Flaws Of Positive Accounting Theory The Premises example essay topic

Introduction Positive accounting theory (PAT) is a general term for any theory that provides descriptive information regarding the behavior of accountants. The title has been used by Watts and Zimmerman and this is largely an expansion of previous studies carried out firstly by Fama and later by Ball & Brown in the 1960's. In looking at the apparent acceptance by politicians, firms and wide publication in academic journals PAT could easily be mistaken as being a success. A deeper analysis of the premises of PAT, its questionable scientific status, and the groups upon whom this theory has appealed to would suggest that it is flawed on many levels and is little more than an argument for deregulation and market capitalism. This opposes its claim to be a useful theory used regularly by those concerned with the effects of accounting policy on the status of the firm. The Premises of Positive Accounting Theory.

Positive Accounting Theory finds its roots with the Efficient Market Hypothesis (EMH). The EMH was developed by Fama in the 1960's and is based on economic principles and assumes a perfect market where there is information symmetry and no transaction costs. The semi strong form of EMH argues that capital markets will reflect all information that is publicly available and it is this form that Watts and Zimmerman claim to be predominant. The EMH was used in a study performed by Ball and Brown during the same period.

The Ball and Brown study rejected the argument put forward by normative theorists that present accounting results were misleading and irrelevant and stated that historical cost accounting is actually useful (Deegan 2000). This was because their study demonstrated that unexpected accounting earnings produced abnormal returns in capital markets. This was also the case for unexpected poor earnings as they produced abnormal losses in capital markets. This was measured using the Capital Assets Pricing Model (CAPM). Watts and Zimmerman used this research in developing PAT to illustrate that because there was a reaction in capital markets when accounting information showing abnormal results was released this information was useful and those who wanted to change the present system of measurement failed to appreciate the incumbents usefulness. They claimed that capital markets could see through changes in accounting policy and see the bigger picture of firms, therefore rendering them impervious to misleading accounting methods (Watts & Zimmerman 1986).

This was then used to form and anti regulatory stance. As capital markets could 'see through' the accounting methods being used, regulation was considered little more than an inefficiency that interfered with the function of free markets and was costly to firms. These firms could determine the best ways to report for themselves and it is believed under this theory that auditing will also occur without regulation because users of information will demand audited information so as to give it some value (Mouck 1992). The question still existed however, that if managers didn't change accounting methods in order to affect share prices then why did they do it? This is the question that Watts and Zimmerman attempted to answer and this was done with assistance from the concept of 'agency theory'. Agency is defined as "A contract under which one or more (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent" - Jensen & Meckling (1976, p. 308) This means (in a nutshell) that firms are a nexus where various self motivated utility maximizes met to generate as much wealth as possible for their own selfish selves.

This means that the owners of firms must align their goals with those of the 'drivers' of firms in order to minimize the associated costs of the separation of ownership and management (e.g. laziness). This will mean tying bonuses to goal achievement and this then produces the need for accounting information with which to measure goal achievement. It is from this theory that the three main parts of Watts and Zimmerman's PAT come into existence; the debt hypothesis, the political cost hypothesis and the bonus plan hypothesis. For example, the bonus plan hypothesis states that management will change their accounting policies (to the extent that is reasonably allowed) in order to maximize reported income if their bonuses are dependant on the level of reported income due to their self interest. This notion of self interest can also be applied to the other PAT hypothesis put forward by Watts and Zimmerman.

Therefore, the premises of Positive Accounting Theory can be summarized as: empiricism and scientific research; the economic theory of perfect markets, The Efficient Market Hypothesis, (which is reliant upon the above economic theory) and agency theory and its arguments of self interested agents. The broader new age conservative / anti regulation ideology could also be said to be a premise for PAT (although not an overt one). The Flaws of Positive Accounting Theory - The premises. The Flaws of Perfect Markets. The first flaw that can be found with a premise of PAT is that of economics and its reliance on the theoretical perfect market.

