The theory of positive accounting explains the manager’s choices of the specific accounting methods regarding self-interest. It also outlines the relationship among the different categories of stakeholders, and the manner in which financial accounting should be applied to minimize cost through aligning the competing interests.
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Therefore, this paper is a research work that describes and discusses two contrasting arguments, (ex ante ‘efficiency’ and ex post ‘opportunistic’) regarding policy selection and application, in the context of positive accounting theory.
Since the financial statements are perceived as composite whole, they comprise of Balance Sheet, Profit and Loss Accounts, Cash Flows, and other constituent elements (Bennett 2010, p. 7). This means the companies Act and other statutes have provisions to govern the entities during policy selection. This is very useful because proper selection of the policies makes the accounting records valid and the outcome reflects the entity’s financial position (Bebbington, Gray & Laughlin 2001, p. 402).
In selecting the accounting policy, compliance and statutory provisions might differ, thereby compromising the fairness and truth. As a result, selection and determination of such policies are based on appropriateness to the entity.
The issue of ex ante ‘efficiency’ or ex post ‘opportunistic’ arguments are very critical to the study of positive accounting theory applicable in financial accounting. Literally, an entity is only stable to the extent that it is well-organized and perpetuates the efficiency (Sun & Rath 2008, p. 406). In addition, the efficiency would enable the entity to exploit the opportunities, which are available while selecting and applying the accounting policies.
Ex ante (Efficiency Arguments)
Ex ante refers to ‘before the fact’. Considering the assumptions of ex ante, capital markets would efficiently react to the information that is publicly available without any bias (Sun & Rath 2008, p.408).
Essentially, this happens prior to any action so that the entity prepares for up front before the process of selecting and successive application of the accounting policies take place (Bebbington, Gray & Laughlin 2001, p. 404). Therefore, selecting and applying the accounting policies depend on the efficiency with which the entity would respond to the market dynamics (Taylor, Taylor & Coulton 2005, p. 554).
In addition, the various data sources are of significant use in the process of selecting and applying the accounting theories, meaning that the management has to make truthful revelations, which neither contradict nor corroborate other available data (Glautier, Underdown & Morris 2010, p. 42).
In this regard, the assumptions related to the entity’s efficiency in selecting and applying the best accounting policies underscores the managers’ integrity (Sun & Rath 2008, p.412). As a result, the market would be less concerned with the successive accounting disclosures, which the managers are considered to be accountable for.
Within the perspective of efficiency, one realizes that there are mechanisms in the entity, which minimize the cost of operation while at the same time, increase the output in qualitative and quantitative aspects (Taylor, Taylor & Coulton 2005, p. 559). In this argument, the position is vital because it paves way for formulating the best accounting policy options, which would benefit the entity.
Ex post (Opportunistic Arguments)
The ex post is the opportunistic perspectives of PAT. Indeed, it is called ex post because it happens ‘after the fact’. For example, the anticipated opportunities after the formulation of the accounting policies in respect to public behaviour should be addressed (Sun & Rath 2008, p.416).
This perspective portrays the negotiated and possible contractual arrangements regarding the particular firm. Additionally, it predicts and explains into details the anticipated opportunistic behaviours upon the application of the accounting policies (Bebbington, Gray & Laughlin 2001, p. 405).
In explaining this perspective, the entity relies on expectations, which may occur or fail to materialise (Sun & Rath 2008, p.417). For instance, the accounting policies especially the ones, which are expensive, might yield unintended outcome from the public.
The reason justifying the opportunistic argument is that sometimes, the specific contractual arrangement could have been arrived at because it was perceived to be effective, reliable and satisfactory to the interest of the majority in the entity (Taylor, Taylor & Coulton 2005, p. 566).
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However, with time, the accounting policies, which were thought to be very efficient, might become impractical depending on the status quo. This might force the firm to alter the accounting policies to match the current guidelines, events and human behaviour (Glautier, Underdown & Morris 2010, p. 43).
The proponents of this argument also postulate that it might not be easy to write a comprehensive accounting policy that provides absolute guidelines applicable in all situations (Taylor, Taylor & Coulton 2005, p. 567).
This means the managers would have some levels of optimism, thus should be flexible in terms of selecting and applying the accounting policies. Besides, the policies should also be flexible for future alterations as situations, events and human behaviour changes (Sun & Rath 2008, p.417). Apparently, this would make the policies relevant, applicable and suits the status quo.
The perspective also considers the opportunistic actions, which the public could undertake if the different contextual strategies have conceptualised by the policy makers (Sun & Rath 2008, p.418). As mentioned earlier, it is costly and not easy to stipulate comprehensive accounting rules, which are applicable to all situations.
Therefore, PTA postulates that the entities will always have room to select the practicable accounting policies, which they prefer bearing in mind the anticipated opportunistic variables after the selection (Taylor, Taylor & Coulton 2005, p. 568). In this sense, the agents or entity would exercise as much caution as possible.
