Positive Accounting Theory

136

Positive Accounting Theory and Science

JCC
Journal of CENTRUM Cathedra ™

Positive Accounting Theory and Science by M. Humayun Kabir Senior Lecturer, Faculty of Business Auckland University of Technology, Auckland, New Zealand

Abstract
This paper examines the development of positive accounting theory (PAT) and compares it with three standard accounts of science: Popper (1959), Kuhn (1996), and Lakatos (1970). PAT has been one of the most influential accounting research programs during the last four decades. One important reason which Watts & Zimmerman (1986) have used to popularize and legitimize their approach is that their view of accounting theory is the same as that used in science. Thus, it is important to examine how far accounting has been successful in imitating natural science and how the development of PAT compares with the three standard accounts of science. This paper shows that accounting could not emulate the success of natural science. Further, the methodological positions of PAT conform to none of the standard accounts of science. Rather, PAT contains elements of all three. Finally, this paper identifies some methodological gaps in PAT. Keywords: Positive Accounting Theory, Philosophy of Science, Methodological Controversies

Acknowledgements
I would like to thank two anonymous reviewers of the journal for their helpful comments. Earlier versions of this paper benefited from comments from Lee Parker of the University of South Australia, Keith Hooper of Auckland University of Technology, Divesh Sharma of Kennesaw State University, and Santi Narayan Ghosh of the University of Dhaka.

Introduction
This paper examines the development of positive accounting theory (PAT) and compares it with three standard accounts of science. There is some confusion about what PAT is. If the definition of accounting theory (i.e., accounting theory seeks to explain and predict accounting and auditing practice) given in Watts and Zimmerman’s 1986

