Positive Accounting Theory (PAT) that popularized by Watts and Zimmerman is one of positive theory accounting. PAT is concerned with explaining accounting practices. It is designed to explain and predict which firms will not use a particular method. It does not say something as to which method a firm should use. This is what differentiates positive and normative theories. Normative theories prescribe how a particular practice should be undertaken and this prescription might be a significant departure from existing practice.

PAT focuses on the relationship between the various individuals involved in providing resources to an organization and how accounting is used to assist in functioning of these relationships. PAT is based on the central economics-based assumption that all individuals’ actions are driven by self-interest and that individuals will always act in an opportunistic manner to the extent that the actions will increase their wealth.

From an efficiency perspective, why could the introduction of new rules on share option accounting be costly for an organization?

Share-based payments have been widely used by many organizations as an incentive tool – attracting and retaining employees, and compensate senior executives. Because there was a significant change in the accounting requirements on share-based payments, this will then affect quite numbers of organizations. The effect on organization can be explained by an efficiency perspective. Efficiency perspective, which also known as ex-ante perspective, is one of perspective under the PAT umbrella.

It considers up-front mechanisms in order to minimize future agency and contracting costs (TB p. 274).

Theorists of efficiency perspective argued that companies adopt particular accounting methods which best reflect their underlying economic performance. By choosing the best methods, it is being argued that investors and other parties will need not to gather as much additional information from other sources. This will consequently lead to cost saving and reducing the risks of investors, which will then increase the value of the company (TB p. 274).

Another effect on the implementation of AASB 2 is that it will reduce the profit of the company, thus the performance of the company will seems to be not so attractive to the potential investors. Unattractive performance of the company may cause the investors to assume that the company has higher risks of default. Thus investors become reluctant to invest in the company or, the investors will require higher return. In other words, the company will be facing a hard time to gain investors confidence or the company will be facing a high cost of capital (TB p. 275).

Since PAT theorists believe that companies will choose the methods best reflect the companies’ performance, this means that there will be no need for regulations to be in place – anti regulation perspective. PAT theorists argued that regulation of financial accounting imposes unwarranted costs on reporting entities (TB p. 275). In the case of share-based payments, by superseding AASB 1046 with AASB 2, this provides restrictions to the company as to limited methods available to choose from. This will create inefficiencies – the companies may not able to choose the method that best reflect their performance.

Besides, by expensing share-based payments, this would harm start-up companies and decrease the entrepreneurial activity of growing companies (Sacho & Wingard 2004). The reason behind this is that both new and growing companies usually do not always have enough cash to be used as incentive tool – attract and retain skillful employees. Thus, in order to attract and retain talented employees, such companies use share options instead of giving cash incentives. Under the previous standard, whereby share options do not need to be recorded as an expense in the profit and loss statement, this will result in higher profitability which may be assumed as a good performance by investors. Besides, this will result in higher returns from investment (ROI). Thus, this makes the financial position statement of those companies look better (stronger) which then allow them to access greater capital than they would had if they have to expensed share option.

Debt covenants, which also known as banking or financial covenants, are agreements between a company and its lenders that the company should operate within certain limits (Pietersz 2009). The limits set by the lenders are usually expressed in accounting numbers (i.e. level of gearing ratios). Besides set the limits, lenders will also impose obligations if the company breaches the agreement. Thus, if the company has to expense-off the share-based payments transactions, this will affect the bottom line of its financial statement which then will affect some accounting ratios. This will create difficulties for the company to operate within the limit written in the debt covenant. Company will need to re-examine the debt covenants and need to consider how to communicate this adverse impact on reported profits and key performance ratios to the market. In a worse case, company may wants to renegotiate the terms and conditions of the agreements (Chalmers & Godfrey 2005). Both re-examine and renegotiate are not easy tasks, it takes a lot of efforts, considerable amount of time, and it is costly.

Since AASB 2 requires companies to record share-based payments transactions as an expense, which then leads to lower profit, this will discourage companies to use share options as a compensation tool. This may cause managers to lose their motivation to improve the performance of the company, because share option is a method that widely used and most benefiting to the managers. Sacho and Wingard (2004) argued that expensing share-based payments would hurt companies like Apple, Intel and Microsoft (information technology companies) due to earnings pressures caused by share-based payments.

Expensing share options will also distort earning per share (EPS). Distortion may occur due to inclusion of expense for employee stock options in the profit and loss statement will result in an inaccurate ‘double’ charge in the financial statement (BIO 2004). When the employees exercise their options, it will be recorded as an expense and increase in the number of share issued. Thus, EPS will be diluted.

In compliance to AASB 2, companies have to determine the fair value of the stock options. However, it is complicated to determine the fair value of stock options at grant date, due to difficulties in predicting future movement of share prices. Thus, mathematical models, such as lattice model are often used to predict the future movement in the share price and therefore to derive the value of the stock options. However, to apply this model, expertise is required. Thus, companies have to hire external experts. Besides, additional internal compliance costs, costs of external audit will also increases (BIO 2004).


  • Watts, R. L., & Zimmerman, J. L. (1986). Positive accounting theory.
  • Watts, R. L., & Zimmerman, J. L. (1990). Positive accounting theory: a ten year perspective. Accounting review, 131-156.

Images Sources: Google Images