A perfect market relies on (amongst other things) perfect information and no transaction costs. This point of view finds problems because "accounting exists because of transaction costs" (Boland & Gordon 1992). It is also difficult to imagine equilibrium for information when accounting information contributes to this equilibrium. Watts and Zimmerman also say that regulation and political costs interfere with the operation of perfect markets. In saying this they are effectively conceding that perfect markets do not exist as they call for the removal of regulation to assist in the more efficient allocation of resources (Boland & Gordon 1992). The Flaws of Efficient Market Hypothesis.

This lack of perfect markets then calls into question the EMH as it is upon perfect markets that it finds its basis (Deegan 2000). Defenders of the EMH will argue that there is empirical evidence to back up this perspective; however an analysis performed by Chambers in 1992 demonstrated that the Ball and Brown research on the EMH relied on some rather superficial evidence. Chambers tells of how only a very small number of shares were ever traded after the release of information and the evidence did not include collapsed companies. It is also pointed out that capital market reactions to accounting information were not a new discovery and that researchers had known of it for some time. Another question about the EMH regards the assumption by Ball and Brown that because historical cost information is 'used' it is then instantly transformed into being useful. The 'uselessness' of historical cost information is something that theorists such as Chambers had taken as a given during the normative period of research and as nothing substantial had changed in accounting policy during the period there seems little reason to change that point of view.

Plausible explanations (for example), that much investment is done in an ad hoc manner also find no place with in the EMH framework. Essentially the EMH and the premise of PAT that historical cost information is useful and the system does not need additional regulation are questionable (and perhaps somewhat dogmatic). The Flaws of Agency Theory. The EMH argues effectively that markets can see through accounting methods, but it doesn't explain why accountants change their reporting methods from time to time. This is why Watts and Zimmerman have called upon another theory with which to support their work.

Agency theory uses examples of self-interested people who don't act out of good will. This theory has been criticised as being dehumanizing (Godfrey, Hodgson & Holmes 2000) as being "unobservable" (Chambers 1992) and referring to phenomena that could be explained in another way. For example, agency theory describes political interference in accounting as being the way self interested politicians can gain popularity - by acting on the wants of minority groups. Politicians acting in the public interest could also explain the same occurrence just as effectively (Mouck 1992).

There are further PAT studies that look to notions besides that of self-interest and look at efficiency; however Watts and Zimmerman have not been a part of this. Above all, agency theory is hard to swallow on the basis that people are self-interested. If such a notion were true then it would be logical to introduce more legislation, not less. The Flawed argument that PAT is scientific and empirically based. Watts and Zimmerman have claimed that normative theories were not effective and are not to be respected because they did not base themselves on scientific or empirical research (Godfrey et al. 2000).

This argument however is flawed on numerous levels. Although Watts and Zimmerman spend a lot of time discussing their empirical basis for their theory, the actual results are not particularly firm. Mouck (1992) has stated that their basis is more of rhetoric than science and that for two researchers who spend so much time describing the benefits of empiricism the results are somewhat disappointing. Watts and Zimmerman's only counter to the small amount of empirical evidence supporting PAT is "Methodology criticisms have failed the market test because they have little influence on accounting research" - Watts and Zimmerman (1990, p. 149) It will be discussed later as to why the level of research as a basis for judging a theory is spurious when claiming success. Other arguments of the 'flawed's scientific nature of PAT come from the presumption by Watts and Zimmerman that they are objective observers of an identifiable reality, are therefore free of value judgements and are able to conduct their research within a vacuum. This point of view seems contradictory because one of the premises of PAT - agency theory - is heavily reliant on the value judgement that people are self-interested.