References: Ahmed, A. S., & Duellman, S. (2007). Accounting conservatism and board of director characteristics: An empirical analysis. Journal of Accounting and Economics, 43, 411-437. Ali, A., & Hwang, L.-S. (2000). Country-specific factors related to financial reporting and the value relevance of accounting data. Journal of Accounting Research, 38, 1-21. American Accounting Association (AAA), Financial Accounting Standards Committee (FASC). (2005). Response to the FASB’s exposure draft: FVAs. Accounting Horizons, 19, 187-196. Ball, R. J., & Brown, P. (1968). An empirical evaluation of accounting income numbers. Journal of Accounting Research, 6, 159-178. Ball, R., Robin, A., & Wu, J. (2003). Incentives versus standards: Properties of accounting income in four East Asian countries. Journal of Accounting and Economics, 36, 235-270. Ball, R., & Shivakumar, L. (2006). The role of accruals in asymmetrically timely gain and loss recognition. Journal of Accounting Research, 44, 207-242. Barth, M. E., Beaver, W. H., & Landsman, W. R. (1996). Value-relevance of banks’ fair value disclosures under SFAS 107, The Accounting Review, 71, 513-537. Barth, M. E., Beaver, W. H., & Landsman, W. R. (2001). The relevance of the value relevance literature for financial accounting standard setting: Another view. Journal of Accounting & Economics, 31, 77-104. Barth, M., & Clinch, G. (1998). Revalued financial tangible and intangible assets: Associations with share prices and non-market based value estimates. Journal of Accounting Research, 36 (supplement), 199-233. Basu, S. (2004). What do we learn from two new accounting-based stock market anomalies? Journal of Accounting and Economics, 38, 333-348. Beaver, W. H. (1968). The information content of annual earnings announcements. Empirical Research in Accounting: Selected Studies, Journal of Accounting Research, 6 (supplement), 67-92. Beaver, W. H., Clarke, R., & Wright, W. (1979). The association between unsystematic security returns and the magnitude of earnings forecast errors. Journal of Accounting Research, 17, 316-340. Beaver, W. H., Lambert, R., & Morse, D. (1980). The information content of security prices. Journal of Accounting and Economics, 2, 3-28. Becker, C. L., Defond, M. L., Jiambalvo, J., & Subramanyam, K. R. (1998). The effect of audit quality on earnings management. Contemporary Accounting Research, 15, 1-24. Begley, J., & Freedman, R. (2004). The changing role of accounting numbers in public lending agreements. Accounting Horizons, 18, 81-96. Benston, G. J. (2006). Fair value accounting: A cautionary tale from Enron. Journal of Accounting and Public Policy, 25, 465-484. Biddle, G. C., & Lindahl, F. W. (1982). Stock price reactions to LIFO adoptions: The association between excess returns and LIFO tax savings. Journal of Accounting Research, 20, 551-588. Blaug, M. (1992). The methodology of economics or how economists explain (2nd ed.). Cambridge, England: Cambridge University Press. Brinn, T., Jones, M. J., & Pendlebury, M. (1996). UK accountants’ perceptions of research journal quality. Accounting and Business Research, 26, 265-278. Burgstahler, D., & Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of Accounting & Economics, 24, 99-129. Bushee, B. (1998). The influence of institutional investors on myopic R&D investment behavior. The Accounting Review, 73, 305-333. Byrne, A., I. Clacher, D. Hillier, & A. Hodgson, (2008). Fair value accounting and management discretion. Retrieved January 12, 2009, from http://ssrn.com/abstract=1101691 Chalmers, A. F. (1999). What is this thing called science? (3rd ed.). Indianapolis, IN: Hackett Publishing Company. Chambers, R. J. (1966). Accounting, evaluation and economic behavior. Englewood Cliffs, NJ: Prentice Hall. Chambers, R. J. (1993). Positive accounting theory and the PA cult. Abacus, 29, 1-26. Christenson. C. (1983). The methodology of positive accounting. Accounting Review, 58, 1-22. Christie, A. A. (1990). Aggregation of test statistics: An evaluation of the evidence on contracting and size hypotheses. Journal of Accounting & Economics, 12, 15-36. Clarkson, P., Hanna, J. D., Richardson, G. D., & Thompson, R. (2009). The impact of IFRS adoption on the value relevance of book value and earnings. Retrieved August 19, 2009, from http://www.afaanz.org/openconfafaanz2009/modules/request.php?module=oc_proceedings&action=view.php&a=Accept+as+Paper&id=23 Coase, R. H. (1937). The Nature of the Firm. Economica, 386-405. Deakin III, E. B. (1979). An analysis of differences between non-major oil firms using successful efforts and full cost methods. The Accounting Review, 54, 722-734. Positive Accounting Theory and Science DeAngelo, L. E. (1986). Accounting numbers as market valuation substitutes: A study of management buyouts of public shareholders. The Accounting Review, 61, 400-420. DeAngelo, L. E. (1988). Managerial competition, information costs, and corporate governance: The use of accounting performance measures in proxy contests. Journal of Accounting and Economics, 10, 3-36. Dechow, P., & Dichev, I. