Question

a)What is the main purpose of simplifying assumptions of Positive Accounting Theory (PAT)?b)Explain why PAT assumes ‘problems’ between managers and shareholders? Suggest ways shareholders can minimise these “problems”c)Define ‘creative accounting’, and its relationship with ethical dilemma for manager.

Answer 1

There are several assumptions made in development of positive accounting theory.They are in simplified manner so that it can be easily understood and one can make quick analysis from it. 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.

SHAREHOLDER CAN MINIMISE PROBLEM IN FOLLOWING MANNER:

• In relation to PAT, because there is a need to be efficient, the firm will want to minimize costs associated with contracts. Examples of contract costs are negotiation, renegotiation, and monitoring costs. 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.

CREATIVE ACCOUNTING:

Creative accounting consists of accounting practices that follow required laws and regulations, but deviate from what those standards intend to accomplish. Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better image of the company. Although creative accounting practices are legal, the loopholes they exploit are often reformed to prevent such behaviors.

Ethical Perspective of Creative Accounting

There are some ethical issues concerning the exercise of creative accounting. Loopholes in accounting standards provide manager some spaces in the sense of manipulate the timing in income reporting. Accounting is a tool to supervise contracts between managers and financial groups, identify possibility of accounting manipulation and how properly it reflected in pricing and contracting decisions. Ethics of bias in choosing accounting policy which implied in creative accounting can be seen through accounting regulators and management level.

Managers tend to misapply accounting principles to give better appearance in financial statement to investors. Conflict of interest, client requests to alter account and for tax evasion are the most frequent ethical issues. Failure to act ethically may damage the reputation as an accountant unless he or she reports the abuse to the appropriate party. Slotting is not an acceptable accounting treatment in company practices.