Positive Accounting Theory and Accounting Policy Choice
The managers of a company have the discretion or power to choose among several accounting policies in compliance to their countries regulatory environment. However, the company still has to adhere to the Generally Accepted Accounting Standards. There are several benefits and risks that accrue in allowing managers to choose the accounting policy for their company. Reports on earnings management and creative accounting have caused several experts to call for the restraining of manager’s power in accounting policy choice.
Accounting Policy Choice
Managers have the discretion of using different accounting methods and policies. The flexibility offered by regulatory authorities in choosing the accounting policy is advantageous. The managers are able to disclose additional information to the investors. The information in the capital markets is not perfect. It can be said there is imperfection of information. The management possesses the knowledge to determine the best accounting policy to utilize. There is also the aspect of principle agency conflict. The management is able to choose an accounting policy that reflects favorably on its debt and employee compensation contracts. The environment the company is operating in may necessitate the company to choose a different accounting policy. The company stakeholders may also require different kind of information causing managers to adopt different accounting policies.
However, there are dangers and risks in managers being offered this kind of discretion. First of all it may lead to earnings management. Earnings management refers to the managers manipulating accounting principles in order to manage the company earnings. The main goal by managers is to maximize their own utility. There is a low percentage of management who will in addition to maximizing their utility try to maximize the shareholder’s wealth. There are arguments against and for earnings management. They are those who advocate for it saying the managers are able to protect the company from the internal and external environment. Managers are the ones who know the operations of the company fully so they should be allowed to ensure smooth or growing earnings in the financial statements in order to communicate the stable affairs or state of the company.
The managers who practice earnings management operate on an aggressive accounting policy. They may have excessive provisions and reserves. They will also have very low estimates of their liabilities. All this leads to inappropriate figures in profits. The managers also tend to treat accruals in the financial statements incorrectly. The arguments for earnings management are faulty. In accounting, the financial statements should reflect the correct and true financial position of the firm. The statements should always communicate the economic realities on the ground. If the company is experiencing volatility, this should be reflected or captured in the financial statements.
Managers are highly motivated to get involved in earnings management by certain factors. The employee’s compensation is affected by the company’s current earnings. The managers therefore want to receive high compensation and bonuses. The managers may also want to reduce tax liability. Another reason could be the desire by senior managers to control the debt-equity ratio so that the current ratio, net worth and other financial parameter are at an acceptable level as per the debt covenant (Bhattacharyya, 2005, p586). The managers of huge corporations engage in earnings management in order to reduce their political visibility.
They do not want to be shackled to more additional regulations by the government whose actions are influenced by political pressure. There is also a huge temptation for managers to manage earnings during the time of an IPO (Sun, & Rath, 2008). The price of the company share is influenced by the company’s earnings. The flexibility in accounting policy choice may also lead to creative accounting. This is where the managers use complicated and innovative ways of classifying assets, incomes and other items in the financial statements.
The aim of the managers is to influence the users of the financial statements so that they take certain actions. It is the misrepresentation of the items in the financial statements. Creative accounting is what has led to numerous accounting scandals and reforms in the country. Senior managers in Enron and Worldcom were involved in creative accounting. There are several motivations for managers to get involved in creative accounting. In 2002, one of the reasons was the granting of stock options to senior managers as compensation or rewards. The managers inflated the earnings so that the company’s shares would trade at a higher price. They would then be able to exercise their options and sell their shares profitably.
In light of the advantages and disadvantages that have been mentioned, the risks in accounting policy choice are higher than the benefits. History keeps repeatedly telling us the dangers of allowing managers too much financial power. The accounting bodies should find a way to be more stringent in granting accounting choices to managers. The shareholders are the ones who keep losing their funds while senior managers get richer with higher compensation and bonuses.
Bhattacharyya, A. (2005). Financial Accounting for Business Engineers. India: Prentice Hall.
Sun, L & Rath, S. (2008). Fundamental Determinants, Opportunistic Behavior and
Signaling Mechanism: An Integration of Earnings Management Perspectives. International Review of Business Research Papers, 4 (4) ,406-420 Retrieved from: