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Positive Accounting Theory (PAT)

Positive Accounting Theory tries to make good predictions of real world events and translate them to accounting transactions. While normative theories tend to recommend what should be done, Positive Theories try to explain and predict

o Actions such as which accounting policies firms will choose
o How firms will react to newly proposed accounting standards

• Its overall intention is to understand and predict the choice of accounting policies across differing firms. It recognizes that economic consequences exist.

• Under PAT, firms want to maximize their prospects for survival, so they organize themselves efficiently.

• Firms are viewed as the accumulation of the contracts they have entered into.

• In relation to PAT, because there is a need to be efficient, the firm will want to minimize costs associated with contracts. Examples of contract costs are negotiation, renegotiation, and monitoring costs. Contract costs involve accounting variables as contracts can be stipulated in terms of accounting information such as net income, and financial ratios.

• The firm will choose the accounting policies that best acknowledge the need for minimization of contract costs.

• PAT recognizes that changing circumstances require managers to have flexibility in choosing accounting policies.

• This brings forward the problem of “opportunistic behavior”. This occurs when the actions of management are to better their own personal interests.

• With this in mind, the optimal set of accounting policies are described as a compromise between fixing accounting policies to minimize contract costs and providing flexibility in times of changing circumstances (considering the effects of opportunistic behavior).

The Three Hypotheses of Positive Accounting Theory

Positive Accounting Theory has three hypotheses around which its predictions are organized.

1. Bonus plan hypothesis

• Managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period. By doing so, they can increase their bonuses for the current year.

2. Debt covenant hypothesis

• The closer a firm is to violating accounting-based debt covenants, the more likely the firm manager is to select accounting procedures that shift reported earnings from future periods to the current period.

• By increasing current earnings, the company is less likely to violate debt covenants, and management has minimized its constraints in running the company

3. Political cost hypothesis

• The greater the political costs faced by the firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods.

• High profitability can lead to increased political “heat”, and can lead to new taxes or regulations esp. for large firms which may be held to higher reporting standards

How to Achieve Positive Accounting Theory

• Changing accounting policies
• Managing discretionary accruals
• Timing of adoption of new accounting standards
• Changing real variables--R&D, advertising, repairs & maintenance
• SPEs (Enron), capitalize operating expenses (WorldCom)

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