Topic 6 Flashcards
(2 cards)
7.1 What is the difference between a positive and noramtive theory of financial accounting and is one better than the other? 7.1
A positive theory of financial accounting would seek to explain and/or predict particular financial reporting practices (or perhaps how different users will react to particular accounting disclosures) whereas a normative theory of financial accounting would seek to prescribe particular approaches to or methods of financial accounting with these prescriptions being based on particular perspectives about the role of financial accounting, and the needs and expertise of financial statement readers.
Because normative theories serve a different role to positive theories, it is not appropriate to say one is better than the other. Indeed, rather than seeing them as competing, they can actually be used in a complementary manner. For example, positive research and positive theories might provide valuable insights into how different categories of financial statement readers react to particular forms of accounting disclosures. These insights can then be used by other people who are seeking to make prescriptions about the types of disclosures that reporting entities should make.
7.2 Early positive research investigated evidence of share price changes as a result of the disclosure of accounting information. However, such research did not explain why particular accounting methods were selcted in the first place. How did Positive Accounting Theory fill this void? 7.2
Early research considering share price reactions to accounting information relied on various assumptions about the efficiency of the capital market and assumed that capital market participants could ‘undo’ the effects of organisations using different accounting methods. It also assumed the absence of transaction costs. Accepting these assumptions, and to the extent that the selection of accounting method did not affect taxation, then the choice of accounting method would have limited implications for the firm and hence managers should be indifferent when choosing between alternative accounting methods. However, evidence indicates that managers are not indifferent.
The development of agency theory suggested that where there is a delegation of decision making within an organisation there can be inefficiencies because agents will not necessarily work in the interests of the organisation, but rather will work in their own interests. However, the principals will anticipate the opportunistic actions of the agents and will reduce their payments accordingly (that is, the principals will price protect). To minimise the agency costs, and to align the interests of principles and agents, numerous contractual arrangements will be put in place.
Accepting the perspectives provided by Agency Theory, Watts and Zimmerman (1978) showed how accounting-based contractual arrangements can act to minimise the transaction costs that might arise within an organisation. The choice of one method of accounting in preference to another was deemed to be important in maximising the value of an organisation. For the reason that there are many uncertainties when investing or lending funds to an organisation, managers will agree to provide investors and lenders with financial statements. This reduced risk associated with being able to monitor the performance of the entity will be expected to reduce the costs associated with attracting funds to the entity. Since some methods of accounting are able to better reflect the performance of an entity, managers will select some methods in preference to others (the efficiency perspective). This will have direct implications for the cost of attracting funds into the organisations.
Further, accepting that managers might not always work in the interests of the owners, it is common to find accounting-based bonus plans. Again, some methods of accounting might be more relevant in some organisations than alternative methods of accounting and again, PAT provides an explanation for why certain accounting methods might be selected in preference to others.
