Proponent
Positive Accounting Theory (PAT) is most often credited to Ross L. Watts and Jerold L.
Zimmerman, two American accounting scholars whose work significantly shaped empirical
research in accounting. Their collaboration brought a scientific, economics-based perspective to
the study of accounting standards and choices, replacing purely normative approaches with
explanatory and predictive models grounded in observed behavior.
Year of Contribution
1978 – PAT was first formally introduced in their influential article, “Towards a Positive
Theory of the Determination of Accounting Standards,” published in The Accounting
Review. This seminal paper marked a paradigm shift by framing accounting research in
terms of explaining and predicting actual choices rather than prescribing ideal practices.
1986 – Their work was expanded and consolidated in the book “Positive Accounting
Theory.” This text provided a comprehensive framework, integrating earlier studies,
empirical evidence, and economic reasoning to formalize PAT as a dominant approach in
accounting research.
1. Descriptive and Predictive Nature
Unlike normative theories that prescribe ideal accounting methods, PAT focuses on describing
and predicting actual accounting practices adopted by firms. It uses empirical research to
explain why managers choose particular accounting policies under given circumstances.
Relevance to Business Studies – PAT’s empirical orientation helps future managers and
analysts understand patterns in corporate decision-making, preparing them to anticipate
competitive and financial reporting behaviors in real markets.
Connection to Hypotheses – The theory predicts that managers under bonus plans will
adopt income-increasing methods (Bonus Plan Hypothesis), debt-constrained managers
will use policies that reduce reported liabilities (Debt Covenant Hypothesis), and
politically visible firms will opt for income-decreasing choices to avoid scrutiny
(Political Cost Hypothesis).
2. Managerial Incentives and Behavior
PAT examines how self-interest, contractual obligations, and incentive structures influence
accounting decisions. Managers are not neutral record-keepers—they respond strategically to
incentives.
Relevance to Accounting – Accountants and auditors can use PAT insights to detect and
understand earnings management, enabling better evaluation of the reliability of financial
statements.
Connection to Hypotheses – The Bonus Plan Hypothesis explains how managerial
compensation linked to reported profits can lead to aggressive revenue recognition. The
Debt Covenant Hypothesis shows how leverage pressures encourage accounting choices
that prevent covenant breaches, and the Political Cost Hypothesis shows how public
image concerns influence conservative reporting.
3. Policy and Standard-Setting Insight
PAT informs regulators, policymakers, and educators about the likely behavioral responses of
firms to new standards and policies. By predicting these reactions, it helps reduce unintended
consequences such as widespread earnings management or loophole exploitation.
Relevance to Economics – PAT’s predictive element aligns with economic modeling of
incentives, allowing regulators to anticipate market distortions caused by policy changes.
Connection to Hypotheses – For example, when designing tax rules, policymakers can
use the Political Cost Hypothesis to anticipate resistance from large firms, or the Debt
Covenant Hypothesis to foresee lobbying from highly leveraged industries.
4. Integration with Agency Theory
PAT directly builds on agency theory, which studies the conflicts of interest between principals
(owners) and agents (managers). Accounting numbers are central in reducing information
asymmetry and enforcing contractual terms.
Relevance to Business Studies and Economics – Agency theory provides the
foundation for understanding how financial reports serve as monitoring tools in principal-
agent relationships, making PAT a bridge between economic theory and real-world
governance.
Connection to Hypotheses – The Bonus Plan Hypothesis reflects how contracts link
performance to rewards, the Debt Covenant Hypothesis captures lender–borrower
monitoring through accounting ratios, and the Political Cost Hypothesis shows how
external stakeholders (e.g., governments, unions) act as quasi-principals influencing firm
strategy.
5. Economic Consequences of Accounting Choices
PAT emphasizes that accounting policies are not neutral—they have economic consequences
that influence resource allocation, taxation, and even stock prices.
Relevance to Accounting and Economics – Investors, creditors, and analysts can use
PAT’s predictions to forecast how firms might react to changes in laws, tax rates, or
reporting rules, improving valuation models and investment strategies.
Connection to Hypotheses – The Debt Covenant Hypothesis predicts shifts in
asset/liability recognition under debt pressure, the Bonus Plan Hypothesis predicts
earnings maximization near performance review dates, and the Political Cost
Hypothesis predicts profit minimization during times of regulatory scrutiny.
6. Educational Application
PAT is highly relevant for teaching and learning in business, economics, and accounting
courses because it moves beyond textbook idealism and introduces students to strategic
reporting behavior.
Relevance to Education – It prepares students to critically evaluate financial reports,
detect earnings management, and understand the interplay between regulation and
corporate strategy.
Connection to Hypotheses – Using case studies on the three hypotheses allows students
to apply theory to real scenarios—e.g., analyzing how a manufacturing firm changes
depreciation methods when bonuses depend on net income, or how a mining company
adjusts revenue recognition during an environmental investigation.
