Normative versus Positive Accounting Theory

Abstract

As accounting theories develop, debates concerning the application of these theories in the accounting profession have also progressed, as economists seek to identify theory application. Some economists believe that the normative theory is the best approach to accounting, as it allows judgment on the desirability or undesirability of situations. Put simply, it is the theory of accounting that looks at how accounting procedures should be conducted. Others believe that the positive theory is much suited towards accounting practices, because provided judgment concerning how accounting procedures are conducted at present. Discounting the debates on the issue of normative versus positive accounting theories, the preferred accounting theories should have the ability to provide the relevant guideline towards the presentation of financial data.

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Key Words: Normative Accounting Theory, Positive Accounting Theory

Introduction

Economists define the development of Accounting Theory as the gradually process of trial and error that comes as a response to the social and economic forces that affect accounting procedures (Deegan, 2009).  Notably, the field of accounting is one of the few disciplines that encourages the development of theories of practice based on current changes. This means that most accounting theories are developed to be consistent with current practices. For that reason, economists argue that a broad structure of allusion is required, which should not upset the system of accounting but instead adhere to the system.  Essentially, the concept of Accounting Theory in finance cannot be specifically defined to suit a particular approach. For that reason, various theories of accounting have been developed ranging from classical accounting theories to modern accounting theories. The main purpose of these theories is to guide assist accountants in reporting annual financial activities in the organization (Deegan, 2009). Because the accounting issues keep changing and demand current theories for problem solving, the modern accounting theories are the  principal areas of concern for many economists.

Two major modern accounting theories have been identified including the normative and positive accounting theories (Deegan, 2009). The normative theory of accounting emphasizes on the adherence to accounting principles, hence encouraging accountants to provide financial information based on the accepted accounting principles (Misiewicz, 2008). The positive account theory, on the other hand, looks at current accounting practices identifying the problems in these procedures. The inconsistency in the employment of normative and positive accounting theories has recently become the subject of much debate.  This is because of the underlying principles of both of these accounting theories that seem to be at a collision with each other. The principles of normative accounting theory are to facilitate the standardization of accounting practices, which in turn allows coherent accounting instruction. The positive theory, on the other hand, emphasizes the need for academic validation, and the principles in this theory originate from observable accounting behavior (Mintchik, & Farmer, 2009). Accordingly, the differences in the acceptance of these two theories in the field of accounting have encouraged further research on these two theories, as well as, the advantages and disadvantages of these theories.

This paper examines the historical development of the normative and positive accounting theories, illustrating the current GAAP for both these theories. The paper also identifies problems that are revealed in the debate arena concerning the two accounting theories provides an analysis of this in relation to the accounting conceptual framework. Conclusively, the paper suggests appropriate courses of action for the reduction of these problems.

 

Historical Development of Normative and Positive Accounting Theories

Accounting theories have been developed over time, with this practice being traced back to over 8,000 years ago (Deegan, 2009). Both the normative and positive theories of accounting have been derived from the well known  economic theory of accounting, which seeks to create awareness on the different accounting relationships in the economy. Fundamentally, the economic accounting theory explains institutional behavior in markets while excluding the accounting policies that have been applied by such market actors. Economic accounting theories emphasize the need for understanding the correlation between the cultural significance of accounting, as well as, its impact on society.

More specifically, positive accounting theory found way into accounting documents in the year 1978, after a research conducted by Watts and Zimmerman provided the necessary theoretical foundation for this theory (Mintchik, & Farmer, 2009). This, in turn encouraged other researchers to look into this theory of accounting into what is recognized today. In their studies on the positive theory of accounting, Watts and Zimmerman suggested that individuals are inclined to perform actions that capitalize on their own convenience (Mintchik, & Farmer, 2009). The main hypothesis in their study is that managers, as well as, accountants have the ability to manipulate financial records to increase firm value in the market. For that reason, the positive accounting theory was developed to prevent such activities in the organization. In 1989, the normative theory of accounting was developed to counteract the proposals concerning the positive accounting theory. Researchers Belkaoui and Karpik were responsible for the development of this theory and they argued that financial records cannot be modified to suit individual needs (Misiewicz, 2008). That financial reporting could only be consistent with the underlying principles of accounting. This in turn prompted economists and other accounting researchers to look deeper into the normative theory of accounting and its application in organizations.

