accounting

The accounting essay below has been submitted to us by a student in order to help you with your studies.

Positive Theory of the Determination of Accounting Standards

Heading the pioneer of “the Rochester School of Accounting”, Jensen (1976) argued that most accounting theories were unscientific in that they were normative and should be replaced by positive theories which could explain “why accounting is what it is, why accountants do what they do, and what effects these phenomena have on people and resource utilization” (Jensen, 1976, P13). The basic message is that positive theories which can explain actual accounting practices in terms of the management’s voluntary choice of accounting standards and how the regulated standards have changed over time should supplant the unscientific accounting theories. The major subjects of the positive theories focus on existing accounting practices and management’s attitudes towards the accounting practices (Riahi-Belkaoui, 2004). Furthermore, the positive theories also highlight three key hypotheses as follows: 1. The bonus plan hypothesis: maintains that managers of firms with bonus plans are more likely to use accounting methods that increase current period reported income. The rationale is that such action may increase the percent value of bonuses if there are no adjustments for the method chosen; 2. The debt equity hypothesis: maintains that the higher the firms debt/equity, which is equivalent to the closer the firm is to the constraints in the debt covenants and the greater the probability of a covenant violation and of incurrence of technical default costs, the more likely managers are to use accounting methods that increase income; 3. The political cost hypothesis: larger firms rather than small firms are more likely to use accounting choices that reduce reported profits (Watts and Zimmerman, 1986 and 1990).

The last hypothesis was supported by Watts and Zimmerman who were the colleagues of Jensen in 1978, by investigating the influence of management’s attitudes towards accounting standards. This paper contributes a lot to accounting theories. According to Holthausen and Leftwich (1983), this research has uncovered empirical regularities in accounting practices. Besides, this research not only benefits academics in accounting, finance and economics, but also to students and accounting professions (Zimmerman, 1980). Moreover, the approach used in this article is innovative and more empirical (Riahi-Belkaoui, 2004) However, these advantages are not naturally shared by everybody. A great deal of criticisms have risen since the article was published in 1987. This essay aims to point out three major criticisms of the research conducted by Watts and Zimmerman (1978) based on the view of Hines (1988). The key article will be reviewed firstly in this paper, and then three criticisms will be discussed respectively. At last, a conclusion will be given.

Review of the Key Paper

Before Watts and Zimmerman’s research, Gordon (1964) had formulated the income smoothing theories which contribute a lot to Watts and Zimmerman’s work, based on the assumption that “the shareholder satisfaction is solely a positive function of accounting income and increases in share price always accompany increases in accounting income” (Watts and Zimmerman, 1978, P114). However, numerous serious doubts are cast on this assumption. For the purpose to avoid the pitfalls that may exist in Gordon’s theories, in the 1978’s research, Watts and Zimmerman assumed that share price is dependent on cash flow rather than the accounting income.

Generally, all the work shown in this article aimed to support the political cost hypothesis. Personally, this article can be divided into three parts. In the first part, guided by the assumption of agency and contracting cost theories, the authors determined the factors which they thought could affect manager’s attitudes, that is, political cost, taxes, information cost, regulation and management compensation plan (Watts and Zimmerman, 1990). Second part was used to combine these factors into a model and generate theory: for larger firms, mangers favoured the accounting standards which could lead to income decrease and more likely to make a submission. Following this, the theory was tried to be confirmed. 53 firms were selected, which had already made submission, so as to test their responses to the FASB’s General Price Level Adjustment Standard. The results were consistent with the previous theories, including their assumption that political cost and taxes domain the management compensation plan. Moreover, statistics techniques were also being adopted to confirm that political cost factor weighted more heavily than taxes factor. Therefore, according to all the work in this research paper, the political cost hypothesis was supported in the end.

Criticisms of the Research

Although Watts and Zimmerman had shown all their works in the article to support the political cost hypothesise, evidence contrary to the political cost hypothesis has been found. For an instance, a replication test undertaken by Mckee, Bell and Boatsman (1984) aimed to test the results of the key article. They first replicated Watts and Zimmerman study using the same sample and then compared the results with the identical test based on a larger sample. The results showed less supportive than those reported in the key article. Consequently, the validity of this research appears to be uncertain. In order to discover the reasons, attempts had made by huge number of researchers (Ball and Foster, 1982; Tinker et al. 1982; Christenson, 1983; Holthausen and Leftwich, 1983; Whittington, 1987). Among them, Hines (1988) commented this article with six weaknesses. Personally, these drawbacks can be concluded into three areas: 1. Proxies were crude; 2. Basic assumption was unrealistic; 3. It is suggested that any anomalies should be tested rigorously and any theories against their results should be presented as well. Based on Hines’s criticisms, the following paragraphs will discuss them respectively and responses from Watts and Zimmerman will be provided as well.

