Positive Accounting and Agency Theories sample Essay - Essay Prowess

Positive Accounting and Agency Theories sample Essay

Positive Accounting and Agency Theories sample Essay


Positive Accounting Theory and Agency Theory

Watts and Zimmerman’s Positive accounting theory (PAT) offers accountants’ related descriptive information.  PAT has been dramatically accepted by firms, politicians, and academic learning. Many people have an opinion that PAT has been a success. However, a comprehensive analysis of PAT on its premises and disputes on its economic status can imply that this theory is flawed to some extent. The flaws in the theory can be applied to oppose this theory. It is suitable to be constantly applied by accountants when assessing the impacts of the accounting policy on the corporation’s status. The PAT theory is designed in such a manner that it should aid the accountants in having a better understanding of the existing pressures on the firm. The theory also helps in situations whereby determining how accounting standards impact people and their behaviors and how they determine the manner in which resources are allocated within a firm. As Watt and Zimmerman indicate, a corporation’s management can make decisions that aim to serve their interests. The theory also suggests that it is essential to investigate and have better know-how on how a corporation’s accounting standards can impact the management and their behaviors (Watts and Zimmerman, 1990). With a proper understanding and application of the Positive Accounting theory, it becomes easier to achieve proper reporting and transparency within an organization. The theory focuses on the observed accounting activities within a firm.

On the other hand, agency theory is centered on the major concern of agency problem and its solution.  This theory aims at reducing agency loss, which can also be defined as resolving issues that might occur between the agents and corporations principals. In most cases, organization executives are the principals, while the shareholders are the agents. The agency theory assumes that the principals in the contractual relationship will delegate the agents with authority to make decisions within the corporation, and they would expect the agents to undertake certain activities and be rewarded as a result (Lambert, 2006).  The theory also suggests that both the agents and the principals are individuals inspired by self-interests, which differ depending on information, conviction, and preference. In addition, the theory expects that the principal should offer the capital and bear the risk. The expectation towards the agents is that they should make decisions that favor the principal, undertake certain activities, and also bear the risk (Lambert, 2006).  

Bonus Plan and Debt Covenant Hypotheses

Watts and Zimmerman’s PAT theory is deeply rooted in the Efficient Market Hypothesis (EMH) (Unerman and Deegan, 2006).  EMH takes the assumption that the market is perfect, there are no transaction costs, and the information in the market is symmetrical.  Watts and Zimmerman also indicate that the form of the market that their theory is based on is the semi-strong EMH, which they indicate is the predominant form. PAT theory also points out that upon the release of abnormal information in the capital market, there was a useful reaction that could be applied to change current corporations’ state. PAT theory offered impervious and distorted accounting techniques in that, Watt and Zimmerman suggested that capital markets could see through the accounting policies. PAT can be applied in forming an anti-regulatory position. As Watt and Zimmermann indicate, it was possible for the capital markets to see through the accounting techniques being applied. The regulation was well thought to be an inefficiency that could impact the functioning of the free markets (Watts and Zimmerman, 1990). It was also an expensive technique. Corporations could find a better means in which they could undertake their own reporting tasks. PAT theory also suggests that the procedures of auditing must be performed in the absence of regulations because information users tend to demand to see the information to accord it a value.

 The concepts of agency theory can be applied to help in answering the Watt and Zimmerman PAT theory. If corporation management did not want to alter the accounting techniques to impact share prices, then why did they do it? The concepts of the agent theory are based on the argument that operates under the assumption that the principals in the contractual relationship will delegate the agents with the authority of making decisions within the corporation, and they would expect that the agents will undertake certain activities and be rewarded as a result (Lambert, 2006). The agency theory also argues that corporations are nodes whereby different self-motivated utility exploits connected in order to create the maximum riches possible that could better serve their selfish needs. This also implied that corporations’ owners’ goals must be aligned to the goals of the organizations’ drivers. As a result, management and separation of ownership costs could be minimized. In addition, agency theory also argues that there is a great need to tie rewards on achieved goals in the corporation. For a corporation to do so, it must produce accounting information, which is a necessity when measuring goals attained within the firm.

 The primary parts of Watts and Zimmermann’s PAT theory, which are bonus plan, debt, and political cost hypotheses, can be linked to the agency theory. For instance, as the agency theory bonus plan points out, management can alter their accounting policies, up to the utmost point, to exploit the reported income whenever their rewards depend on reported income level because of their self-desires (Unerman and Deegan, 2006). The concept of self-interest pointed out in the Agency theory is also applicable in the Positive Accounting Theory hypothesized by Watt and Zimmerman. Thus, PAT theory can be termed out to be scientific research and empiricism, the economic theory of semi-strong markets, which relies upon the agency theory’s concepts, more so on the concepts of the self-interest of the agents. 