Accounting Policy Selection
For Intangible Assets
In financial transaction, accounting policy selection is very important because it allows easy comparison of reporting for the entities (Bennett 2010, p. 15). It is important that the selection relies on an outline of other accounting policies.
Any change in the accounting policy would automatically alter the mode of selection and the specific policies to be applied (Bebbington, Gray & Laughlin 2001, p. 408). In addition, proper guidelines have to be applied, especially those from IASB while selecting the accounting policy so long as it is fit for the circumstance (Glautier, Underdown & Morris 2010, p. 42).
As well, the selection and application of accounting guidelines have to consider the error margins so that the policies do not become irrelevant. For instance, in selecting an accounting policy for an entity with depreciating assets, the best policy would depend on the hours that the particular asserts have been in use (Bebbington, Gray & Laughlin 2001, p. 412). The policy should also allow for gradual depreciation based on the value of the item through determining the degree of tear and wear.
For Financial Instruments
In cases of financial instruments, the entity has to be keen while selecting the policy to make its application easy and convenience. In this regard, the selection of policy should be guided by factors such as prudence, substance and materiality (Glautier, Underdown & Morris 2010, p. 48).
This is the level of caution that the entity exercises when making judgements on the various conditions of certainty or uncertainty (Glautier, Underdown & Morris 2010, p. 48). The decision will depend on the item the entity has, thus may vary from one to another. Through exercising due prudence, the anticipated profit is not the basis of consideration, but all known losses should be compressively covered.
Every item has economic value and substance that must be considered while selecting the policy option (Glautier, Underdown & Morris 2010, p. 50). Notably, determining the worth of the item is crucial in formulating the accounting policy to its effect.
Often, materiality affects information of an item. Information could be classified as material if the errors and omissions, which have significant affect on economic decision of the user, in relation to the financial statements (Glautier, Underdown & Morris 2010, p. 52).
In order to select the best accounting policies, financial statements have to unveil material items, which could influence the user’s decision. It is also essential to consider other factors such as relevance, completeness, reliability, and neutrality is important to the users because the attributes make the financial statements meaningful (Glautier, Underdown & Morris 2010, p. 52).
For Intangible Assets
In accounting practice, there are specific cases when the IFRS particularly applies to certain transaction, condition or event. In such cases, the accounting policy application on the item is directly correlated to IFRS principles (Bennett 2010, p. 27). When the policy implementer ignores the IFRS provisions, then the application of the policy becomes very complicated.
Another important aspect of accounting policy application is that the laws are resilient to IFRS guidelines because the policies realized after considering the conclusions of ISAB on the financial statements (Glautier, Underdown & Morris 2010, p. 54). Notably, the financial statements have reliable and relevant data regarding the particular transaction, condition and events to the effect of their application.
Therefore, the policies should be applied in cases where the effects of such application are deemed immaterial. Alternatively, if the consequences of applying such policies are material in nature, they should never be used (Glautier, Underdown & Morris 2010, p. 56).
However, it would be inappropriate to leave or make immaterial that are uncorrected, especially those originating from IFRS. Engaging in such an act to achieve specific presentation of the business’ financial position, cash flow or financial performance could be of very severe consequences to the entity (Bebbington, Gray & Laughlin 2001, p. 419).
In addition, the IFRS has guidance that help the entity apply its requirements (Bennett 2010, p. 29). Here, all the guidance gives an account of the IFRS integral parts, thus becomes useful in applying the accounting policies. Furthermore, the implementers have to use the guidance that depends on entire IFRS integral parts (Marshall 2010, p. 11). However, the guidance that does not depend on IFRS integral parts might not contain the necessities of financial statements.
In cases where IFRS that particularly applies to events, transaction, or condition is absent, the entity has to make judgement on the ways of developing and subsequently applying the accounting policy (Marshall 2010, p. 14. Therefore, it makes the application of accounting policies be relevant to prevailing economic conditions and cares for the interest of the users.
For Financial Instruments
In the cases of for financial instruments, once the accounting policy is reliably, its application becomes easy. The reliability is achieved when the financial statement portrays some of the characteristics below.
First, when the financial statements represent the entity’s actual financial position, cash flow and financial performance, the application of the accounting policies becomes simplified in the organization (Taylor, Taylor & Coulton 2005, p. 556). This implies that the accounting policy makers would examine all the entity’s financial statements to formulate workable guidelines whose application would not be challenging.
Secondly, if the financial statements reflect on the economic value of the items, which the entity offers, the policy makers would not rely on the legal form, but on the condition, worth, and events under which the transactions were made (Taylor, Taylor & Coulton 2005, p. 557).
This enables the implementers of the accounting policies work within certain limitations, which guarantees easy application. This signifies that the application of such accounting policies is not limited to the products itself, but also to the event, condition and its economic value (Bebbington, Gray & Laughlin 2001, p. 420).
Third, the financial statements are reliable to the extent that they are non-biased (Taylor, Taylor & Coulton 2005, p. 557). It is easier to implement the accounting policies, which are arrived at, through neutral means. Indeed, such policies reflect the truth about the transactions, making their application non-controversial.
