Positive accounting theory

Positive Accounting Theory as developed by Watts and Zimmerman and others, is based on
the central economics-based assumption that individuals action is driven by self-interest and
that individuals will act in an opportunistic manner to the extent that the actions will increase
their wealth. Given an assumption that self-interest drives all individual actions, PAT predicts
that organisations will seek to put in place mechanisms that align the interests of the
managers of the firm with the interest of the owners of the firm. Some of the method of
aligning interest will be based on the output of the accounting system (such as providing
manager with a share of the organisations profits). Where such accounting-based alignment
mechanisms are in place, there will be a need for financial statement to be produced.
A key to explaining managers choice of particular accounting method came from Agency
theory. Jensen and Meckling (1976) defined agency relationship as:
A contract under which one or more (principals) engage another person (the agent) to
perform some service on their behalf which involves delegating some decision-making
authority to the agent.
It is assumed within Agency Theory that principals will assume that the agent will be driven
by self-interest, and therefore the principals will anticipate that the manager, unless restricted
from doing otherwise, will undertake self-serving activities that could be detrimental to the
economic welfare of the principal.
Firm can be viewed as a nexus of contracts and these contracts are put in place with the
intention of ensuring that all parties, acting in their own interest, are at the same time
motivated towards maximising the value of the organisation. Thus, the contractual
arrangement can be used as a basis of controlling the efforts of self-serving agents.
Assuming that self-interest drives the action of the managers, it may be necessary to put in
place remuneration schemes that reward the managers in a that is, at least in part, tied to the
performance of the firm. Given that the amounts paid to the manager may be directly tied to
accounting numbers, any changes in the accounting methods being used by the organisation
will affect the bonuses paid.
To test the assumption that managers choice of accounting method is directly correlated with
existing earnings arrangement, Watts and Zimmerman (1990) identified three key hypotheses

to explain and predict whether an organisation would support or oppose a particular

accounting method. The hypotheses are interpreted as follows:
1. The bonus plan hypothesis is that managers of firms with bonus plans are more likely
to use accounting methods that increase current period income. This hypothesis
predicts that if a manager is rewarded in terms of a measure of performance such as
accounting profits that manager will attempt to increase profits to the extent that this
leads to an increase in his or her bonus.
2. The debt covenant hypothesis: the closer a firm is to violation of the accounting-based
debt covenants, the more likely the firm manager is to select accounting procedures
that shift reported earnings from future periods to the current period.
3. The political cost hypothesis: the greater the political costs faced by a firm, the more
likely the manager is to choose accounting procedures that defer reported earnings
from current to futures periods.
These three hypotheses form an important component of PAT. Note that they all led to
empirically testable predictions. For example, managers of firm with bonus plans are
predicted to choose less conservative accounting policies than managers of firm without such
plans.
However PAT empirical findings, criticisms of the theory are as follows:

It does not provide prescription and therefore does not provide a means of improving

accounting practice.
It is not value free as it asserts.
The assumption that all action is driven by a desire to maximise ones wealth is far too

negative and simplistic perspective of humankind.

It is scientifically flawed
The theory have limited accomplishment

Foreign currency translation

Key definitions

Functional currency is the currency of the primary economic environment in which

the entity operates.

Presentation currency is the currency in which financial statements are presented.
Exchange difference is the difference resulting from translating a given number of
units of one currency into another currency at different exchange rates.

Exchange rate problem

Translation presents problems because exchange rates are not fixed. If for example, the
exchange rate between the pound and the dollar were always that 1 was equal to $1.45.
There would be no grounds for differences of opinion as to the translated pound value of a
US asset with a dollar value of $100. However, exchange rates are not fixed.
The fact that exchange rate are not fixed created two problems for the accountant
1. What is the appropriate rate to use when translating an asset/liability denominated in a
foreign currency?
2. How should one account for the gain or loss that arises when exchange rate change?
Addressing problem (1):
Non-monetary assets

Non-monetary assets are entered in the books of account at their historical cost in

terms of home currency.

All subsequent adjustments follow the normal accounting rules
The fact that the assets were acquired in foreign currency is not relevant.

Monetary assets and liabilities

In principle, there are three different ways in which monetary assets and liabilities that are
denominated in foreign currency can be translated:
1:

At the historical rate: with this method, the home currency amount to these items is
left unchanged and no translation gain or loss is reported.

2:

At closing rate: translation at the balance sheet rate gives the current value of these
items in terms of home currency

3:

At the lower (higher) of the historical rate and the closing rate of assets/liabilities:
when this method is used, assets are stated at the lower of two possible values and
liabilities at the higher.

Of the three methods, the first method is rarely used. Some accountants justify its application
on the grounds that, in a period of fluctuating exchange rates, the historical rate is as good a
guide to as the closing rate to the rate at which the debtor or creditor will be settled.
There are good arguments, however, well grounded in accounting theory, for both the second
and the third method. The second method is based on the accrual principle, and the third on
the prudence principle. So, in deciding between the second and third methods, a judgement
has to be made on the relative weight to be given to these two fundamental principles of
accounting.
Addressing problem (2):
Exchange differences arising on the settlement of monetary items or on translating monetary
items at rates different from those at which they were translated on initial recognition during
the period, or in previous financial statements, must be recognised in the statement of
comprehensive income during the period in which they arise, unless the company has entered
into a hedging transaction under IAS 39.
IAS 39: monetary item should be translated at the closing rate and the forward contract
reported at fair value, with all the value changes reflected in current income.