Political Cost Hypothesis

            Watt and Zimmerman’s PAT theory is flawed in that it bases its arguments on the foundation of a perfect market. For any market to be considered perfect, there must be no transaction costs in the market, and also, there must be perfect information. As Zimmerman suggests, there should be no transaction costs in the market, which is not practical since it must also be there for accounting to exist. Watt and Zimmerman also highlight in their theory that political regulations and costs often interfere with the operations of the perfect markets, contradicts their theory that assumes that there can be perfect markets. The PAT theory also greatly depends on that it bases its argument on the fact that there should be semi-strong EMH, which is not possible as EMH highly depends on the concept of a perfect market. Watt and Zimmerman applied the concept of Agency theory to aid them in their work. Agency theory applies the concepts of self-interested groups. Agency theory asserts that a corporation is organized in such a manner that there is a group of people who delegate the task while the other group undertakes them (Watts and Zimmerman, 1990). In order for a corporation to be in a position to perform these procedures, the principals hire the agents to be performing the tasks that they feel they are not able to perform or unwilling to perform.  For instance, in large corporations, the shareholders are treated as principals, whereas the agents are the management and company executives. The executives, managers, as well as the principals, should play their role guided and motivated by the principles of self-interest. The theory is also flawed since it bases its argument on the principles of self-interest, which, as a result, creates so many conflicts. If both the principles and the agents are guided by self-interests,  the company managers and executives will aim at pursuing their self-interest first, which also dramatically varies with the interests of the Principals. In addition, the goals and objectives of both parties also deviate from each other. 

            Since PAT theory, has borrowed much of its principles from the Agency Theory,  and the Agency theory is flawed in such that it uses the concepts of self-interested people, who do not act out of goodwill, then both theories have some flaws. The Agency theory is also dehumanizing and unobservable since it applies a phenomenon that can be described in another varying manner. For instance, Agency Theory suggests that politicians cause interference in the accounting procedures in order to increase their popularity. It is through causing these interferences that the minority groups can view them as people who act on their needs, which can also be described as acting efficiently. Thus, since Watt and Zimmerman applied many concepts from the Agency Theory, their theory also became flawed.

The Efficiency Perspective

            Presently, researchers have come up with new approaches to synergize the concepts of agency theory into the Positive Accounting Theory, and as a result, they have created a more unified approach. In real-world situations, agency theory gives attention to the ethical disconnection that might arise between the agents of a corporation and the stakeholders, who are the principals. Contrary, the Positive Accounting Theory provides a set of rules, assumptions, frameworks, and approaches that oversee the accounting activities and the reporting of financial issues within a corporation.  Although the two theories were previously applied distinctly,  in the current situation, they are applied in unity. 

In the governance of any corporation,  agency theory is applied,  as it provides particular guidelines to the board of governance or the management and executive of an organization. The theory proposes that firm agents have a fiduciary responsibility to perform in the best interests of the organization’s shareholders. In addition, agency theory gratifies the agents to act in a manner that will favor both the companies agents and the principals. In the present world, corporations usually view the principal’s of best interest as a factor that greatly contributes to the corporations’ gains. Since any corporation aspires to amass greater profits, organizations effectively incorporate the principle of self-interest in the business ventures to maximize profits. 

Corporations consider the fact outlined by the agency theory, which states that conflicts within a corporation are inevitable. Since the Agency theory proposes that agents should be rewarded for positive improvements and better gains within a corporation, some executives manipulate the results for them to have better self-gains. These corporations also have an agency responsibility to several stakeholders, such as suppliers, customers, shareholders, debtors, creditors, and the community. Several stakeholders within the same business entity, who usually have different self-interests and goals, increase the chances of conflicts. Positive Accounting Theory provides a framework and sets of concepts that can be applied in guiding the accountants in assessing and analyzing information related to economics. As opposed to the Agency Theory, PAT theory does not have a logical code collection or a dominant guiding principle. Rather, it comprises a collection of several rules, valuation models, business concepts, and hypotheses. AS a result, whenever accountants are applying this theory, they can decide how they wish to apply either the hypotheses, rules, or the principles outlined by this theory. Some corporations apply the law in financial reporting, while others apply it to establish their practical application of the theory.  In addition, Watt and Zimmerman’s PAT is more dynamic as compared to Agency Theory. Thus, it constantly adapts to the needs necessary for them to operate. However, the theory also incorporates the Agency Theory for the ethical operation of both the agents and the principals.


Lambert, R.A., 2006. Agency theory and management accounting. Handbooks of management

accounting research, 1, pp.247-268.

Unerman, J. and Deegan, C., 2006. Financial accounting theory. European ed.

Watts, R.L. and Zimmerman, J.L., 1990. Positive accounting theory: a ten year perspective.

Accounting review, pp.131-156.