Positive Accounting Theory

LITERATURE REVIEW

Positive accounting emerged with empirical studies that propagated in accounting in the late 1960s. It started with some underlying assumption of normative accounting prescription in 1960’s. This theory attempts to explain and predict definite accounting practices. There were two sets of empirical studies conducted. One set of studies examined the relationship between accounting earnings numbers and stock prices and results specify that earnings numbers reflects factors such as cash flow and risks relevant to stock valuation. As researched by(Kabir, 2010) cited in Watts and Zimmerman (1986), undermined the claim in normative accounting literature that accounting earnings numbers were meaningless because they were computed

It has initiated a great deal of pragmatic research on the relationship between accounting numbers and stock prices and returns, and factors that determine accounting choices by management. The three basic hypotheses outlined by Watts and Zimmerman (1978) underlying positive accounting theory are bonus plan hypotheses, debt/equity hypotheses and political cost hypotheses. Bonus plan hypotheses states that managers of firms with bonus are to be expected to use accounting methods that boost current period reported income. Such collection presumably increases the present value of bonuses if he compensation committee of the board of the directors does not adjust to the method chosen. Debt/equity hypotheses forecast that big firms rather than miniature firms are more likely that the managers use accounting methods that boost income. Political cost hypotheses forecast that big firms rather than miniature firms are more likely to use accounting choices that trims down reported profits.

According to(Kabir, 2010), positive accounting theory has improved the perceptive of various accounting phenomenon and numbers. It has yielded vital insights into the connection between accounting numbers and stock returns andmanagement’s financial reporting incentives. Even with this, its contribution to accounting practice hasbeen very narrow. Accounting

(Salah, 2010)states that earnings management can used to develop managements own situation. When bearing in mind the practice of earnings management, the Agency Theory explicates the existence of the incentive for management to use earnings management. As explained earlier managers are liable to have an information advantage over the principal due to the day-to-day information and the insider knowledge. The motivation to use earnings management can occur from conflicts of interest, for instance when the purpose of the management vary from those of the shareholders. Moreover, management might try, by using earnings management, to deceive shareholders by showing a diverse image of the company’s earnings. Management could permit shareholders to deem that the earnings are higher or lesser than they actually are. Clearly the use of earnings management will be used to improve managements own condition, either openly at the cost of the company or by improving the company’s