1. Crude Proxies

The most striking criticism of this area focuses on firm size. Watts and Zimmerman (1978) originally used firm size to proxy political cost. Bujaki and Richardson (1997) claimed that they found eighteen distinct theoretical constructs for which size was used to proxy by reviewing the empirical use of firm size in accounting articles. This reveals that firm size can be used to proxy more than political cost. In addition, Milne (2001) asserted that empirical research suggested that numerous measures could be adopted to proxy political cost, such as profit, industry membership, labour intensity and others. Besides, Ball and Foster (1982) also criticized size as too noisy a proxy by presenting several reasons. Firstly, they claimed that the industry membership should not be ignored, since the majority of larger firms sample were occupied by oil industry which applied "excess profits tax". However, the observation that the tax rate of Superior Oil Company was the same as that of Exxon showed looser relationship between tax rate and firm size. Secondly, the increase of firm size would not be accompanied by the rise of relative cost, if certain companies’ fixed assets were under government regulation. Thirdly, misunderstanding of Siegfried’s conclusion (as cited in Boll and Foster, 1982), Watts and Zimmerman made a wrong relationship between firm size and political costs which should be negatively related to each other.

2. Unrealistic Assumption

A number of researchers challenged the basic assumption that “individuals act to maximize their own utility” (Watts and Zimmerman, 1978, P113). Sterling (1990) criticized that unlike behavioural science which tried to discover the factors that could motivate managers to pursuit self-interest, Watts and Zimmerman (1978) assumed that everyone would like to maximize utility. Meanwhile, Gray et al. (1995) argued that positive accounting theory failed to provide any essential evidence to prove the positive relationship between manager’s self-interest and accounting standards selection. Moreover, Milne (2001) argued this assumption seemed to neglect any firm targeted for anti-trust monopoly behaviour, environment considerations or labour exploitation.

In addition, Sterling (1990) also pointed out that this assumption was inappropriate, because it explained too much. For example, the policeman will be said to have maximized his utility by his heroic charge to arrest thieves and by his cowardly refusal to arrest them. Similarly, managers will be said to have maximized their utilities to favour or oppose the General Price Level Adjustments by increasing or decreasing the reported income. Actually, it explained nothing.

Furthermore, Watts and Zimmerman’s usage of this assumption contradicted to their own justification that positive accounting theory qualified as a scientific theory. Popper (1983) stated that a statement could be considered to be scientific if and only if it is falsifiable. In addition to that, Popper (1983, P xx) also used an example to explain it: “‘[That] all human actions are egotistic, motivated by self-interest . . . is widely held . . . [but it] is not falsifiable: no example of an altruistic action can refute the view that there was an egotistic motive hidden behind it “.

3. Anomalies Exist

Positive accounting theory can also be called predictive accounting theories (Vorster, 2007). This sheds light of the significance role of prediction in positive accounting theory. It seems that the Rochester School themselves also believes prediction is essential in positive accounting theory (as cited in Christenson, 1983). Popper (1972) stated that a true prediction should be derived from theories which had been rigorously tested. However, several aspects shown in the article of Watts and Zimmerman in 1978 appear to break the rules. For example, the fact that three firms in the sample did not make submission could not be explained by the theory (Christenson, 1983). Although Watts and Zimmerman (1978, P127, note 37) made a confession that” While we can only expect a positive theory to hold on average”, it was considered to be excuse by Christenson. This is because of Pareto’s words:

“A 'law' that has exceptions, that is to say, a uniformity which is not uniform, is an expression devoid of meaning.... If one grants to a person who is stating a law that his law may have its exceptions, he can always meet every fact that is adduced against him with the excuse that it is an "exception," and he will never be caught in the wrong. And that is exactly what literary economists, moralists, and metaphysicists do” (quoted in Christenson, 1983).

As a result, the positive theory’s performance seems to be unimpressive.

Responses from Watts and Zimmerman

Confronting a large number of criticisms, instead of keeping silence, Watts and Zimmerman (1990) defended their work by arguing that the criticisms did nothing to affect the subsequent research. Firstly, fewer researchers improved their work by considering these suggestions. Secondly, most criticisms came from different paradigms with different measurements and no common ground. Last, the criticisms raised by Hines (1988) were too rigorous to be accepted as the criterions for publishing articles.

Personally, the second reason seems more reasonable than the other two, because knowledge or theory from different paradigms cannot be compared (Smith, 1998). On the other hand, the first reason appears to be wrong. Numerous efforts have been done by subsequent researchers to avoid the drawbacks existing in Watts and Zimmerman’s work. For an instance, Sutton (1988) attempted to adopt profit margin as a proxy for political cost, because he noted that U.K. firms with extremely high profit margin tended to be under government regulation. Meanwhile, the last defence seems to be more an excuse than an actual reason.

Conclusion

It may be true that Watts and Zimmerman’s article in 1978 and their positive accounting theories have contributed a lot to accounting study. However, the disadvantages cannot be neglected. Based on Hines’ arguments, this paper has discussed three main drawbacks of Watts and Zimmerman’s article. They are crude proxies, unrealistic assumption and anomalies exist. Although Watts and Zimmerman have responded to the criticisms, the defences seem to be powerless.

Accounting researchers have been struggling to seek for an objective or scientific method for a long time. Positive accounting theory is one of the products. However, accounting researchers never consider studying accounting in a different way. According to Hines (1988, P 660):” If the dangers of scientism can be appreciated by researchers early in the methodological debate within accounting and finance literature, then research may perhaps be saved from the dogmatism and may diversions of resources that have resulted in other fields or inquiry and from an unwarranted reverence for science and the scientific method”. Therefore, though the influence of these approaches was manifested in the accounting literatures of the last decade, accounting theory still needs revolution.

Work Count: 2025


Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay


More from UK Essays