Watts and Zimmerman also claim "The objective of accounting theory is to explain and predict accounting practice" (1986, p. 2). This statement is a very much value judgment that leads us to think their claim to objectivity is something of a myth (Deegan 2000). PAT can not be judged as being successful on the basis of its premises. They all have deficiencies in at least one respect and when put together to form PAT they produce a theory that bears little resemblance to anything that can be applied to actual situations. The only respect in which PAT has been successful has been in the area of publication and research and the reasons for this lie more with ideology than merit. Positions put forward by others regarding the success of PAT.

A normative theorists' position on PAT- Chambers. The premises of PAT are not the only things that have been criticized by competing researchers. Differences in ideology and research beliefs have also contributed to the debate as to its success. Chambers, whose research came to prominence during the normative period of the 1960's questioned the usefulness of scientific or empirical research. He was quoted as saying that PAT has "set the research agenda back 20 years".

It was stated that PAT doesn't improve present methods or lead us to improved techniques. It is a given fact that the present historical cost basis for measurement of assets is problematic due to a lack of 'additivity', yet PAT ignores these problems. In effect, it justifies the problems of the generally accepted accounting principles (GAAP) without ever trying to fix them and this in itself is not satisfactory (Chambers 1993). While the Chambers is criticizing from a different paradigm his arguments are still valid. PAT leaves its readers with something of an empty feeling as there no prescription other than to behave in ones own self interest. This in itself is a danger because research claiming people act in a self interested manner could potentially encourage such behavior (Deegan 2000).

The Lack of Development of PAT. When Positive Accounting Theory was first developed in the 1970's it relied upon three hypotheses, the debt hypothesis, the bonus plan hypothesis and the political cost hypothesis. Since this period however there have been no additions to these three, nor has there been any development or expansion of them. Although much research has been performed throughout the 1980-90's PAT has remained stagnant in its development and this has perhaps led to the present decline in interest in PAT (Deegan 2000). Sterling (1990, p. 130) has argued that PAT doesn't have any potential for future development and that it will continue indefinitely in its present form without any new ideas. This lack of development and PATs recent decline in research are firm arguments that PAT will be deemed a failure in the light of hindsight.

Critical theory and the popularity of PAT. Positive Accounting Theory has been the predominant research paradigm of the 1980's and 1990's however upon reading PAT this becomes something of a curious phenomenon (Mouck 1992). Watts and Zimmerman would claim this 'success' is due to its scientific or empirical basis however the evidence of this is threadbare at best and rhetoric is the main instrument used in getting PATs message across. This leads us to examine other reasons for PATs popularity.

The positive / empirical paradigm became popular around the same time that new age conservative governments were elected in the USA and the UK. A connection can therefore be made between the rise of governments ruled by ideologies based around deregulation and 'small government' and an accounting theory that argues the same point. It is also plausible that universities in the USA that benefit from corporate funding were conducting accounting research as a tool to promote the deregulation argument that forms the foundation of Positive Accounting Theory. This means that the apparent success of PAT in the 'research market' has little to do with the merits or applicability of PAT, and much more to do with its ideological arguments that preserve the power of those who presently hold capital (Deegan 2000).

Those who stand to reap the benefits of a deregulated government have in effect 'captured' the accounting research movement so as to glorify and justify their position. Conclusion. Watts and Zimmerman will claim that PAT is a success because it has dominated accounting research and publication and because it is scientific. These claims are false on one hand because the amount of publication it has received is due its popularity with the right-wing deregulatory ideology and on the other because far from being scientific PAT is actually based on large amounts of rhetoric used as a veil to conceal its poor ability to predict behavior that has been reflected in its empirical results.

The flow of PAT from its economic roots through the EMH and agency theory appears to be logical upon first inspection; however given greater scrutiny the premises of PAT have themselves been shown to be of questionable reliability. This leads to the conclusion that far from being a success, PAT is simply a mish mash of other theories that has been used as vehicle to promote the free market ideology that has dominated the political and research program. Recently PAT has been running out momentum in terms of publication and this is perhaps evidence that PAT was a fad that has had its time and has now been shelved in favor of more pragmatic and useful research opportunities.

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