 

Current GAAP

Research by Gaffikin, indicates that for most of the twentieth century the accounting profession sought to maintain a regime of self-regulation (Gaffikin, 2008).  Accounting professional bodies worked hard to avoid the imposition of regulation on the discipline (Gaffikin, 2008).  The Generally Accepted Accounting Principles (GAAP) were developed, followed by an attempt at a conceptual framework that would serve as the basis of an accounting theory.  A review of the literature indicates that the search for GAAP and a theoretical framework has been a struggle for the discipline and its Members, a result of widely differing viewpoints on the necessity and form of regulation.  The financial accounting scandals in the prior decades have spurred the need for reform and strictly adhered-to accounting regulations.  Public interest and awareness resulting from the notable and widespread scandals demanded such regulations, and the GAAP was amended and implemented. A review of the literature indicates that much has been written about the Generally Accepted Accounting principles (GAAP).  For example, the current GAAP is more “rule-based” standards with specific application guidance than the earlier versions.  According to Epstein et al., the significance of the differences of the current GAAP varies with respect to individual entities depending on factors such as the industry of operation, accounting policies adopted, as well as, the nature of the entity (Epstein et al., 2009). Under first time adoption in the current GAAP, there is not a specific standard, and the practice is generally full retrospective application unless the transitional provisions in a specific standard require otherwise.  The current GAAP sanctions the use of sequential instability or industry index capacity for private entities especially when it is not feasible to approximate volatility (Epstein et al., 2009).  Under the current GAAP, share-based payments with graded vesting features can choose accounting policies meant for awards with a service condition. The choices provided include the repayment of complete grants on a directly over the highest vesting period and the recognition of charges similar to IFRSs (Epstein et al., 2009).

Other examples of the current GAAP in practice are that a liability for a planned post-acquisition restructuring can be recognized if the restructuring relates to the acquired business and certain conditions are met.  For purchased in-process R&D, the current GAAP determines the fair market value of in-process R&D and expense immediately unless it has an alternative future use.  The current GAAP also demands the collection of interests for combined entities under universal organization (Epstein et al., 2009).  For comparative prior year financial statements, there is no specific requirement under the current GAAP to present comparatives.  Generally, at least one year of comparative financial information is presented (Epstein et al., 2009).  Public companies are expected to adhere to SEC policies and procedures, which require two years of proficient financial reporting in the creation of income statements, as well as, other statements of accounts (Epstein et al., 2009).  There are many other differences and requirements underneath current GAAP.

Positive Accounting Theory vs. Normative Accounting Theory

The distinction between positive accounting theory and normative accounting theory has encouraged debates concerning these two theories and their application in the field of accounting. In discussing market failure and regulation, a similar distinction is made, demonstrating diverse evaluations of accounting regulations that derive their principles from positive and normative economics (Gaffikin, 2008).  Normative accounting theories are described as long-term values of economic parameters that cannot be confirmed or refuted by data (Misiewicz, 2008).  They cannot be confirmed by data because the long term refers to a time so far ahead that it is impractical to conduct any objective tests.  Normative theory emphasizes on the observance of a “right” approach, whereas, the positive accounting theory avoids the observance of this.

Positive theory involves examining the environment in which accounting decisions are made, and using this to develop testable hypotheses (Mintchik, & Farmer, 2009).  This theory considers factors such as the probable accounting risks, such as legal liabilities, specialized censure, or client loss.  Positive accounting theory aims to provide explanations of practice, through observation and the generation of hypothesis.  On the other hand, normative accounting theory aims to provide prescriptions for practice, through the codification of practice and premises to prescriptions (Misiewicz, 2008).  The methods of both theories are different; positive accounting theory places emphasis on testing, whereas normative accounting theory is concerned with little testing.  The uses of positive accounting theory is that it leads to better understanding and better predictions.  The uses of normative accounting theory are the standardization of practice, training for practice, and the market for excuses.