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77 (supplement), 35-59. Dechow, P. M., & Sloan, R. G. (1991). Executive incentives and the horizon problem. Journal of Accounting & Economics, 14, 51-89. Dechow, P. M., Sloan. R. G., & Sweeney, A. P. (1995). Detecting earnings management. The Accounting Review, 70, 193-225. Deegan, C. (1997). Positive accounting theory: A useful tool for explanation and prediction, or a body of vacuous, insidious and discredited thoughts. Accounting Forum, 21, 63-72. Deegan, C. (2007). Financial accounting theory. North Ryde, NSW, Australia: McGraw-Hill Irwin. Dhaliwal, D. S. (1980). The effect of the firm’s capital structure on the choice of accounting methods. The Accounting Review, 55, 78-84. Duke, J. C., & Hunt III, H. G. (1990). An empirical examination of debt covenant restrictions and accountingrelated debt proxies. Journal of Accounting and Economics, 12, 45-63. Durkheim, E. (1964). The rules of sociological method, Glencoe, IL: Free Press. Eccher, A., Ramesh, K., & Thiagarajan, S. R. (1996). Fair value disclosures by bank holding companies. Journal of Accounting and Economics, 22, 79-117. Edwards, J. R. (1989). A history of financial accounting, London, England: Routledge. Fay, B. (1996). Contemporary philosophy of social science, Oxford, England: Blackwell. Feyerabend, P. (1993). Against method, New York, NY: Verso Books. Foster, G. (1977, January). Quarterly accounting data: Time-series properties and predictive-ability results. Accounting Review, 52, 1-21. Francis, J. R., Maydew, E. L., & Sparks, H. C. (1999). The role of Big 6 auditors in the credible reporting of accruals. Auditing: A Journal of Practice and Theory, 18(2), 17-34. Frankel, R. M., Johnson, M. F., & Nelson, K. K. (2002). The relation between auditors’ fees for nonaudit services and earnings management. The Accounting Review, 77 (supplement), 71-105. Grant, E. B. (1980, Spring). Market implications of differential amounts of interim information. Journal of Accounting Research, 18, 255-268. Hagerman, R. L., & Zmijewski, M. E. (1979). Some economic determinants of accounting policy choice. Journal of Accounting & Economics, 1, 141-161. Hall, S. C. (1997). In defense of positive accounting theory. Accounting Forum, 21, 43-52. Healy, P. M. (1985, April). The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics, 7, 85-107. Hines, R. D. (1988, October). Popper’s methodology of falsificationism and accounting research. The Accounting Review, 657-662. Hirshleifer. D., Hou, K., Teoh, S. H., & Zhang, Y. (2004). Do investors overvalue firms with bloated balance sheets? Journal of Accounting & Economics, 38 (1-3), 297-331. Holthausen, R. W., & R. L. Watts, (2001). The relevance of the value-relevance literature for financial accounting standard setting, Journal of Accounting and Economics, 31, 3–75 Hung, M, & Subramanyam, K. R. (2007). Financial statement effects of adopting international accounting standards: the case of Germany. Review of Accounting Studies, 12, 623-657. Ijiri, Y. (1975). Theory of accounting measurement. Studies in Accounting Research. Sarasota, FL: American Accounting Association. International Accounting Standards Board (IASB), (2009). Presentation of Financial Statements. International Accounting Standard 1. London, England: IASCF. International Auditing and Assurance Standards Board (IAASB). (2009). Identifying and assessing the risks of material misstatement through understanding the entity and its environment. International Standard on Auditing 315. Retrieved from http://web.ifac.org/download/a017-2010-iaasb-handbook-isa-315.pdf Jones, J. J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29, 193-228. Kaplan, R. S., & Roll, R. (1972). Investor evaluation of accounting information: Some empirical evidence. Journal of Business, 45, 225-257. Kaplan, R. S. (1985). Comments on Paul Healy: Evidence on the effect of bonus schemes on accounting procedures and accrual decisions. Journal of Accounting and Economics, 7, 109-113. Kothari, S. P., Leone, A. J., & Wasley, C. E. (2005). Performance matched discretionary accrual measures. Journal of Accounting and Economics, 39, 163-197. 147 148 Positive Accounting Theory and Science Krishnan, G. V. (2003). Does Big 6 auditor industry expertise constrain earnings management? Accounting Horizons, 17 (supplement), 1-16. Kuhn, T. S. (1996). The structure of scientific revolutions (3rd ed.), Chicago, IL: The University of Chicago Press. Lakatos, I. (1970). Falsification and the methodology of scientific research programmes. In I. Lakatos & A. Musgrave (Eds.) Criticism and the growth of knowledge, Cambridge, England: Cambridge University Press. Landsman, W. R. (2007). Is fair value accounting information relevant and reliable? Evidence from capital market research. Accounting and Business Research, Special Issue: International Accounting Policy Forum, 19-30. Lessnoff, M. H. (1974). The structure of social science- A philosophical introduction, London, England: George Allen & Unwin. Lev, B., & Zarowin, P. (1999). The boundaries of financial reporting and how to extend them. Journal of Accounting Research, 37(2), 353-385. Lev, B. (2001). Intangibles management, measurement, and reporting. Washington, DC, Brookings Institution Press. Liberty. S. E., & Zimmerman, J. L. (1986). Labor union contract negotiations and accounting choices. The Accounting Review, 61(4), 692-712. Littleton, A. C. (1953). Structure of accounting theory. Monograph No. 5. Sarasota, FL: American Accounting Association. MacNeal, K. (1970). Truth in accounting. Houston, Tx: Scholars Book Company. (Original work published1939) McNichols, M., & Manegold, J. G. (1983). The effect of the information environment on the relationship between financial disclosure and security price variability. Journal of Accounting & Economics, 5, 49-74. McNichols, M., & Wilson, G. P. (1988). Evidence of earnings management from the provision for bad debts. Journal of Accounting Research, 26 (supplement), 1-31. Milne, M. (2002). Positive accounting theory, political costs and social disclosure analyses: A critical look. Critical Perspectives on Accounting, 13(3), 369-395. Morais, A. I., & Curto, J. D. (2009). Mandatory adoption of IASB standards: Value relevance and country-specific factors. Australian Accounting Review 46: 128- 143. Mouck, T. (1990). Positive accounting theory as a Lakatosian research program. Accounting and Business Research, 20, 231-239. Ness, K. E., & Mirza, A. M. (1991). Corporate social disclosure: A note on a test of agency theory. British Accounting