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Normative and Positive Approaches in Accounting

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Normative and Positive Approaches in Accounting
Table of Contents
  1. Introduction
  2. Normative and Positive Accounting Theories Explained
  3. Merits and Demerits of Normative and Positive Approaches
  4. The Theories and Decision Making
  5. Normative or Positive Accounting Theory
  6. Conclusion
  7. References

Introduction

Financial accounting theory attempts to specify which events to record, how the recorded data should be manipulated, and how the data should be presented (Schroeder, Clark & Cathey 2011). According to Whittington (2007, p. 367), the literature of financial accounting theory contains several different approaches which co-exist, in some places, as clearly defined and separate layers, and in other places, mixed in the manner of geological strata. This geological analogy can be carried further because, like geological strata, these different approaches were first laid down in different historical periods, and the older strata tend to be the ones that are mined most extensively by current standard setters and practitioners. The historical approach is a useful method of classifying these layers of theory for expository purposes, and it can also aid our understanding of how ideas have developed.

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As in any other discipline, a methodology is required for the formulation of an accounting theory. The divergence of opinions approaches, and values between accounting practice and accounting research have led to the use of several methodologies. Over the years, there have been numerous debates to determine the most appropriate accounting methodologies to use. Two basic types of accounting theory discussed in this paper are normative and positive accounting theories. The paper explains the two approaches and looks at the strengths and weaknesses of each. In addition, a discussion is presented on the choice of accounting practice theory.

Normative and Positive Accounting Theories Explained

Normative theories are based on sets of goals that proponents maintain prescribe the way things should be. This not withstanding, no set of goals is universally accepted by accountants. As a consequence, normative accounting theories are usually acceptable only to those individuals who agree with the assumptions on which they are based. Generally, accounting theories are normative because they are based on certain objectives of financial reporting. Positive theories on the other hand attempt to explain observed phenomena. They describe what is without indicating how things should be. According to Schroeder et al. (2011, p. 123), the extreme diversity of accounting practices and applications has made development of a comprehensive description of accounting difficult. For example, not only must the use of historical cost be observed, but under the positive theory that uses must also be explained. Positive accounting theory has risen because the existing theory does not fully explain accounting as a practice. Agency theory is an example of positive accounting theory that attempts to explain accounting practices and standards. The basic assumption of agency theory is that individuals maximize their expected utilities and are resourceful and innovative in doing so. Agency theory also attributes the preponderance of normative theories of accounting to the influence of political processes. When a crisis develops, elected officials base their positions on public interest arguments. These positions are frequently grounded in the notion that the problem is caused by inefficiency in the market that can be remedied only by government intervention. Elected officials then seek justification of their position in the form of normative theories supporting that position. They also tend to look for theories prescribing accounting procedures that should be used to increase the information available to investors or make the market more efficient. According to Belkaoui (2004, p. 446), the call for a positive approach to accounting came when it became apparent that research in accounting was mostly unscientific since its focus had been overwhelmingly normative and definitional. This led to the development of a positive theory of accounting to explain why accounting was what it was, why accountants do what they do, and what effects these phenomena have on people and resource utilization. The basic message communicates was that most accounting theories are unscientific because they are normative and should be replaced by positive theories that explain actual accounting practices in terms of management’s voluntary choice of accounting procedures and how the regulated standards have changed over time. The major thrust of the positive approach to accounting is to explain and predict management’s choice of standards by analyzing the costs and benefits of particular financial disclosures about various individuals and the allocation of resources within the economy. The positive theory is based on the propositions that managers, shareholders, and regulators are rational and that they attempt to maximize their utility, which is directly related to their compensation and, hence, to their wealth. The choice of an accounting policy by any of these groups rests on a comparison of the relative costs and benefits of alternative accounting procedures in such a way as to maximize their utility. For example, it is hypothesized that management considers the effects of the reported accounting of numbers on tax regulation, political costs, management compensation, information production costs, and restrictions found in bond indenture provisions. Similar hypotheses may be related to standard setters, academicians, auditors, and others. The central ideal of the positive approach is to develop hypotheses about factors that influence the world of accounting practices and to test the validity of these hypotheses empirically. Generally, positive accounting theories assume that the stock price depends on cash flows rather than on reported earnings. Furthermore, given an efficient market, two firms with identical cash flow distributions are valued the same way despite the use of different accounting procedures. The central problem in positive theories is to determine how accounting procedures affect cash flows and, therefore, management’s utility functions to obtain an insight into the factors that influence a manager’s choice of accounting procedures. According to Whittington (2007, p. 391), the essence of the positive accounting methodology seems to be that its objective is to explain and predict accounting practice. This is distinguished from normative positions’ which seek to prescribe the contents of accounting reports. The distinction depends upon the view that prescription requires the specification of an objective and an objective function. This leads to the claim that positive theory is the economics-based accounting theory that evolved from the use of the scientific concept of theory. It might be inferred from this that positive theory is somehow value-free and scientific whereas normative theory was highly value-laden and, therefore, unscientific. Two objections can be made to such an inference. First, the positive theory is not free from value judgments or prescriptive implications. At the most basic level, the question asked implies a prior view of what is an interesting question, and at the level of empirical testing, value judgments can influence the choice of maintained hypothesis. It is, however, believed that positive accounting research can, if given the diversity of results, serve the market for excuses (Whittington 2007, p. 392). Secondly, it would be incorrect to assume that all theory that is not positive, in the sense of leading to empirically testable propositions, is normative in the sense of leading to prescriptions. Another distinctive feature of positive accounting theory is its emphasis on predictions rather than assumptions as a means of testing the validity of theories. The normative approach establishes theoretical models based on mathematical logic, to describe specific characteristics of natural equilibrium states. The results of such theoretical studies are used in political arguments to justify particular policies that should be pursued, to attain the benefits of the theoretical ideal. The positive accounting approach uses empirical research, based on actual observations and data analysis, to characterize the effect of particular policies that are used in existing socio-economic organizations. The results of such empirical studies are used in political arguments to either legitimize existing policies or to justify particular policy changes (Bloom 1994, p. 24). Based on theoretical arguments, normative accounting principles focus on the necessary and sufficient conditions that accounting information should reflect to fulfill the classical criteria of an efficient economic market system. In contrast, a positive accounting system assumes the existence of efficient markets and attempt to discover stable relationships between a firm’s choice of accounting techniques and other important economic variables. Academic research developed the Efficient Market Hypothesis (EMH) by postulating that security markets adjust quickly and accurately to new information. According to this hypothesis, markets will not be fooled by special accounting techniques as long as the basic information is disclosed in the notes to statements. This hypothesis views accounting data in terms of its information content, so that positive accounting models may be used, for example, to investigate empirical relationships between accounting numbers and stock market prices or returns. The lack of finding such relationships may lead to different conclusions, but it does not imply that accounting information is not useful. Academics have long argued that it is the publication of financial statements that leads to market efficiency.

