Analysis of Positive Accounting Theory and Current Issues in Finance

This report analyzes the implications of Positive Accounting Theory (PAT), focusing on a journal article examining its hypotheses. The study reviews the opportunistic approach within PAT, particularly concerning corporate social disclosures and the influence of political costs. It explores the limitations of PAT in explaining voluntary social disclosures and examines the role of managers in utilizing accounting systems for personal gain. The report delves into the three main hypotheses of PAT: the bonus plan, debt covenants, and political costs hypotheses, and their impacts on accounting practices. The case study examines a Brazilian oil and gas company to assess how its accounting choices align with PAT. The report discusses the contributions of Watts and Zimmerman, the founders of PAT, and their views on earnings management and efficient contracting. The implications of PAT are discussed, including its ability to predict and interpret accounting transactions and its impact on managerial choices. The conclusion highlights that in the absence of opportunistic approaches, PAT may not contribute to accounting choices, however, companies do use social disclosures in financial reports.

Accounting Theory and Current Issues
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Author Note

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Introduction
Accounting theories that govern the fundamental principles of accounting are constantly
being modified and evolved in order to enhance the suitability and adoptability of the accounting
principles in relation to the global standards. The topic that has been chosen for the purpose of
the study is that a journal article that depicts the implications of the positive accounting theories
hypotheses. The particular journal article that has been chosen for the purpose of the study is the
“The opportunistic approach of the Positive Accounting theory fails to explain a case study: An
anomalous situation?” by Adolfo Henrique Coutinho e Silva, Moacir Sancovschi and Ariane
Gabriela Chagas dos Santos
The journal article reviews particular literature that seeks to establish evidence that
supports the positive accounting theory of corporate social disclosures. In this particular article
focus has been put upon the Watts and Zimmerman’s reference to social responsibility.
Furthermore, the high degree of revenue that have been displayed by the organizations to
decrease and the unprecedented rise in the political costs make the disclosures related to social
theories, confusing. This particular study also lists the potential problems that are reflected by the
companies while adopting the positive accounting theory (Williams 2014).
Case Study Analysis
There have been numerous accounting theories in use like the legitimacy theory,
stakeholder theory and the critical or political economic theory. Along with these traditional
theories, the new accounting theory that has come up in the new age, political accounting theory
or the political cost hypothesis that effectively justifies the voluntary social disclosures. The
article depends on the studies conducted by Watts and Zimmerman and other related literature.
There have been enough literature supporting the fact that the positive accounting theories are
not about how a social report should be but the what a social report is. It has been argued by the
experts that the positive accounting theories contribute in no way for the improvement of social
reporting based on the corporate standards (Li 2015).
The view that has been proposed in the journal has been that the managers in an
organization make use of the accounting systems for performing the opportunistic voluntary

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changes in the accounting practices for affecting the external contracts or maximizing their own
compensations. The Positive Accounting Hypothesis explains the opportunistic accounting
choices without taking into consideration that the estimations in regards to this theory (McLellan
2014). The three major hypotheses of this theory are as follows:
 Bonus Plan Hypothesis
 Debt Covenants Hypothesis
 Response to the regulatory constraints or political costs
Other experts argue that the justification in relation to as to why companies provide
voluntary disclosures in the financial reports, the role of positive accounting theories cannot be
demeaned. However, the critiques have provided enough argument stating that the social
disclosures depend on a number of material factors like the size of the firm and the nature of
industry in which the business is established. Thus, in order to reject the positive accounting
theory on the basis that it does not provide enough justification in the firms providing voluntary
disclosures, the implications of the voluntary disclosures have to be understood properly. This
can be achieved by the proper understanding of the works conducted by Watts and Zimmerman
on social responsibility (Biondi 2017).
The organization that has been selected in the journal is the largest private oil and gas
explorer in the recent history of Brazil. The case study that has been presented in the journal
suggests that the company had made use of the incentives in order to perform the accounting
choices similar to the ones that have been forecasted by the positive accounting theory
hypothesis (Samaha and Khlif 2016).
The company had also gone through a phase of decline and growth that motivated the
organization to perform the voluntary disclosures in regards to the accounting choices such as the
voluntary management changes; restructuring of the corporate governance hierarchy; execution
of the initial public offering; issuance of debt notes. Thus, this evidently states that the positive
accounting theory hypothesis has not properly justified the voluntary disclosures in the financial
report of the company.
In order to understand the implication of the positive accounting theory with much more
clarity, the concept of Positive Accounting Theory should be discussed in accordance to the

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theories that has been proposed by the founders of the Positive Accounting Theory, Ross Watts
and Jerold Zimmerman
The founders of the theory suggests that managers in an organization have greater
incentives for the purpose of lobbying for the accounting standards that evidently increases the
earnings and in turn increase the wealth of the mangers. The cash flows and stock prices can
decrease due to the taxes, procedures that are regulatory in nature and information and political
costs. However, the managers also have to keep in mind the impact of the earnings that have
been reported as the costs might have been imposed on the firm (Oulasvirta 2014).
Watts and Zimmerman in their accountancy paper have mentioned that the positive
accounting theory helps the understanding of the focus points that the accounting principle
setters refer. The positive accounting theory also focuses on the effects that the various
accounting standards bring about on the different groups of entities that belong to the society
(Oulasvirta 2014).
The theory proposed by Watts and Zimmerman indicates that the firms result in proper
organization of its activities for the maximizing their chances of survival in this market. It has
been indicated that the management of the earnings becomes economically efficient when the
value of the firm has been maximized and the earnings become opportunistic when the value
does not increase (Oulasvirta 2014).
Furthermore, the three hypotheses that have been developed by Watts and Zimmerman
for analyzing the fact that why managers choose certain accounting practices. These three
hypotheses are as follows:
 Debt Covenant Hypothesis
 Bonus Plan Hypothesis
 Political Costs Hypothesis
The Bonus Plan Hypothesis has stated that the managers should opt for the accounting
policies that lead to the increase in income. This leads to the shift in the reported earnings from
the upcoming period to the current period for improving the financial benefits in case the bonus
plan is linked with the income obtained by the organization .