Review, 23(3), 211-217. Neu, D. (1997). Positive accounting theory: A pragmatic assessment. Accounting Forum, 21, 53-62. Nichols, D. C., & Wahlen, J. M. (2004). How do earnings numbers relate to stock returns? A review of classic accounting research with updated evidence. Accounting Horizons, 18, 263-286. Paton, W. A., & Littleton, A. C. (1940). An introduction to corporate accounting standards. Monograph No. 3. American Accounting Association. Peasnell, K. V., Pope, P. F., & Young, S. (2005). Board monitoring and earnings management: Do outside directors influence abnormal accruals? Journal of Business Finance & Accounting, 32, 1311-1346. Popper, K. (1959). The logic of scientific discovery. London, England: Routledge. Popper, K. (1970). Normal science and its dangers. In I. Lakatos and A. Musgrave (Eds.) Criticism and the growth of knowledge, Cambridge, England: Cambridge University Press. Pourciau, S. (1993). Earnings management and nonroutine executive changes. Journal of Accounting and Economics, 16, 317-336. Press, E. G., & Weintrop, J. B. (1990). Accounting-based constraints in public and private debt agreements: Their association with leverage and impact on accounting choice. Journal of Accounting and Economics, 12, 65-95. Reitenga, A. L., & Tearney, M. G. (2003). Mandatory CEO retirements, discretionary accruals, and corporate governance mechanisms. Journal of Accounting, Auditing, & Finance, 18, 255-280. Ricks, W. (1982). The market’s response to the 1974 LIFO adoptions. Journal of Accounting Research, 20, 367387. Sawabe, N., & Yamaji, H. (1999). Institutional accounting research: An introduction. In S. Sunder and H.Yamaji (Eds.) The Japanese Style of Business Accounting, Westport, CT: Quorum Books, Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71, 289-316. Soderstrom, N. S., & Sun, K. J. (2007). IFRS adoption and accounting quality: A review. European Accounting Review, 16, 675-702. Sterling, R. R. (1990). Positive accounting: An assessment. Abacus, 26, 97-135. Sue, M. (1997). Comments on positive accounting theory: A necessarily blinkered view. Accounting Forum, 21, 73-80. Sunder, S. (1973). Relationship between accounting changes and stock prices: Problems of measurement and some Positive Accounting Theory and Science empirical evidence. Empirical Research in Accounting: Selected Studies, Journal of Accounting Research, 11 (supplement), 1-45. Sunder, S. (1975). Stock price and risk related to accounting changes in inventory valuation. Accounting Review, 50, 305-315. Sunder, S. (1997). Theory of accounting and control. Cincinnati, OH: Thomson. Sunder, S. (1999). Design and implementation of contracts: A comparison of factor markets relevant to financial reporting in Japan and the United States. In S. Sunder and H. Yamaji (Eds.) The Japanese style of business accounting. Westport, CT: Quorum Books. Taffler, R. J., Lu, J., & Kausar, A. (2004). In denial? Market underreaction to going-concern audit report disclosures. Journal of Accounting and Economics, 38, 263-296. Teoh, S. H., Wong, T. J., & Rao, G. R. (1998). Are accruals during initial public offerings opportunistic? Review of Accounting Studies, 3, 175-208. Watts, R. L. (2003a). Conservatism in accounting, part I: Explanations and implications. Accounting Horizons, 17, 207-221. Watts, R. L. (2003b). Conservatism in accounting part II: Evidence and research opportunities. Accounting Horizons, 17, 287-301. Watts, R., & Zimmerman, J. (1978). Towards a positive theory of the determination of accounting standards. Accounting Review, 53, 112-134. Watts, R. L., & Zimmerman, J. L. (1986). Positive accounting theory, Englewood Cliffs, NJ: Prentice-Hall. Watts, R. L, & Zimmerman, J. L. (1990). Positive accounting theory: A ten year perspective. The Accounting Review, 65, 131-156. Whitley, R. D. (1988). The possibility and utility of positive accounting theory. Accounting, Organizations, and Society, 13, 631-645. Whittington, G. (1987). Positive accounting: A review article. Accounting and Business Research, 17, 327-336. Zmijewski, M., &Hagerman, R. (1981, August). An income strategy approach to the positive theory of accounting standard setting/choice. Journal of Accounting and Economics, 3, 129-149. 149 Footnotes 1 See, for example, Chambers (1966), Ijiri (1975), Littleton (1953), MacNeal (1939), and Paton and Littleton (1940). 2 This section is largely based on Watts and Zimmerman (1986). 3 Watts and Zimmerman (1986, Chapter 3 and 4) review some early studies of this literature. 4 The no-effects hypothesis says that stock price changes are not associated with voluntary changes in accounting procedures unless they have any cash flow impacts. This hypothesis is based on EMH, CAPM, and zero contracting costs. On the other hand, the mechanistic hypothesis posits a mechanical relation between accounting changes and stock price changes. This hypothesis states that managers can systematically mislead the stock market by manipulating the earnings number through accounting changes. The no-effects hypothesis, on the other hand, says that the market can see through the earnings number. See Watts and Zimmerman (1986, pp. 72-76). 5 Contracting costs denote the amalgam of transaction costs, information costs, agency costs, renegotiation costs, and bankruptcy costs ( Watts & Zimmerman, 1990, pp. 134-135). 6 Under the EMH and CAPM regime, accounting is mere form and does not affect cash flow except the switch to the LIFO inventory method that affects tax in the USA. 7 One such decision is to demarcate the theory under test from the unproblematic background knowledge. (Lakatos, 1970, p. 107). 8 See Watts and Zimmerman (1990) for this and other criticisms of the positive accounting literature. * Correspondence concerning this article should be directed to Humayun Kabir at: [e-mail]