Political Costs and Social Responsibility in Positive Accounting Theory
This paper examines the concept of political costs as developed by Ross Watts and Jerold Zimmerman in their Positive Accounting Theory. Beginning from the foundational assumption that individuals act to maximize their own utility, the paper traces how managers may manipulate reported earnings to serve personal and corporate interests. It explores how political costs — arising from public scrutiny and electoral politics — incentivize firms, especially larger ones, to reduce reported earnings through investments, PR campaigns, and advocacy advertising. The paper also critically evaluates limitations of the theory, citing General Electric under Jack Welch as a counterexample in which high reported earnings enhanced rather than damaged public and investor perception.
- Introduction to Positive Accounting Theory: Origins and core assumptions of Watts and Zimmerman's theory
- Political Costs and Their Origins: Definition and electoral basis of political costs
- How Firms Respond to Political Costs: Managerial strategies to reduce reported earnings
- The Oil Industry as a Case Study: Oil companies and advocacy advertising after 1973
- Implications of Earnings Management: Three positive effects of reduced reported earnings
- Critical Limitations of the Theory: GE counterexample and market economy objections
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What makes this paper effective
- Clearly traces a logical chain from the foundational assumption of utility maximization through to concrete firm-level behaviors such as advocacy advertising and deferred earnings reporting.
- Balances theoretical exposition with a well-chosen counterexample (GE under Jack Welch), demonstrating critical engagement rather than mere summary.
- Synthesizes multiple scholarly sources — including Watts and Zimmerman's original work and Milne's critical review — to support the analysis.
Key academic technique demonstrated
The paper models how to present and then critically evaluate a theoretical framework. After explaining Watts and Zimmerman's political costs hypothesis in full, the author identifies a real-world case that challenges the theory's assumptions, showing that reported earnings can sometimes enhance rather than damage a firm's public image. This move — exposition followed by reasoned critique — is a core skill in applied accounting and finance essays.
Structure breakdown
The paper opens by situating Positive Accounting Theory historically, then builds the political costs argument step by step: definition, firm-size dependency, managerial responses, and a sectoral case study (oil companies in the 1970s). It consolidates the theory's implications into a numbered list before pivoting to a critical section that challenges the theory's universality, closing with the GE counterexample. References follow in a numbered bibliography.
Introduction to Positive Accounting Theory
Watts's and Zimmerman's research in the late 1970s gave way to Positive Accounting Theory and to their book, Positive Accounting Theory, published in 1986. In order to discuss political costs and how they may influence accounting standards — and the way profit is regulated to fit individual needs — it is first necessary to briefly address social responsibility as it appears within the positive accounting theory.
Most importantly, 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 to influence accounting standards in 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).
Reported earnings influence both of these reward forms. Increases in reported earnings will most likely increase the managerial cash reward, because they clearly demonstrate positive management that has led to increases in company wealth. On the other hand, managers who hold stock within the company must consider additional costs associated with methods of reporting earnings increases. It may therefore be the case that these costs counterbalance the positive effects of higher reported earnings due to a decrease in stock value. Among these costs, one can enumerate regulatory procedures, information costs, and political costs — the primary focus of this discussion.
Bibliography
1. Lubberink, Martien Jan Peter. 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 working paper. Available at http://www.commerce.otago.ac.nz/acty/research/pdf/postive_accounting_theory.pdf
3. Rezaee, Zabihollah. "An Investigation of the Relationship Between Multinational Companies Attributes and the Market Effects of SFAS No. 52." Journal of Financial and Strategic Decisions, Volume 7, Number 3, Fall 1994. Available at
4. Watts, R. L., & Zimmerman, J. L. (1978). "Towards a Positive Theory of the Determination of Accounting Standards." The Accounting Review, Vol. 53, No. 1, pp. 112–134.
5. Sidhu, K., & Whittred, Greg. "The Role of Political Costs in the Deferred Tax Policy Choice." Australian Journal of Management, June 2003.
6. Nujaki, Merridee. "A Citation Trail Review of the Uses of Firm Size in Accounting Research." Journal of Accounting Literature, 1997.
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