Positive Accounting Theory - Essay Example

Reflection to Accounting in Theory and Practice The purpose of this essay is to present a reflection to the topics discussed in the paper “Accounting in the news”. This essay will put forward my thoughts over the discrepancy in the accounting theories and principles and the actual accounting in practice. The Financial Accounting Standards Board has developed certain generally accepted accounting principles in public interest and have set accounting standards for public companies in the U.S. Generally accepted accounting principles include standards, conventions, and rules that the accountants/ accountant firms should follow in recording and summarizing transactions, and in the preparation of financial statements. However, sometimes there is difference in the accounting methods in theory and practice. Positive Accounting theory (PAT) is defined by Scott as “concerned with predicting such actions as the choices of accounting policies by firms and how firms will respond to proposed new accounting standards.” PAT uses the theory to predict how the management will choose the accounting policies for their firm. This theory helps to merge efficient securities markets with economic consequences. PAT does not propose that organizations completely identify what accounting policies they will use. According to PAT, firms conduct themselves in such a way that it maximizes their own best interests. Managers have flexibility to choose a set of accounting policies. Managers do not always do what is best for shareholders. They do what is the most beneficial to their organization. The organizations’ choices depend on the type of industry they are in and the factors within that industry. The accounting policies that are most favorable to an organization involve balance of minimal costs and flexibility to give management an option to change policies according to changes in external environment. The ultimate objective of PAT is to understand and forecast accounting policy choice across different firms, and different industries. PAT assumes that all accountants are primarily motivated by interest of maximizing their wealth so they will select a particular accounting method among available alternatives, which will benefit them or their organization. The bonus plan hypothesis states that managers will use accounting policies that are likely to shift reported earnings from future periods to the current period. They will always try to maximize their personal compensation by reporting a high net income and maximizing their utility through bonuses and incentives. The debt covenant hypothesis states that if a firm is close to compromising their debt covenants, the management is more likely to use accounting policies that shift reported earnings from future periods to the current period because higher net earnings will reduce the probability of technical default on debts. The political cost hypothesis states that if the political cost (taxes, regulations) to the firm is high, the management is more likely to use accounting policies to defer reported earnings from current periods to future periods. The political cost hypothesis brings politics into the choice of accounting policies. This is why highly profitable firms attract media and consumer attention to create an increase in taxes and other regulations. Agency Theory states that the agent (like the principal) will be driven by self-interest. Therefore the principals will anticipate that the manager will undertake self-serving activities that could be detrimental to economic welfare of the principals, unless he is restricted from doing otherwise. According to the Efficient Market Hypothesis, the capital markets react in an efficient and unbiased manner to publicly available information. If we try to look at the examples that are referred to in the referenced articles, we find that many of the technology companies are going to benefit from the Government decision to do away with certain accounting requirements and approve proposals for changes in accounting rules by allowing them to recognize more revenue when their products are actually sold. This would give a boost to their earnings. The change might make some companies more attractive in terms of investments and would help their price-to-earnings ratio to look attractive to retail investors. In contrast to the Principle of prudence that is showing the reality "as is" and one should not try to make things look prettier than they are, in times of recession, when the economy is down and people try to find scapegoats for financial losses and failed deals, many a times the accounting firms become the victims. Trouble started when CPA firms started expanding their services beyond tax, auditing and accounting services. They started offering personal financial services like investment and wealth management advice. In times of recession and economic slowdown all over the world, on one hand companies are cutting down expenses, slashing salaries and sops and taking different measures to reduce debts. However, on the other hand they are paying fat pay packets and stock options to top executives more than that is allowed under company rules. Companies are replacing excess options with stock appreciation rights vesting on the same schedule and having the same exercise prices. Some have even approved an incentive scheme for the next two years. They are struggling with debts and their auditors have given them worst ratings. To avoid economic downturn and recession like last year, all the countries should coordinate their efforts in taking important financial decisions and changing their accounting regulations globally. They should reduce the government's role in the country’s financial sector. Stricter and stringent international standards are required for higher capital reserves for banks to hold as a cushion against potential losses in case of large firms that pose a threat to the overall stability of the country’s financial system. They should eliminate the conflicting approaches on “mark-to-market” accounting rules between international financial institutions and financial accounting standard setters. The “mark-to-market” accounting rules should be adopted to force banks to value their assets on balance sheets at current market prices, even if they have plans to hold them for years. Accounting standards should be more stringent to restrict the availability of credit and make it difficult for banks to get rid of loans (which they sell as securities) in their balance sheets. In conclusion, we can say that there is still discrepancy in the accounting theories in practice and how accounting theories work in real life. Changes in accounting rules can go a long way to benefit certain companies in terms of revenues and share market. Governments are taking appropriate steps in changing accounting regulations to boost the revenues of Public and Private sector companies but their efforts should be coordinated globally to boost the world economy as whole. At the same time accounting firms should stop giving services beyond their reach and capacity to avoid litigations and frauds. There is long way to go for the actual recession to recede and the world economy starting to show growth as before. In adverse times like today, all companies should reduce fat pay packets for top executives and stop the layoffs and pink slips for their employees. Read More