Watts's and Zimmerman's Research in the Late Term Paper

Excerpt from Term Paper :

Watts's and Zimmerman's research in the late 70s gave way to the positive accounting theory and to their book, Positive Accounting Theory, published in 1986. In order to refer to political costs and how they may influence accounting standards and the way profit is regulated in order to fit individual needs, we first need to briefly refer to social responsibility, as it appears in the positive accounting theory.

Most important, Watts and Zimmerman assume that "individuals act to maximize their own utility"

It is clear, in this sense, that managers within a company will act in order to influence accounting standards to their own interest. There are two reward forms that may be influenced: cash bonuses (compensation plans) and changes in share prices (via stock and stock options)

The reported earnings influence both these reward forms. As such, increases in reported earnings will most likely increase the managerial cash reward, because it clearly shows a positive management that has led to increases in company wealth. On the other hand, managers who hold stock within the company will need to consider additional costs that are included in methods of reporting increases in earnings. As such, it may be the case that these costs counterbalance the positive effects of increases in reported earnings due to a decrease in stock value. Among these costs, one can enumerate regulatory procedures, information costs and political costs. This brings us to the discussion on political costs.

According to Watts and Zimmermann, "political costs are another form of contracting costs associated with the financial impact of SFAS No. 52"

. In this sense, it may be the case that political costs influence any accounting decision related to revenue increase or decrease. The political costs can be described as a series of costs that impact the company and that are based on political decisions that politicians are deemed to make on an electoral basis. In this sense, companies with high earnings may come into the public's attention as gainers from a misfortunate and inefficient economic system, a system where favoritism and governmental support may have induced those higher earnings.

In this case, politicians may turn to wealth redistribution in order to regain electoral support. It is quite logical that Watts and Zimmerman have pointed out that "the magnitude of the political costs is highly dependent on the firm's size"

. Indeed, the higher the reported earnings within the company, the more acute the measures that the politicians will take in order to counterbalance public opinion reactions on the subject.

Further more, Watts and Zimmerman also draw our attention towards the association usually made between large reported earnings and monopoly power. Public criticism and the association of large companies with a profit in any conditions priority, leading to environmental and social misfortunes, is again the common denominator here. Large companies, accumulating large profits, are somehow psychologically related to a misdoing or an abuse on the market.

As such, following the explanation presented here above, we may state that companies often have every interest to decrease or at least maintain at constant levels the reported earnings, in order to boost its reputation and perception of the individual voters. This would, in turn, lead to an increase in confidence and perception of the company and may boost up stock value as well. Reduction of profits and earnings can be performed through advertising campaigns, PR campaigns aimed at improving the company's overall image.

One of the examples that many theoreticians use when referring to Watts's and Zimmermann's theories on social responsibility and political costs is related to oil companies, especially during the 70s, after the first oil crisis of 1973. It was such companies that took upon advocacy advertising as a way of (1) decreasing overall earnings in order to increase public confidence and (2) "present a point-of-view about a major public issue"

Following the entire description of the political costs, as applied by Watts and Zimmermann in their positive accounting theory, we are now able to draw some conclusions on the issue. First of all, the evidence clearly points out that it may be financially reasonable for a company to reduce its reported earnings in order to decrease political costs and increase value of stock due to increased confidence form the public.

Indeed, a company can use part of its profit in investments that will decrease overall reported value of earnings, without minimizing the economic efficiency of the company in the respective period of time. Reported decreased earnings will thus have at least three positive effects.

(1) The company has used parts of its earnings for internal investments, as well as for image and PR campaigns, with a direct impact on the public and on the customers' reaction.

(2) The company maintains a low profile and does not become dangerous for any of its competitors.

(3) The company avoids political costs. Due to lower earnings, the company cannot be accused of leading a socially irresponsible policy.

In this sense, we may consider that this latter fact will lead to an increase in stock value, because, naturally, the company will receive a positive aura following its image as a company which is not monopolizing the market and for whom profit is not necessarily the only strategic objective.

Finally, "the larger the firm, the more likely it is to select accounting procedures that defer reported earnings from the current period to future periods"

. Indeed, the direct proportional relationship between the company's size and its vulnerability facing political costs is intermediated by the company's exposure on the market and, especially, to the eyes of the public. It is certain that a company with growing size will negatively impact the people, many of whom may see a sign of unjustified wealth, wealth which could be redistributed by the political class.

On the other hand, despite its logical parts and definite theoretical meaning, Watts's and Zimmeraman's theory on political costs and social responsibility has some unexplainable aspects which we need to refer to.

First of all, in a market economy, it is not necessary that a growing company, with reportedly high earnings, will be negatively exposed to the public. A functional economy has control over market functions such as competition and ensures that the earnings a company has received are as fair as possible. It may be the case that the market forces will intervene in order to regulate situations in which a company's profits has been obtained through illicit or immoral means.

It may otherwise be the case that a company reporting higher earnings will be considered as reflecting its growth potential and managerial efficiency. The best example in this case may be General Electric. During Jack Welch's period as CEO, the company constantly increased its earnings. During this time, the company's stock rose significantly, to such a degree that the company was able to present rewards in the form of stock options.

As such, the reflection of the company for the public and, especially, for the investors on Wall Street, was not that of a monopolistic company (the company operated in extremely competitive industries and had to face the Japanese and European companies) that manipulated competitors and customers alike, but that of an extremely efficient company. In this sense, Jack Welch launched the slogan "number one or number two," which meant that GE would only remain to compete in industries where it had chances to rank no.1 or no.2.


1. Martien Jan Peter Lubberink. Financial statement information: the impact of investors and managers. Groningen: SOM, 2000

2. Milne, Markus J. Positive Accounting Theory, Political Costs and Social Disclosure Analyses: A Critical Look. University of Otago. Page 4. On the Internet at http://www.commerce.otago.ac.nz/acty/research/pdf/postive_accounting_theory.pdf


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