Positive Accounting Theory (PAT) aims to explain accounting practices by predicting which firms will use certain practices based on incentives. It originated from ideas in the Efficient Markets Hypothesis and Agency Theory. Watts and Zimmerman promoted PAT in research beginning in 1978. It assumes managers act in self-interest and choose accounting practices based on how capital markets will reward or punish unexpected news. While standards provide minimums, managers have discretion in areas like asset measurement, allowing them to disclose information favoring their interests.

1. LO 1: Define Positive Accounting
Theory and explain its historical
development
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2. What does Positive Accounting Theory (PAT)
mean?
There are three levels to PAT. Pay attention to the capitalisation:
1. Positive, or positivist theory refers to that branch of theorising that values objective, value-
free empirical research. All scientific research is positivist (known as the scientific method).
2. Positive accounting theory is the branch of accounting theorising that makes use of the
positivist, scientific method for research.
3. Positive Accounting Theory (PAT) is a specific theory within the positivist accounting
theories in accounting (hence the capitalisation).
Therefore, positive theory, positive accounting theory and Positive Accounting Theory (PAT)
are all related but they do not refer to the same thing. Make sure you know the difference.
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3. Definition of PAT
PAT is concerned with explaining accounting practice by predicting
which firms will, and which firms will not use a particular accounting
practice.
Note that PAT is not at all concerned with what accounting practice
firms should be using. PAT is a study of accounting practice in the wild,
not a study of an ideal or norm.
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4. Origins of PAT
The ideas that form PAT have two main
origins:
• The economic foundation of Efficient
Markets Hypothesis (EMH), and
• Agency Theory.
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5. Watts and Zimmerman
Watts and Zimmerman promoted PAT through a number of journal publications,
starting with Watts and Zimmerman (1978).
From the 1970s, accounting research moved to a more "scientific" approach to
counter the dominance of normative research. There was a view, which is still
widely held, that to be a serious discipline, accounting research had to use
"serious" scientific methods.
This view had already been forming in the big US business schools since the 1950s,
but accounting was slower to take this up. Accounting was a more recent discipline
than economics and management, and still forming its theoretical foundations.
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6. Origins #1: Hypothesis forming
The 1950s saw the emergence of accounting research that depended
up forming and testing hypotheses (known as the scientific method).
This was considered to be a paradigm shift from the dominant form of
research at the time: normative research.
Hypothesis testing allowed the theory to be tested and confirmed or
rejected based on tests of empirical data.
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7. Origins #2: Efficient Market Hypothesis (EMH)
EMH is based on the assumption that capital markets react in an
efficient and unbiased manner to publicly available information.
Ball and Brown (1968) used EMH to determine what happens after
unexpected earnings announcements. They concluded that capital
markets behave as expected in EMH, and that abnormal returns =
actual rate of return - expected rate of return.
Ball and Brown had shifted an economic model into accounting,
because earnings announcements are in the realm of the accountant.
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8. Origins #3: Agency Theory
Agency theory is a theory of how owners (principals) and managers
(agents) behave towards each other. Its predictive capacity is based on
the assumption that all actors (principals and agents) can be relied on
to act in their own self interest.
Although Agency theory tends to focus on managers, it is important
that everyone is expected to act in self interest, including shareholders,
the board of directors, lenders and so on.
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9. How it comes together
1. Accountants and managers are expected to make decisions that
favour their own self interest.
2. Accountants and managers know that the efficient market will
reward unexpected good news, punish unexpected bad news, and
be neutral towards any news (good or bad) that was expected.
3. Accountants and managers will therefore adopt accounting
practices that will lead to rewards from the market, and avoid
accounting practices that will lead to punishment from the market.
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10. But wait, don't the accounting standards tell
accountants what to do?
Not completely. Accountants and their managers have a lot of freedom for
professional judgement, not least in how assets and liabilities are to be
measured.
Accounting standards also represent a floor for declarations in the
financial reports, not a ceiling.
That means that the accounting standards set a minimum for what
information must be declared, and how. Beyond that, accountants and
managers are free to make whatever disclosures they see fit.
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11. So PAT tells us…
Accountants and managers will select accounting practices and
voluntarily disclose information on the basis of what it means for
them.
How principals (owners of the company and their board of directors)
'encourage' agents (managers and their accountants) to make
decisions for the interests of the company (i.e. in the interests of the
principals) is the subject of the next presentation.
Stay tuned…
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12. References
Ball, R. & Brown, P. 1968, 'An empirical evaluation of accounting
income numbers', Journal of Accounting Research, vol. 6, no. 2, pp. 159–
178.
Watts, RL & Zimmerman, JL 1978, ‘Towards a positive theory of the
determination of accounting standards’, Accounting Review, vol. 53, no.
1, pp. 112–134.
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