ACC 6030 Module 4 Written Assignment: Positive Accounting Theory Applied Example

Predicting Managers' Choices: Positive Accounting Theory Applied to a Distributor Near Its Covenant

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M.S. in Management in Accounting, Thomas Edison State University

ACC-6030: Accounting Theory

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Month Day, Year

Predicting Managers' Choices: Positive Accounting Theory Applied to a Distributor Near Its Covenant

Introduction

Accounting theory can try to answer two different questions. Normative theory asks what accounting should be, deriving recommended practices from objectives such as decision usefulness or from concepts such as true income. Positive theory sets out to explain and forecast the accounting choices managers and rule makers actually make, reading them from their incentives (Schroeder et al., 2011). Each has a role, and confusing them leads to arguments in which neither side addresses the other.

Normative Approaches

Normative theories dominated accounting thought before the 1970s. Some deductive theories began from premises about the nature of income or capital and reasoned to methods, such as current cost accounting. Others began from user needs, the approach the conceptual framework later adopted. Normative theory is valuable for standard setting because standard setters must decide what accounting ought to be. Its weakness is that recommendations depend on value judgments that cannot be tested.

Positive Accounting Theory

In the late 1970s, Watts and Zimmerman (1978) proposed explaining accounting choices through economic incentives. Managers, they argued, choose accounting methods, and lobby on proposed standards, according to how those methods affect their own welfare through contracts and politics. Three hypotheses became central:

These hypotheses are testable. Healy (1985) looked at bonus schemes with a floor and a ceiling and found managers pushed accruals down when earnings sat below the floor or above the ceiling and up when earnings fell between them, a sharper fit to the bonus hypothesis than a plain urge to report more income.

Applying the Hypotheses: Meadowlands Chemical Supply

Meadowlands Chemical Supply, a composite private distributor of industrial chemicals in Secaucus, New Jersey, has a bank loan with a covenant requiring a debt to EBITDA ratio below 3.5. At its last measurement the ratio was 3.3. Its managers receive bonuses equal to 5% of net income above a $2 million floor, with no cap. The company is not large enough to attract political scrutiny, though it operates in a regulated industry.

The debt covenant hypothesis predicts that Meadowlands' managers will favor income-increasing choices, such as extending the estimated useful lives of delivery vehicles, choosing FIFO rather than LIFO in a period of rising chemical prices, or reducing estimates of bad debts, because a higher EBITDA lowers the ratio and avoids a costly violation. The bonus plan hypothesis points the same direction: with earnings above the floor and no cap, each additional dollar of reported income raises the bonus. The political cost hypothesis has little force here, though environmental regulators might scrutinize the company if large profits followed an incident.

The theory also predicts limits. Auditors, the bank's own review of the numbers and the reversal of accruals in later periods constrain how far managers can go. And some choices, such as switching inventory methods, require disclosure and justification, which makes them costly.

Evaluating Positive Theory

Positive accounting theory brought rigor and testability to accounting research and explains much observed behavior. Critics argue that it assumes managers act only in self-interest, that its proxies for contracts and political costs are crude and that it cannot say what accounting should be, which is the question standard setters must answer. The two approaches are best seen as complements: positive theory predicts how managers will respond to a proposed standard, and normative reasoning decides what the standard should require.

Critics also argue that the theory's tests often cannot separate opportunism from efficient contracting. A manager who chooses longer asset lives may be avoiding a covenant breach or may simply hold better information about how long the assets last; both explanations predict the same choice. Later research addressed this by studying situations in which incentives change while the economics stay the same, such as just before management buyouts.

Conclusion

Normative theory prescribes; positive theory explains and predicts. Applied to Meadowlands, positive theory predicts income-increasing choices driven by the covenant and the bonus plan, constrained by auditors, lenders and disclosure. Understanding those incentives helps auditors, lenders and standard setters anticipate how accounting rules will be used.

References

Healy, P. M. (1985). The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics, 7(1-3), 85-107. https://doi.org/10.1016/0165-4101(85)90029-1

Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2011). Financial accounting theory and analysis: Text and cases (10th ed.). John Wiley & Sons.

Watts, R. L., & Zimmerman, J. L. (1978). Towards a positive theory of the determination of accounting standards. The Accounting Review, 53(1), 112-134.