issues, and critiques centered on the limitations of

economics-based accounting research. In their 1990

article, Watts and Zimmerman responded to most of

the published critiques. They specifically claimed

that methodological criticisms have failed to have

any influence on accounting research. In theur

article, Boland and Gordon provides a critical

examination and assessment of these alleged failures

by examining two types of critiques, economics-

based critiques and those based on issues of the

philosophy of science. The critiques discussed

include those to which Watts and Zimmerman

responded as well as several other critiques that

either Watts and Zimmerman failed to discuss or

that were not published until after their 1990 article

appeared. Positive accounting theory is shown to be

applied economic positivism. Tracing the historical

background of positive accounting research through

its economic roots shows that the "positive" aspect

of the Watts and Zimmerman approach is more

rhetoric than methodology.

Besides opinions from (Ittner and Larcker,

2002), (Hopwood, 2002) and (Lukka and Mouritsen,

2002), there are still other researchers who disagree

with (Watts and Zimmerman, 1986). (Kabir, 2007)

examines the development of positive accounting

theory. He said that Positive Accounting Theory has

been one of the most influential accounting research

programs during the last four decades. One

important reason which (Watts and Zimmerman,

1986) have used to popularize and legitimize their

approach is that their view of accounting theory is

the same as that used in science. Thus, it is

important to examine how far accounting has been

successful in imitating natural science and how the

development of Positive Accounting Theory. The

paper shows that accounting could not emulate the

success of natural science. Further, the

methodological positions of Positive Accounting

Theory conform to none of the standard accounts of

science. Rather, Positive Accounting Theory

contains elements of all three. Finally, this paper

identifies some methodological gaps in Positive

Accounting Theory.

In other side, (Christie, 1990) noted that more

powerful tests of a theory of choice of accounting

methods and the effect of changes in these choices

on equity values are provided. The power increase

comes from efficiently aggregating results across

studies. One conclusion is that at least six variables

common to more than one study have explanatory

power. These variables are managerial

compensation, leverage, size, risk, and constraints

on interest coverage and dividends. Another

conclusion is that the posterior probability that the

theory taken as a whole has explanatory power is

close to one. This conclusion includes the effect of

variables that only appear in one study. This clearly

supports positive eccounting theory.

(Lev and Sunder, 1979) also support positive

accounting theory. It appears that the extensive use

of financial ratios by both practitioners and

researchers is often motivated by tradition and

convenience rather than resulting from theoretical

considerations or from a careful statistical analysis.

Basic questions, such as: Is the control for firm size,

a major objective of the ratio form, called for by the

theory examined; what is the structural relationship

between the examined variables and size; and what

is the optimal way to control for industry-wide

factors, are rarely addressed by users of financial

ratios. The major purpose of their research is to

discuss the conditions under which conventional

tools, such as financial ratios and measures of

industry central tendency, achieve the intended

objectives of analysis (e.g., size control).

(Healy, 1985) did a research examining

managerial accounting decisions postulate that

executives rewarded by earnings-based bonuses

select accounting procedures that increase their

compensation. His test results suggest that (1)

accrual policies of managers are related to income-

reporting incentives of their bonus contracts, and (2)

changes in accounting procedures by managers are

associated with adoption or modification of their

bonus plan.

The main purpose of positive accounting theory

as described earlier is being able to explain and

predict accounting practices, associated with

individual behavior in choosing accounting methods

that can maximize their utility. To be able to

understand the interests of management in financial

reporting, it is necessary to appreciate the concept of

economic consequences (Scoot, 2009). Positive

accounting theory tries to understand and predict a

company's accounting policy choices. In general, the

assessment of accounting policies to be chosen is

aimed at minimizing the cost of capital and other

contract costs. Accounting policies are generally

determined by the organizational structure of the

Positive Accounting Theory: Theoretical Perspectives on Accounting Policy Choice

1131

company, which is influenced by the environment in

which the company is located. Thus the choice of

accounting method to be used is part of the entire

process of corporate governance.

Positive accounting theory does not directly

determine the choice of accounting policies that are

appropriate for the company. In this case, the

selection of accounting policies will be easier if

viewed from the management side. Because

management has the flexibility to choose accounting

policies for its companies, this indicates flexibility

also for management to respond to changes that

occur in the corporate environment, such as the

existence of new accounting standards. The financial

accounting standards were originally made by the

standard board in each country, as a result the

accounting standards between one country and

another country are very different. But with

globalization and because of differences in the

environment, legal, social, political, and economic

conditions between countries, international

accounting emerged, which tried to describe

accounting theories and practices that apply

internationally. This has caused some changes

related to the accounting method that management

can choose. As an illustration, International

Accounting Standard Board (IASB) establishes fair

value as a basis for measuring assets and liabilities.

Fair value is the price that will be received in the

sale of an asset or payment to transfer liabilities in a

structured transaction between participants in the

market and the date of measurement. There are 3

hierarchies in estimating fair value, that is by using

market value, comparison with market prices of

items that can be compared with items assessed, and

using estimates. But the weakness of the fair value is

not based on historical evidence, so that it raises

subjective implications. The use of fair value on

depreciated fixed assets can have no small economic

consequences. This can occur when a fixed asset is

revalued, which shows market value that is higher

than its historical cost. As a result, the value of the

company's assets increases and the meaning must be

balanced with an increase in the debt side. Besides

that, it also has an impact on the company's income

statement, which later leads to taxes that must be

paid by the company. The emergence of new

accounting standards requires managers to be able to

understand it well and be able to choose accounting

methods that provide prosperity for shareholders.

5 CONCLUSIONS

The presence of positive accounting theory has

contributed significantly development of accounting,

which is to produce systematic patterns in

accounting choices and provide a specific

explanation for the pattern, providing a framework

clear in understanding accounting, shows the main

role of contracting cost in theory accounting,

explains why accounting is used and provides an

internal framework predict accounting choices,

encourage relevant research where accounting

emphasizes predictions and explanations for

accounting phenomena.

Criticism of positive accounting theory is a

discourse that actually can provide accounting

scientific contributions. Criticism arises because of

the frame of mind Watts and Zimmerman are more

motivated by the existence of pragmatism utility of

knowledge accounting research, where the size used

is determined according to contribution the result,

positive accounting theory can provide direct

benefits in the form of the ability to explain and

predict the associated accounting practices with

individual behavior in maximizing its utility.

Positive accounting theory will always be a part

of accounting researchs and one of a base of

management’s choices regarding accounting policies

to maximizes their own best interests

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