Positive Accounting Theory Revision

...

Accounting choice also is endogenous in the political process. The potential costs of a proposed accounting standard effect the standard before it is released. The correlation between financial and compensation policies and accounting policy is likely affected by the firm’s tax accounting policies. Within some financial accounting method choices do not affect taxes reducing bookkeeping costs by keeping one set of books and the possibility that tax audits or future taxes might be levied using reports income induce a relation between financial accounting and tax accounting methods.

One cannot test claims that variable like debt/equity and size are surrogates for alternative explanations until those alternatives are identifies and the relation specifies. Given the investment opportunity set and taxes are identified as possible explanatory variables, future research can investigate their implications as alternative hypothesis to those currently advanced. For example, changing accounting methods can result from a change in the firm’s investment opportunity set causing the efficient contracts and accounting method of change.

We state that the objective of and accounting theory is to explain and predict accounting practice. Neither prediction nor explanation is preeminent. We adopted label positive from economics where it was used to distinguish research aimed at explanation and prediction from research whose objective was prescription. Our use of the term positive differentiated our and other people’s research from traditional normative theories by emphasizing the importance of prediction and explanation. It helped place normative theories and their role in a clearer perspective.

In retrospect, the term positive generated more confusion than we anticipated. For example, some though we meant logical positivism. We merely intended to distinguish positive propositions from the extant normative propositions in the literature. While the term positive avoided debates over normative uses of the work, the term positive generated considerable debate over philosophical issues.

Despite its problems, we prefer ‘positive accounting literature to alternative terms that have arisen, particularly the term ‘economic consequences literature’. This latter term suggests accounting standards are decided on some higher basis and that economic consequences are a secondary factor only considered after the initial decision is made in the higher basis.

Summary and conclusion

The best theory is determinate in a competition to meet practitioners’ demand from practitioners for theories that explain and predict accounting choice. It is unlikely an accounting or a social science theory with prefect predictions will ever exist. Researchers are influences by their values. But, to the extent those researchers are competing to meet practitioners’ demand for theories, they have incentive to reduce that influence. Further, the careful dichotomy between theory and prescription helps reduce that influence. Lastly, accounting is an activity carries out by people and one cannot generate a theory that predicts and explains accounting phenomena by ignoring the incentives of the individuals who account.

The literature explains why accounting is used and provides a framework for predicting accounting choices. Choices are not made in term of better measurement of some accounting construct, such as earnings. Choices are made in terms of the individual objectives and the effects of the accounting methods on the achievement of those objectives. For example, some accounting instructors teach that certain accounting methods are better than others. But, no explanation is offered why these better measures are not adopted. The positive accounting literature take as given the proposition that the accepted set maximum the wealth of the contracting parties and then seeks to understand how wealth is affected by specific accounting methods.

Another literatures is to highlight the contracting costs. Positive accounting research has more recently recognised the importance of contracting costs to explain accounting. The prices model were developed under assumptions of costless information and such models explain why different securities sell for different relative prices. To explain such institutional differences requires assumptions of costly information and contracting. Likewise, accounting would not exist without contracting costs and so it is difficult to produces a theory that predicts and explains accounting without assumptions about the relative magnitudes of these costs. The central role of contracting costs highlight the positive accounting research makes it difficult to ignore these costs in accounting theories.

The single most important task facing accounting researchers is improving the linkage between the theory and empires tests. The theory predicts that the magnitude of debt renegotiation costs will affect manager’s choice of accounting methods and will set an upper bound on the magnitude of the default costs. To data, researchers have been unable to document the magnitude of renegotiation costs. The empirical tests can no longer assume accounting choices is made either efficiency or opportunistic reasons. Both must be incorporated into the tests. Also, estimates of the relative magnitudes of the various components of contracting costs can help to further refine linkage between the theory and tests by identifying those costs most influential in driving accounting choice.

When accounting choice is cast as part of the efficient contracting technology, variables often used to explain and predict accounting choice are endogenous. For example, changes in accounting procedures occur simultaneously with changes in the firm’s investment opportunity set, its financial and compensation contracts, its organisational structure, and even in its political environment. Managers choose packages for accounting policy, financial policy and organisational structure. Theoretical and empirical models have to be developed to sort out the endogenous problems among variables and, thereby, increase the power of the tests. While this is no easy task, it seems essential to significant advances in both the theories of the firms and of accounting.

While the positive accounting literature has yielded empirical regularities and explanations for these regularities, it is clear there are many research opportunities available beyond those currently exploited. The major breakthroughs are likely to come from viewing accounting as choice that is endogenous with the choice of organisation, contracting and financial structure. such a breakthrough will be difficult to achieve, but important foundations can be