The beginning of positive accounting theory is the Efficient Markets Hypothesis (EMH). The EMH is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information. The main strengths of Positive Accounting Theories over Normative Accounting Theories are the facts that hypothesis are framed in such a way that they are capable of falsification by empirical research. Also, these theories aim to provide an understanding of how the world works rather than stating how the world should work. Moreover, PAT tries to understand the relationship and connection between various accounting information, managers, firms, and markets; and also analyze these relationships within an economic framework.
There are several assumptions made in development of positive accounting theory. The first is that the firm is a nexus of contracts. In relation to Positive Accounting Theory, because there is a need to be efficient, the firm will want to minimize costs associated with contracts. Contract costs involve accounting variables as contracts can be stipulated in terms of accounting information such as net income, and financial ratios. The firm will choose the accounting policies that best acknowledge the need for minimization of contract costs. PAT recognizes that changing circumstances require managers to have flexibility in choosing accounting policies which brings forward the problem of ‘opportunistic behavior’. This occurs when the actions of management are to better their own personal interests.
The other assumption is that the managers are rational economic decision makers and will act to maximize their own profit and not the profit of the company. Under Positive Accounting Theory, firms want to maximize their prospects for survival, so they organize themselves efficiently.
Criticisms of Positive Accounting Theories
One of the main criticisms of Positive Accounting Theory is that it doesn’t provide prescription for accounting and therefore doesn’t provide any means of improving accounting practice. This, therefore results in alienation of practicing accountants. It is argued that simply explain and predicting accounting practice is not enough. There is no guidance on what people should do, as there is a general absence of prescription.
The other criticisms of Positive Accounting Theory relate to the fundamental that all action is driven by a desire to maximize wealth. Many researchers find this statement very negative in nature. They believe that PAT promotes a morally bankrupt view of the world. The concept of ‘positive theory’ is drawn from an obsolete philosophy of science and is in any case a misnomer, because the theories of empirical science make no positive statement of “what is”. And also of course, Watts and Zimmerman do say, “We do not contend that all issues are settled, but rather encourage others to pursue, correct, and extend our analysis.”