Critical Review

Towards a Positive Theory of the Determination of Accounting Standards



Towards a Positive Theory of the Determination of Accounting Standards

Synopsis

This paper propagates the importance and significance of the positive accounting theories by understands the elements that play a very important role in shaping the behavior and attitude of mangers. Later in the paper certain factors that affect the cash flow stream of firms are also elaborated. This research is tested on the basis of corporate submission to the FASB.

Introduction

Watts and Zimmerman in 1978 (Watts & Zimmerman, 1978, Pp. 112-127) argued about the nature of the accounting theories, according to him positive theories of accounting will replace the normative theories, because positive theories are focus on explaining “what accounting is and why it is, how and why accounting professional do what they do, and how these procedures and phenomenon's affect the people and overall business environment. Positive accounting theories mainly focus on management's approach towards various accounting practices.

In addition to this, there are three hypothesis highlighted by the positive theories: 1. Political cost hypothesis; maintains that big corporations (larger firms) are more probably incorporate various accounting and reporting choices in order to reduce reported profits; 2. debt to equity hypotheses: explains that manager will use various accounting methods to raise the income of a business when they utilize a higher proportion of debt/equity, because higher debt\equity expose a firm to the constrain associated with debt covenant; 3. Bonus plan hypothesis: explains that managers of organizations having effective and strong bonus plan are more probably to incorporate accounting techniques and methods for raising the current period's business income. The idea here is that bonus and personal incentives are the main deriving force for managers to use accounting methods.

Summary of the Article

Prior to Zimmerman and Watts research paper, Gordon in 1964 proposed an income smoothing hypothesis which provide basis and contributed a lot to the work of Watts and Zimmerman. To shun the drawback that were present in the Gordon's research, Watts and Zimmerman in 1978 assumed that there is a direct relationship between the cash flow and share price, and the share price of a firm is directly dependent upon its cash flow rather than on its accounting income (Gordon, 1964, Pp. 251-263).

More prominently the entire work on the article focuses on the political cost hypothesis. Personally I believe we can classify this article into three segments. In the first segment, authors have discussed the assumptions of agency theory and contracting cost theory. Watts and Zimmerman identified and discussed certain variables (information cost, political cost, management bonus plan, taxes and regulation) that may shape the attitudes and behavior of managers or agents. Second segment of the research was aimed at constructing a statistical model based in the stated variables and generate a theory. In the last segment of the research, watts and Zimmerman tried to confirm the theory. For such purpose 53 companies were selected to observe their reaction to the general price level adjustment standards ...