Question

political cost hypothermia of positive accounting theory and what are the various strategies firms can use to avoid political costs

Answer 1

Political cost hypothesis on positive accounting theory:

Political costs are those costs that particular groups external to the firm may be able to impose on the firm as a result of various actions. For example, the costs associated with the community lobbying the government to decrease the subsidy support for an organisation, the costs associated with labor unions taking actions to increase the wages of their members or the costs associated with customer boycotts associated with the firm's products.

The political cost hypothesis predicts that those organisations under political scrutiny will undertake actions to minimize the possibility of adverse cash flows associated with the scrutiny. For example, if a company is being scrutinized in a particular period because of its perceived monopoly powers and those external parties undertaking the scrutiny claim that these monopoly powers enable it to generate excessive profits, then in such periods the entity may elect to adopt accounting methods which reduce the wealth of the organisation. Watts and Zimmerman provide the following explanation of the political cost hypothesis:

"The political cost hypothesis predicts that large firms rather than small firms are more likely to use accounting choices that reduce reported profits. Size is a proxy variable for political attention. Underlying the hypothesis is the assumption that it is costly for individuals to become informed about whether accounting profits really represent monopoly profits and contract with others in the political process to enact laws and regulations that enhance their welfare".

Various strategies firms can use to avoid political costs:

• Avoiding investment
• Adaptation
• Lobbying
• Invaluable status
• Vertical integration
• Local borrowing
• Minimizing fixed investments
• Political cost insurance