Debt hypothesis assumes that the higher the firm’s debt/equity ratio, the more likely managers are to use accounting methods to increase reported income because they try to avoid violating their debt covenants.
The third hypothesis put forward by Positive Accounting theorists is the political cost hypothesis. This hypothesis states that the managers of the large companies, unlike small organisations, may actually choose accounting methods that reduce their reported income. It is argued that large firms are subject to much higher political scrutiny. High reported profits may result in accusations of exploiting other parties, increased taxes and wages claims and even product boycotts so the companies tend to take measures in order to avoid that.
There are many positive factors associated with Positive Accounting Theory. It seeks to predict and explain particular phenomena which occur in accounting. PAT assists in giving an understanding of why different firms choose different accounting policies, why some managers may object to changes in these policies and why investors may react to the potential impact of an accounting policy change. PAT provided explanations for these patterns by using agency theory and efficient market hypothesis.
Agency theory concentrates on the relationship between principals and agents and accepted existence of contracting and information cost which Ball and Brown (1968) through their research were relaying on efficient market hypothesis assumed there were no such costs. That is why they, along with other researchers, struggle to explain why a particular accounting method might have been selected by managers. PAT was developed to solve that problem. It also highlighted the central role of contracting costs in accounting. These contracting costs can be explained as the sum of monitoring costs, bonding costs and residual loss.
More recent research in the field of PAT has led to using contracting costs in explaining accounting costs. These costs contribute to explaining institutional differences such as open and closed end mutual funds which cannot be explained by pricing models such as capital asset pricing model and option pricing model. The central role of contracting costs highlighted by PAT makes it more difficult to ignore these costs in future accounting research (Watts and Zimmerman, 1990, p.151). It helped other researchers to not ignore this underlying issue in future research.
On the other hand, the most concerning weakness of Positive Accounting Theory is that it does not provide prescription and so does not provide a means of improving accounting practice by limiting its focus to explaining and predicting accounting practice.
Secondly, it is not value free as it asserts. However, no research can really be value free.
The third weakness of PAT relates to the fundamental assumption that all action is driven by a desire to maximise one’s wealth. It is argued to be too negative and simplistic a perspective of humankind. Gray et al. in 1996 state that PAT promotes ‘a morally bankrupt view of the world’.
A further negative aspect of PAT is that since its general inception in the 1970s the issues being addressed have not shown great development. Watts and Zimmerman’s three key hypotheses (1978) which are the debt hypothesis, the bonus hypothesis and the political cost hypothesis continue to be tested in different environments and in relation to different accounting policy issues even after the passing of almost 30 years.
Finally, it is important to note that researchers ignore organisational-specific relationships in undertaking large-scale empirical research. PAT researchers typically undertake their research by collecting a large number of observations of data emanating from different reporting entities. They ignore many underlying differences in organisations and assume that their unit of measurement provides an accurate reflection of the issue under investigation. Considering one accounting method choice from the portfolio of all the accounting choices being made within the firm provides a very incomplete picture.
To conclude, there have been numerous criticisms made on Watts and Zimmerman’s positive theory of accounting such as Gray et al (1995), Whittington (1987) and Tinker et al (1982). Included among the various criticisms was a challenge to the central PAT assumption that all individual action is driven by self-interest. However, their theory has had a significant impact on the development of accounting theories and does continue to be used by many accounting researchers. It is important to point out at this point that all theories of accounting will have certain limitations. Our choice of which theory we prefer will generally depend on our own assumptions.
While some would argue that a general theory is not necessary at all I believe there is a need for a theory. However, I do not believe that it can cover every single issue, so a ‘common sense’ approach is needed to be taken in some cases. Accounting is a social science, and so accountants are not machines. The general theory should form the basis to make informed decisions, on the presentation of financial accounts.
REFERENCES
Jensen, M. C. & Meckling, W.H. (1976) Theory of the firm: Managerial behaviour, agency costs and ownership structure, Journal of Financial Economics, 3 (October), pp.305-60
Ball, R. and Brown P., (1965), An empirical evaluation of accounting numbers, Journal of Accounting Research, Vol. 6, pp. 159-178.
Watts R.L and Zimmerman J.L., (1990), Positive Accounting Theory: A Ten Year Perspective, The Accounting Review, Vol. 65, No. 1, pp. 131-156
Deegan, C. & Unerman, G., (2006), Financial Accounting Theory (European Edition), McGraw-Hill.