Changes and Problems Revealed in the Debate

Normative accounting theory has been categorized as being stimulated by the demand for excuses (Misiewicz, 2008).  Most economists argue that normative accounting theory follows where the political or regulatory agenda leads.  Some of the examples cited in this argument include political discriminative practices regarding insurance pricing, and changing pension costs, both of which encourage the application of traditional accounting procedures or the search for alternative approaches.  Another example identified by economists is the concept of “Orphan Estates” which they argue has promoted the need for the application of the normative accounting theory for the overall benefit of the company shareholders. A second consequence of the application of the normative theory is that the validity of this theory cannot be linked to the prosperity of the beneficiaries. This, in turn suggests that the application of the normative theory is not favored by most organizations, as it implies procedural complication in financial reporting (Schroeder et al., 2010). Positive accounting theory appears to have the better position in the debate.  This is because the first step in economics involves identifying the qualitative nature of a policy’s consequences.  Positive analysis allows for the assessment of the expected, objective outcomes.  According to principles of economics, the distinctive component of positive accounting reporting and analysis is the testability of accounting procedures with respect to pragmatic verification and judgment. In other words, it deals with the actual and the desired, which is usually devoid of the preciseness or impreciseness of the activity.  Positive accounting theory supports logical research because it is founded on the established rules of substantiation and logic, both of which are qualitative and quantitative in nature.

Research indicates that a normative accounting theory is comparable to a value judgment that is not precise, and cannot be proved precise or incorrect by factual evidence, or logic (Schroeder et al., 2010).  These value judgments stem from the value system of each individual making the judgment. Since individuals value judgments differ, they cannot be applied universally across the board.  This is a significant problem within the realm of normative accounting theory. Also revealed in the debate between positive and normative accounting theories is that some researchers have sought to combine the two theories.  These researchers have analyzed the existence of one theory without the other, and have found that the theories are coexistent.  Their argument is that positive and normative theories of regulation should be viewed from a complementary rather than a mutually exclusive perspective.  However, neither includes an explanation for the institutional framework of regulation, as institutions were regarded as “black boxes” from which regulation emerged (Gaffikin, 2008).  Such research has indicated that regulation needs the benefits that a combination of both theories has to offer the profession.

Analysis of Historical Development and GAAP in relation to Conceptual Framework

Historically, the general approach of the GAAP was more of a principles based standard with limited application guidance.  This has changed to become more rules based standards with specific application guidance.  Historically, the GAAP would determine the expense based on the grant date fair value for the modification of a ward by change in performance condition. However, the current GAAP determines the expense based on fair value at the modification date.  Historically, under the GAAP, the definition of a discontinued operation continuing involvement was not addressed.  In the current GAAP, the disposing entity should have no continuing cash flows representative of significant continuing involvement (Epstein et al., 2009).  Finally, for rights and obligations under insurance contracts, the historical GAAP addressed recognition and measurement in only a limited way, or an interim standard pending completion of a project.  Under the current GAAP, several comprehensive industry accounting guidelines have been published.

Majority of current literature on the topic indicates that there exists many arguments and debates over the necessity for regulation.  For example, those who support the concept of market efficacy condemn the application of regulations, as most markets will be compelled towards societal operation and the optimization of resource allocation (Gaffikin, 2008).  However, others argue that not all markets focus their activities on the achievement of common interests, and for that reason, regulations to govern their activities need to be established.  An analysis of the conceptual framework indicates that the history of the accounting profession brought about the need for the GAAP.  The GAAP emerged as a natural response to the scandals occurring in the profession and the need for regulation.

With reference to the GAAP, the conceptual framework illustrates that regulations are required, and various reasons are presented to support this belief. At the outset, regulation facilitates proper accounting of the profits that a company receives. It encourages organizations to shun the common accounting practice of recording “windfall Profits” as “normal profits” to prevent the possibility of injudicious financial reporting (Gaffikin, 2008).  An example of such a case is the supply of equipment to assist in the search and  resurgence of data lost in the event of a natural disaster. Because of the urgency in such a situation, the demand for this equipment increases and suppliers may be tempted into increasing the cost of these equipment for the generation of above-normal profits. In turn, the accountants record such profits as normal profits even when aware that it is not the case. However, this practice is not common to the modern accounting institutions and was also practiced in the past. Production activities were vividly excluded from financial reports, with the true costs of such activities ignored in the created financial reports (Gaffikin, 2008). The regulations were mandated by notable scandals that occurred in late 1990s and Early 2000s, with the most notable accounting scandal involving the business giant, Enron. Before the company’s accounting scandal, Enron was one of the most prominent companies in the world. The company’s falsified manipulation and corrupt management of financial information led to its failure as a respected business organization. The company’s team of managers, accountants and auditors altered their financial records and their trading activities, which in turn ked to their downfall.  Enron benefited from this expansion because the greater volume of transactions, the greater Enron’s profits would be.  However, the financial problems for Enron began when the company began trading for the benefit of its own accounts.  This involved the synchronized purchase and sale of the comparable or equal securities, so as to profit from price discrepancies.  This practice resulted in debt and complicated accounting for Enron, who had no risk control strategies in place.

