Positive Accounting Theory and Various Other Relevant Theories of Financial Accounting Term Paper

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Policy Setting Using Ex-Ante and Ex-Post Accounting Techniques

Firms make contracts every day because they are required to gain assets that would be costly for them to obtain otherwise. At one time these contracts were made from an opinion-based accounting model called normative theory. Many departments used this theory because they believed that they could use the knowledge that they had gained to make accurate guesses regarding financial and intangible accounting decisions. The problem with this is that it does not take into account actual empirical data that could be used more accurately to make accounting decisions that helped the firm grow for the long run. Because accounting researchers realized that these types of anecdotal theoretical stances did not actually work, they tried to determine a model that could more accurately predict a firm's accounting needs. The result of this investigation was positive accounting theory. Researchers found that firms who used actual empirical data to determine the correct course were more successful than those that used simple normative calculations. After the positive model came those based on social aspects of firms and behavioral aspects, but they all tie back to the positive accounting theory in one way or another. This paper examines how positive accounting theory, and other related theories, use ex-ante efficiency and export opportunity to make policy decisions.

Accounting Theories

Positive accounting theory was originally a response to what was believed to be the non-empirical basis upon which accounting logic had previously been founded. This was contrasted with the normative view that had been the hallmark of accounting theory for decades. According to Gaffikin (2007),

"It is believed that a positive statement is a statement about what is and that contains no indication of approval or disapproval. A normative statement expresses a judgment about whether a situation is desirable or undesirable and is couched in terms of what should be or ought."

Basically, that means that normative accounting based its stance on the anecdotal evidence that people had gathered from their own unscientific experience. From this experience they formulated equally unscientific theories about how accounting should be conducted. This process was seen to be flawed because a normative system can be chaotic if different people believe that accounting should be conducted in different ways. Trying to conduct cross-company business and establish contractual standards would be almost impossible using this approach.

Since this system was not desirable, positive accounting methods were developed in which empirical data was paramount. It is easy to see this process as cold, but since the consequences of poor policy decisions being made is the alternative, cold often works better than an accounting method whereby things other than the numbers are considered. Gaffikin (2007) points out that "Fundamental to [positive accounting theory] is a belief in rational choice theory." This means that every person is, as Hume would have said in his philosophy, only concerned with self. This means that every person is likely to be opportunistic when it comes to contractual obligations because the individual wants to make the best deal they possibly can. Since a firm is made up of people, it can be said that an organization is a "nexus" of these self-serving contracts (Gaffikin, 2007). The contracts that a firm signs (e, g., with employees and suppliers), "are necessary to get individual parties to act to maximize the wealth of the owners (shareholders)" (Gaffikin, 2007). This seems like an incredibly cynical view, but it is essentially correct. An individual does not sign a contract to benefit anyone else but themselves (and maybe those closest to them, such as their family), so it is in the firm's best interest to use this data to form ex-ante contracts with those individuals so that they will perform for the company.

Another view that can be considered is that of social accounting theory. Since companies are a part of society, what they do affects society, and, in even more profound way, what the society does affects the accounting practices of the company. According to Gomes (2008) "the story that accounting has to tell is also one of changes in socioeconomic thought and the politico-cultural order. The economic, social, and organizational contexts became crucial sources of explanation for accounting change'" This can be seen in a recent example. The latest financial downturn was felt on a global level, but especially in those countries which tied their financial structure to that if the United States (which means most of them). This crisis determined that accounting practices had to become more conservative because the freedom exhibited prior to the crisis was seen as a primary reason for the downturn. In this case, and many others that could be used as examples, the society dictated how accounting was to be carried out going forward.

A similar accounting practice is that of relational exchange theory. Incident in this theory is the belief that "the sociological characteristics of exchange relationships…are argued to be critical determinants…[because they] evolve over time as exchange partners become increasingly familiar with each other and establish behavioral rules for such processes as conflict resolution, monitoring and joint problem solving" (Artz & Norman, 2002). Establishing relationships is seen as central to contract negotiations because this may result in a more efficient, less opportunistic, means of developing contracts. People who have trust relationships with each other are less likely to attempt excess personal gain from a contract.

All of these forms come back to positive accounting methods though. These methods are calculating, although they do not overlook relational theories. The reason for this is that positive accounting theory is "based on the notion that theory should seek to explain and predict accounting practice" (Gomes, 2008). Studies have been conducted as to relational efficacy in contractual negotiations, and there is a positive relationship between ex-ante efficiency and relationship building between contracting parties. Actually, positive accounting theory says that "there will be contracting costs associated with the contracts, for example, costs of negotiating with and maintaining and monitoring the performance of the parties involved" (Gaffikin, 2007), which means that the costs are as a result of trying to maintain the relationship between the parties so that the most efficient contract can be maintained. The goal of the theory is to "minimize the contracting costs" by employing empirical methods to accounting.

The more modern methods of accounting can then be seen to tie together because of the need for the firm to achieve the most efficient accounting methods possible; whether those methods concern financial or intangible assets. The reason that positive accounting theory is stressed is that it what joins the other theories. Firms need to use the most proven methods available and these may use sociological and behavioral data because that is what the research says is the most efficient method of accounting. The following two sections delve into how ex-ante efficiency and ex-post opportunism can be determined by using positive accounting theory methodology.

Ex-Ante Efficiency

An efficient operation is one that uses all of its resources to the maximum extent possible. Therefore, it can be inferred that ex-ante efficiency is the assurance that financial policy makes steps taken prior to the actual event that are as efficient as possible. Since, positive accounting theory is an empiricist stance, it would have the decision makers use the best data available to make the most efficient decisions prior to an undertaking. A social accounting theory would possibly ask that the decision makers build relationships with the other contractual parties before making any decisions. Understanding the resources that are available and ensuring that prior research is examined to determine the most direct line of reasoning are essential for an ex-ante efficiency model.

Ex-ante efficiency offers many advantages which cannot be seen with any opportunistic approach. According to Artz and Norman (2002) "the most challenging aspect of developing and maintaining long-term exchange relationships is how to develop efficient (i.e., least costly) contracts to effectively govern exchange. Formal contracts enable parties in an exchange to coordinate their actions and limit potential opportunistic behaviors" (Artz & Norman). A good example of this is contracts that are set by baseball teams prior to a players arbitration or free agency years that usually are set based on the position the player occupies (some are deemed more valuable than oithers), the distance the player is from their arbitration years (i.e., how many years the player is team controlled), and the relative value that the player has already shown at the major league level. The team wants to get the contract done ex-ante because it allows them to sign the player to a long-term deal for much less than they would potentially make when it came time to sign a contract or "test the market." The player wants to limit ex-ante opportunism, while the team wants to limit ex-post opportunism. Many see the best deal as that of ex-ante efficiency. Also, this is governed by both the financial accounting for the team and intangible assets. The reason that a contract…

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