Of what value is positive accounting theory to financial analysts
Positive Accounting
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Of what value is positive accounting theory to financial analysts
Positive accounting is a theory that is used to predict the choices of the accounting practices that managers will take and how they will react to new accounting policies. It is based on the belief that firms will act in the most efficient manner so that to ensure they increases their chances of survival in the market. However, the theory does not specify on the accounting standard that a firm must use, this is left to managers to adopt policies that are appropriate with their organisations.
The theory puts into account that every person will act rationally, and this includes the managers. The choice on accounting method they will use will be determined by their personal interest rather than those of the organization. They will choose a method out of which they are most likely to benefit.Positive accounting practices are most appropriately used when there is a need to explain past financial events, as well as the cause of an individual current financial standing. Financial analysts use positive accounting to enhance and explain better various accounting phenomena and issues since it helps understand various practices such as stock returns better. It helps explain why managers in an organization choose the particular accounting practices they take by explaining strength and weaknesses of different accounting practices.
The theory is organized around three hypotheses; the first one is bonus plan hypothesis. Financial lending institutions will mostly have a bonus plan; this is the situation where they give their managers some additional amount of money in the form of bonus if there is increased revenues or profit. Positive Accounting suggests that, in such a situation, the finance institution manager will prefer the accounting practice that will increase the currently reported earnings. There are higher chances that the manager will adopt an accounting policy that will record more earnings on the current period.
The second hypothesis is the debt covenant hypothesis. Manufacturing companies will mostly acquire their inputs and heavy machinery on credit; the company might be unable to meet its debt agreement of maintaining a constant debt to equity ratio. If this happens, management is more likely to adopt methods that will transfer future earnings of the company to the present period. Although this will only be a short term solution, management will make sure that they maintain the ratio at a constant.
The third hypothesis is the political cost hypothesis. Power supply companies will enjoy the monopoly rights in their operations; they will face little competition and as a result, they will make super normal profits. The high amount of profits will attract the government to charge super normal profit tax that will most likely be higher than the normal profits. To avoid high taxation, managers of such companies will want to conceal the profits they get so that they can report a lower amount. They will, therefore, adopt accounting policies that tend to shift the current earnings into a future period to also limit the number of responsibilities that might come with a report on super normal profits.
Positive Accounting Techniques help financial analysts identify the need for audit of financial information. The theory clearly states that everybody in the organization will act in his or her own interest and hence, even the managers will act on their own interest, they can manipulate the financial statements so that they overstate and in return have higher remuneration. However, PAT identifies this loophole and calls for an audit of all financial statements.Financial analysts should appreciate the role of management on reporting on financial statement. Managers will choose the most appropriate method that will reduce the cost of an organization while maximizing the profit. The accounting policies that are adopted will be influenced by the environment which the organization operates which will as a result, influence the accounting policy that managers will adopt.