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The Debt Covenant hypothesis states that the managers can effectively choose any
practices in regards to the accounting procedures which will increase the income or improve the
returns from the assets or reduce the liabilities of the firms. This will facilitate the reflection of
the debt-equity level to be the lowest and also avoid violating accounting covenants stated in
contracts (Donelson, McInnis and Mergenthaler 2016).
The Political Costs Hypothesis evidently suggests that the managers should opt for the
accounting practices that lead to the decrease in income for reducing the governmental
intervention in their business. This hypothesis further suggests that choosing the accounting
policy by the managers who are provided with an incentive may lobby with politicians for
accounting procedures that decrease the net income that has been reported in the financial
statements (Donelson, McInnis and Mergenthaler 2016).
Thus, the inference that can be drawn from the above discussed literature is that the
managers can opt for the Debt-equity hypothesis that are less conservative in nature, Political
Costs Hypothesis that is more conservative in nature or the Bonus Plan Hypothesis that is less
volatile in nature.
The Positive Accounting theory can also be executed from the perspective of efficient
contracting. The experts accept the fact that it is difficult to determine whether opportunism or
efficient contracting can properly drive the accounting policy of the firms. However, the positive
accounting theory suggests that efficient contracting should be the sole driver (Donelson,
McInnis and Mergenthaler 2016).
PAT and the effects of the theory
The Positive Accounting Theory efficiently predicts the happenings and interprets them
in terms of accounting transactions. The theory also predicts the way in which the firms should
behave in the environment of the newly proposed accounting standards.Thus, the implications of
the Positive Accounting Theory that can be deduced from the literature that has been discussed
in the preceding paragraphs are as follows:

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 The positive accounting theory intends to understand and simplify the choices that the
managers have in regards to the different accounting polices across the different firms. It
further acknowledges the existence of the economic consequences
 The firms following the positive accounting theory maximize the chances of their
survival in a highly competitive market, thus they organize themselves properly
 The major perspective that is adopted by this theory is that the firms are looked upon as
the accumulation of the contracts that they are a part of.
 In regards to the positive accounting theory, the firms will efficiently reduce the costs
that are associated with the contracts. The costs related to the contracts involve the
accounting variables.
 The firm adopting the positive accounting theory, the firm will opt for the accounting
policies that best realizes the need for reducing the contracts related to the costs.
 The positive accounting theory realizes and takes in consideration the circumstances that
are constantly changing, in order to increase the flexibility of the managers for choosing
the apt accounting policies
 The proposed theory also puts forward the issue of opportunistic behavior. The managers
who look into the satisfaction of their own personal interests may display an
opportunistic behavior
Achievement of the Positive Accounting theory
The achievement of the positive accounting theory or the implementation of the proposed
theory can be done by following the listed procedures:
 The theory can be adopted by the changing the accounting policies
 The management of the accruals that are discretionary in nature
 The theory can also be adopted at the time of adoption of the new accounting standards
or change in the current accounting standards
In case of the particular case study that has been presented in the selected journal, the
company had been experiencing rapid phases of growth and decline which led the managers to
make necessary changes that are voluntary in nature like corporate restructure and initial public
offering. In addition to that the company had been under serous distress which further resulted in

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debt covenant violations and reduction in the life cycle of business. The initial years of the
company had been successful but later it ran into extreme financial difficulties that led to
bankruptcy. This could be evident enough to support the opportunistic accounting choices that
would have affected the internal and external contracts. To be more precise, no evidence is
available that the company in the selected journal has made opportunistic increasing income
accounting changes. Thus, there has been no impact in regards to the debt-covenants and bonus
plan or reflection of the decreased income to avoid unnecessary intervention by the government
(Di Pietr, Art, and Ronen 2015).
Conclusion
The particular conclusion that can be drawn from the above discussed literature and
deduced perspectives is that in the case of the absence of an opportunistic approach, the positive
accounting theory does not contribute to the accounting choice in the case of this case study.
However, in terms with the general perspective, the positive accounting theory returns to the
similar conclusion as the ones that had been drawn in the beginning of this particular study. This
means that in the absence of particular evidence, the management of the companies makes use of
the social disclosures that are presented in the financial reports of the company. Furthermore, it
can be stated that the companies adopting positive accounting theories have failed to evidently
follow the arguments that have been provided by the founders of the positive accounting theory
in their original thesis document.

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References and Bibliography
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McLellan, J.D., 2014. Management Accounting Theory and Practice: Measuring the Gap in
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Biondi, Y., 2017. The Firm as an Enterprise Entity and the Tax Avoidance Conundrum:
Perspectives from Accounting Theory and Policy. Accounting, Economics, and Law: A
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Oulasvirta, L.O., 2014. Governmental financial accounting and European harmonisation: Case
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