Introduction

• Parties have in the past and continue to expend resources to influence the setting of accounting standards

• Moonitz (1974), Horngren (1973) document sometimes intense pressure exerted on the accounting standard-setting bodies

• Positive theory of the determination of accounting standards:

  • Helps us to understand better:

    • the source of the pressures driving the accounting standard-setting process

    • the effects of various accounting standards on different groups of individuals

    • The allocation of resources, and why various groups are willing to expend resources trying to affect the standard-setting process

  • Necessary to determine if prescriptions from normative theories (e.g. current cash equivalents) are feasible

• Watts and Zimmerman believe that management plays a central role in the determination of standards

  • Moonitz supports this view

• A precondition of a positive theory of standard-setting is understanding management’s incentives

Factors influencing management attitudes towards financial accounting standards

• Watts and Zimmerman assume that individuals act to maximize their own utility

  • Implication of this is that management lobbies on accounting standards based on its own self-interest

• One function of financial reporting is to constrain management to act in the shareholders’ interest

• Assuming congruence of management and shareholder interests without further investigation may cause us to omit from our lobbying model important predictive variables

• Assumption that management selects accounting procedures to maximize its own utility is used by Gordon (1964) in an early attempt to derive a positive theory of accounting

  • Gordon’s model and its variants are called the ‘smoothing’ literature by Watts and Zimmerman

  • Lack of confirmation

  • Assumed that shareholder satisfaction (and presumably, wealth) is solely a positive function of accounting income

• Watts and Zimmerman assume that management’s utility is a positive function of the expected compensation in future periods and a negative function of the dispersion of future compensation

• Mechanisms which increase management’s wealth:

  • 1) Increases in share price (i.e. stock and stock options are more valuable

  • 2) Increases in incentive cash bonuses

Factors affecting management wealth

Taxes

• Not directly tied to financial accounting standards except in a few cases

  • Indirect relationship is well documented by Zeff (1972) and Moonitz (1974)

• Adoption of a given procedure for financial accounting does not decrease the likelihood of that procedure’s being adoption in future tax codes, and more likely, will increase the chance of adoption

• Thus lobbying behavior is affected by the future tax law effects

Regulations

• A new accounting standard which reduces a utility’s reported income may provide its management with an “excuse” to argue for increased rates

  • Depends on factors such as information costs

• Utilities have an incentive to favour such changes

• The have an incentive to oppose changes in accounting standards which might lead to a rate decrease (the commission rate they receive)

Political costs

• Corporate sector is...

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