Fourth, the financial statements are reliable to the extent that all the transactions are prudent (Taylor, Taylor & Coulton 2005, p. 558). Here, prudence means that the transactions were cautiously done. This reduces the limitations during the application of such accounting policies. Notably, applying the prudent accounting policies is less controversial compared to the ones, which are done while exercising caution of the variables including condition, event and uncertainty among others (Bebbington, Gray & Laughlin 2001, p. 427).
Fifth, the financial statements are reliable if they are comprehensive in terms of materiality (Taylor, Taylor & Coulton 2005, p. 559). Notably, materiality is central to the application of accounting policies in that the financial statements have to reveal the material items, which could influence the user’s decision, thereby help the implementers during policy application.
There is also retrospective application of accounting policies during adjustment on the transactions affecting the products. In this case, the entity changes the initial balance of the affected product prior to the formulation of the accounting policy (Weygandt 2008, p. 52).
Moreover, it assists during the application because the respective policy would look into the specific elements of each product that the entity provides. Once the policy has been altered comprehensively to correspond to the new products’ particulars, the policy implementers would find it relatively easy to apply the new guidelines for all the entity’s products (Taylor, Taylor & Coulton 2005, p. 560).
Despite the advantages of retrospective application of accounting policies, there are underlying limitations to the same. In essence, the limitations affect the nature of application and the approach in which it should be articulated (Weygandt 2008, p. 53). This could greatly influence the application of accounting policy. Some of the limitations, which might be experienced on issues relating to retrospective application, include the following.
First, in cases where retrospective application is required due to the alterations in the accounting policies, the change would be applied in a retrospective manner, until it proves impractical to resolve either the cumulative or period-specific impacts of the alteration (Weygandt 2008, p. 54). Indeed, the limitation affects the retrospective application of accounting policies due to its specific and cumulative effects on the policy.
Secondly, when establishing the period-specific impacts of altering an accounting guideline becomes impracticable based on the available comparative data for a given period (Weygandt 2008, p. 55).
Here, the entity might be forced to use the latest accounting policies in doing evaluation on the liabilities and assets for the period that required retrospective application, and the timeframe in which it is practicable (Taylor, Taylor & Coulton 2005, p. 561). Notably, the period might be current and has corresponding impacts, which would adjust the initial product’s value for the specific period.
Third, establishing the cumulative impacts might be impracticable during the beginning of implementing the adjusted accounting policies that the case in previous periods (Weygandt 2008, p. 60). This implies that the entity must respond and adjust comparatively, to the information so that it could respond to the challenges of the new accounting guidelines (Taylor, Taylor & Coulton 2005, p. 562).
Therefore, in order to new policies practicable, they should be applied as soon as they are formulated. This indicates that when the entity applies the adjusted accounting guidelines, it has to apply the latest accounting strategies to the relevant comparative information within the period deemed appropriate (Weygandt 2008, p. 65).
In summary, the theory of positive accounting is very explicit regarding the manager’s preferences for the specific accounting policies in relation to self-interest. The research also clarified the relationship between the two contradicting arguments about the issue of ex ante ‘efficiency’ or ex post ‘opportunistic’ that are very critical to the study of positive accounting theory applicable in financial accounting.
It also examined the manner, in which financial accounting should be applied to minimize cost through aligning majorly the competing interests. In the context of positive accounting theory (PAT), the two contrasting arguments of policy selection and application featured prominently.
Analytically, within the perception of ex ante (efficiency), the study concluded that there are mechanisms in the entity, which significantly decrease the cost of operation. Similarly, increase the effectiveness that guarantees high output in qualitative and quantitative terms. Therefore, this argument is fundamental since it helps the accounting policy makers in formulating the practical accounting policy guidelines, which would be to the advantage the entity.
On ex post (opportunity), the research indicated that the specific contractual arrangement is possible because it was perceived to be effective, reliable and satisfactory in the interest of the majority in the entity. However, it became clear that the specific accounting policies, which one would perceive to be very efficient, might become unworkable in future depending on the prevailing condition.
Therefore, it concluded that this might force the entity to modify the accounting policies to match the latest guidelines, human behaviour and events.
Bebbington, J., Gray, R., & Laughlin, R., 2001, Financial Accounting: Practice and Principles, Thomson Learning, New York.
Bennett, G., 2010, Accounting Principles and Practice, BiblioBazaar, Charleston.
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Marshall, P., 2010, A Complete Guide to the Principles and Practice of Business Accounting, How to Books Publishers, London.
Sun, L., & Rath, S., 2008, “Fundamental Determinants, Opportunistic Behavior And Signaling Mechanism”, Business Research Papers, vol. 4 no.4, pp.406-420.
Taylor, S., Taylor, S., & Coulton, J., 2005, “Is ‘benchmark beating’ by Australian Firms Evidence of Earnings Management?” Accounting and Finance, vol. 45, pp.553-576.
Weygandt, J., 2008, Accounting Principles, John Wiley & Sons, New York.