Positive accounting

In business and finance, positive accounting is a theory in accounting research that explains and predicts a firm's choice of accounting methods. The theory provides reasons as to why managers choose particular accounting practices and why managers may favor one technique over another. It also analyzes the costs and benefits of financial disclosures.

The underlying basis of positive accounting is that managers will make accounting decisions to maximize their own self-interest rather than the interests of shareholders and other principals. Three hypotheses describe the motives that managers use in selecting accounting methods: bonus-plan (or management compensation) hypothesis, debt-to-equity (or debt covenant) hypothesis, and political costs hypothesis.

Positive accounting can aid accountants when advising clients on financial decisions and financial reporting. It has come under criticism for not providing a means to improve the accounting methods themselves.

Background

The theory of positive accounting was developed by professors Ross Watts and Jerold Zimmerman. Their work, including joint papers in 1978 and 1979 and the 1986 book Positive Accounting Theory, shaped the school of research. Watts and Zimmerman set out to explain and predict accounting techniques without judging the value of firms' decisions.

Positive accounting theory differs from normative accounting theory. Normative accounting is prescriptive; it aims to determine what should be done. Positive accounting is empirical; it explains what is done and predicts what will be done.

Under positive accounting theory, a firm is a collection of all its contracts. The theory operates under the assumption that a firm runs efficiently to optimize its chances for success. Because the firm is efficient, it will strive to minimize contracting costs, such as those associated with negotiation, renegotiation, and monitoring. Therefore, the firm is expected to choose the accounting methods that will keep contracting costs at a minimum.

The efficient market hypothesis plays into positive accounting. The hypothesis suggests that the stock market does not react to new earnings information due to changes in accounting procedures. The hypothesis states that accounting policy changes will not fool the market if the information is disclosed in financial statements. Positive accounting can then be used to analyze relationships between accounting numbers and stock prices and returns.

Agency theory has been used to explain why managers voluntarily disclose and audit financial information. The theory focuses on the relationship between principals, the owners and shareholders of a firm, and the agents, which are the managers. According to professors Michael C. Jensen and William H. Meckling, agency theory is "a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf." Watts and Zimmerman said the concept of using audits to monitor the shareholder/manager relationship was called stewardship, and the term can be traced back to writings from the late nineteenth and early twentieth centuries. In modern times, owners may institute audits due to information asymmetry, when managers have more information than the firm's owners, and moral hazard, when management's decisions deviate from the owners' preferences. Managers will seek to keep monitoring costs down by submitting to audits.

Agency theory also helps explain why managers choose certain accounting procedures. If changes in accounting practices cannot fool the securities market, then managers must be swayed by other reasons. The prime one is their own self-interest.

Whether managers place their self-interest above that of the principals defines two perspectives key to positive accounting: efficiency and opportunism. This perspective gives rise to the three motives that influence managers' choices of accounting practices.

Overview

Under positive accounting, the selection of accounting policies is tied to prioritizing either management's best interests or the shareholders' best interests. The efficiency and opportunistic perspectives present contrasting approaches.

The efficiency perspective regards the viewpoint before a contract is negotiated. The efficiency perspective predicts managers will put the interest of the principals before their own, with an emphasis on raising the firm's value. Managers would be inclined to choose accounting methods that would reduce monitoring costs and maximize the firm's value.

The opportunistic perspective is the view held after a contract is reached and its mechanisms are in place. Under this perspective, managers are expected to put their own self-interest ahead of the principals' and choose practices that benefit themselves. This creates a divergence between shareholder goals and management objectives.

The three hypotheses that describe manager motivations for choosing accounting policies are bonus plan, debt to equity, and political costs.

Bonuses are often contingent upon meeting accounting numbers to indicate performance. In the bonus-plan (or management compensation) hypothesis, managers are motivated to change their accounting procedures to get higher bonuses. Management would opt for a short-term payout by altering the policies to increase profits in the current period.

Debt covenants are also conveyed through accounting numbers. In the debt-to-equity hypothesis, managers have incentives to select or change accounting practices that are close to violating restrictions in borrowing agreements. Managers are more likely to choose procedures that shift earnings to the current period.

Politicians and other regulators have access to reported accounting numbers and typically go after large, high-profit firms. This can invoke new taxes or regulations. In the political costs hypothesis, firms are inclined to select accounting methods that demonstrate lower profits to escape the attention of politicians and interest groups. Profits from the current period are deferred to a future one.

Positive accounting can be useful when accountants advise clients. When making financial decisions, clients can make predictions based on the explanations for why managers choose accounting practices. The theory considers the economic consequences on the managers, shareholders, and the firm itself.

The theory of positive accounting can also influence clients on when to disclose financial information. They can anticipate the effects on the market, possible regulations, and any political costs.

Positive accounting has garnered much criticism, however. Although the theory seeks to understand the decisions behind accounting practices, it does not attempt to improve them. Positive accounting does nothing to suggest how firms should go about attaining efficiency or best practices. Positive accounting claims to be devoid of value judgments, but that is not necessarily the case. Acting in one's self-interest and choosing policies result in assigning values to those decisions. Also, the generalizations of the positive accounting theory and its hypotheses may not apply to specific situations that arise at individual firms.

Positive accounting fills an empirical niche in accounting research to understand the reasons behind choosing accounting procedures and predicting management actions.

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