Positive Accounting Theory as developed by Watts and Zimmerman and others, is based on
the central economics-based assumption that individuals action is driven by self-interest and
that individuals will act in an opportunistic manner to the extent that the actions will increase
their wealth. Given an assumption that self-interest drives all individual actions, PAT predicts
that organisations will seek to put in place mechanisms that align the interests of the
managers of the firm with the interest of the owners of the firm. Some of the method of
aligning interest will be based on the output of the accounting system (such as providing
manager with a share of the organisations profits). Where such accounting-based alignment
mechanisms are in place, there will be a need for financial statement to be produced.
A key to explaining managers choice of particular accounting method came from Agency
theory. Jensen and Meckling (1976) defined agency relationship as:
A contract under which one or more (principals) engage another person (the agent) to
perform some service on their behalf which involves delegating some decision-making
authority to the agent.
It is assumed within Agency Theory that principals will assume that the agent will be driven
by self-interest, and therefore the principals will anticipate that the manager, unless restricted
from doing otherwise, will undertake self-serving activities that could be detrimental to the
economic welfare of the principal.
Firm can be viewed as a nexus of contracts and these contracts are put in place with the
intention of ensuring that all parties, acting in their own interest, are at the same time
motivated towards maximising the value of the organisation. Thus, the contractual
arrangement can be used as a basis of controlling the efforts of self-serving agents.
Assuming that self-interest drives the action of the managers, it may be necessary to put in
place remuneration schemes that reward the managers in a that is, at least in part, tied to the
performance of the firm. Given that the amounts paid to the manager may be directly tied to
accounting numbers, any changes in the accounting methods being used by the organisation
will affect the bonuses paid.
To test the assumption that managers choice of accounting method is directly correlated with
existing earnings arrangement, Watts and Zimmerman (1990) identified three key hypotheses
It does not provide prescription and therefore does not provide a means of improving
accounting practice.
It is not value free as it asserts.
The assumption that all action is driven by a desire to maximise ones wealth is far too
Key definitions
Non-monetary assets are entered in the books of account at their historical cost in
At the historical rate: with this method, the home currency amount to these items is
left unchanged and no translation gain or loss is reported.
2:
At closing rate: translation at the balance sheet rate gives the current value of these
items in terms of home currency
3:
At the lower (higher) of the historical rate and the closing rate of assets/liabilities:
when this method is used, assets are stated at the lower of two possible values and
liabilities at the higher.
Of the three methods, the first method is rarely used. Some accountants justify its application
on the grounds that, in a period of fluctuating exchange rates, the historical rate is as good a
guide to as the closing rate to the rate at which the debtor or creditor will be settled.
There are good arguments, however, well grounded in accounting theory, for both the second
and the third method. The second method is based on the accrual principle, and the third on
the prudence principle. So, in deciding between the second and third methods, a judgement
has to be made on the relative weight to be given to these two fundamental principles of
accounting.
Addressing problem (2):
Exchange differences arising on the settlement of monetary items or on translating monetary
items at rates different from those at which they were translated on initial recognition during
the period, or in previous financial statements, must be recognised in the statement of
comprehensive income during the period in which they arise, unless the company has entered
into a hedging transaction under IAS 39.
IAS 39: monetary item should be translated at the closing rate and the forward contract
reported at fair value, with all the value changes reflected in current income.