The 2000s marked an era of accounting and financial frauds that came about as a result of administrative malfunctions at different levels, including management, accountants, prominent auditing and law firms, shareholders, and securities analysts that escaped detection (Schroeder et al., 2010).  These scandals changed the business world forever, and new reforms have been implemented as a result. Like Enron, most companies today have, in one way or another, been influenced into manipulating financial data to make their companies appear profitable, hence continue operations. Such companies engaged in numerous intricate transactions involving inexplicable partnerships hence promoting the reporting of false financial gains, while ignoring all connected financial liabilities.

Recommended Course of Action

While analyzing the recommendations for future courses of action, the basic principles underlying theories in general must be taken into consideration.  Essentially, individuals should bear in mind that no accounting theory could be termed good or bad. That both the normative and positive theories of accounting have their own advantages and disadvantage, and the application of these theories is beneficial to organizations. Research studies on the issue illustrate that a theory can only be accepted as valid for the organization if it fosters organizational success especially in financial reporting (Thaler, 2008). The best theories to be applied by organizations are those that can predict its financial situation, hence influence the company into achieving financial credibility and success. However, this is reliant on the equivalence of the principles of the theory to the accuracy of data. Put simply, accounting theories need to be testable against the actual data presented by companies and organizations. The testability of the preferred accounting theory is critical for financial progression within the organizational setting (Gaffikin, 2008).  Positive accounting theory allows organization to focus all academic resources towards actual organizational accounting procedures, which is opposite of the normative principles. However, there does not appear to be one superior method over another to test whether positive or normative accounting theory is better, a combination of the two must be implemented.  This way the stronger aspects of both theories can be applied together.  For example, a better understanding gained from positive theory could be used to training others for the practice or to standardize the practice.

A future course of action would also be the combination business ethics into both positive and normative accounting theories (Thaler, 2008).  Business ethics emphasizes the observance of proper and legitimate business activities, including financial reporting. That those in charge of financial reporting present accurate and concise  financial statements that are free from fault or modifications of any kind. The incorporation of business ethics into the normative and positive theories of accounting will assure organizations of their prosperity in the market. The application of both the normative and positive theories of accounting simultaneously, emphasizes the need for corrective financial operation. Put simply, it means that companies will have the ability to identify problems existing in their financial records, and through this, correct the problems effectively and efficiently (Thaler, 2008). Organizations will have the ability to organize their accounting facilities in line with the accepted standards and principles of accounting, hence profitability. By doing this, organizations will have the ability to apply the principles of both of these theories to promote the success of their companies. Additionally, financial reporting will be carried out with minimal errors, which will in turn ensure that organizations observe the presented rules on business ethics.  Conclusively, a combination of the normative and positive theories of accounting will serve the accounting profession well.

Conclusion

As discussed above, a review of the literature regarding the debate between the application of positive accounting theory and normative accounting theory to the profession indicates that the debate is far from over.  Future courses of action would include ethics in both theories, and finally, more research is needed within the realm of combining both theories for the accounting profession to continue to prosper and grow.

References

Deegan, C. M. (2009). Financial Accounting Theory. New York: McGraw-Hill.

Epstein et al. (2009). GAAP 2010: Interpretation and Application of Generally Accepted

Accounting Principles. New York: John Wiley and Sons, 2009

Gaffikin, M. (2008). Accounting Theory: Research Regulation and Practice. Retrieved from:

http://www.uod.edu

Mintchik, N. M. & Farmer, T. A. (2009). Associations between Epistemological Beliefs and

Moral Reasoning: Evidence from Accounting. Journal of Business Ethics, 84 (2): 259-275.

Misiewicz, K. M. (2008). The Normative Impact of CPA Firms, Professional Organizations, and

State Boards on Accounting Ethics Education. Journal of Business Ethics, 70(1): 15-21.

Schroeder, R. G. et al. (2010). Financial Accounting Theory and Analysis: Text and Cases.

New York: John Wiley and Sons.

Thaler, R. H. (2008). Mental Accounting and Consumer Choice. Marketing Science, 27(1): 15

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