While the EMH has introduced a large number of new arguments and new methodological disputes, it did not contribute in any significant way to improving the work of practicing accountants. Puzzled and confused, practitioners do not understand this type of academic research. They claim that little practical value results from proving that a free market system works efficiently. In this sense, academic research has contributed to a widening of the split between practitioners and academicians. Academic accounting research often seems to demonstrate the obvious or to deal with issues irrelevant to practitioners. The most divisive wedge between academics and practitioners was introduced by Watts and Zimmerman (Bloom 1994, p. 25). It is based on a positive approach and is known as positive accounting. The assumption underlying positive accounting is that managers and agents, or any other users of accounting data for that matter, will make decisions that maximize their utility above the utility of the shareholders and principals. Since microeconomic models are used in positive accounting, the focus is the maximization of short-term utility.

Even without external regulation, managers of companies might be expected to have an interest in providing credible accounts to users. According to Higson (2003, p. 26), agency theory explains why accounting reports would be provided voluntarily to creditors and stockholders, and why independent auditors would be engaged by management to testify to the accuracy and correctness of such reports. It appears that managers have been willing to incur costs to improve the credibility of accounting reports long before they were required to do so by law, and in many cases voluntarily submitted to audit. The provision of audited reports can be traced back to late sixteenth-century England, and suggest that the historical development of both financial reporting and auditing would appear to support the agency theory, which is a form of positive accounting. According to Riahi-Belkaoui (1996, p. 55), the use of crude, unsophisticated or naïve proxy variables has been used in a positive approach and this casts doubt on findings of the positive theories of financial accounting. The use of these proxies is due to the lack of better theories. The main limitation to the development of richer positive theories of accounting is due to the lack of well-specified theories of the firm, of capital structure, and the political process. A richer political process theory would enable researchers to use more refined political cost measures than size in studies explaining cross-sectional variations in accounting procedure choice or the stock price effects of accounting standards. The most striking criticism of the positive accounting approach was based on four points. First, there is the assertion that the kind of positive research undertaken was a prerequisite of the normative accounting theory was based on a confusion of phenomenal domains at the different levels and is thus mistaken. Second, the concept of the positive theory is drawn from an obsolete philosophy of science and is, in any case, a contradiction. Third, although a theory can be used merely for prediction even if it is known to be false, an exploratory theory to be used to test normative proposals ought not to be known to be false. The method of analysis, which reasons backward from the phenomena to the premises that are acceptable based on independent evidence, is the appropriate method for constructing exploratory theories. Fourth, contrary to the empirical method of subjecting theories to severe attempts to falsify them, ad hoc arguments were introduced to excuse the failure of their theories (Riahi-Belkaoui 1996, p. 58). Positive accounting theory is also criticized based on the fact that positive theories tend to also take a normative form with an overload of information. In some instances, critical information may also be hidden.

Positive accounting proponents believe that a normative accounting approach is not theory considering that by itself, theory yields no prescription for accounting practice. Rather, it is concerned with explaining accounting practice. According to proponents of positive accounting practice, any research in financial reporting should start by determining what the issuers are doing. Positive accounting theory goes from the description of what the issuers are doing to an inquiry as to why the interested parties make the choices they do in selecting or recommending financial reporting practices in each of the various. A pre-condition of a positive theory of standard-setting, however, is to understand management’s incentives. Much like science, positive accounting theory can not set priorities. The issuers of financial reports have their foremost priority for financial reporting, which is their welfare. Even though positive accounting theory does not directly work toward improving financial reporting, it might have the indirect result of inciting others to work towards improving it. Positive theorists concede that a positive theory can have normative implications once an objective function is specified. According to Rosenfield (2006, p. 44), positive accounting theory is demanded the normative prescriptions that can be generated from it. To a large extent, the desire for positive accounting theory is informed by the need to know how to achieve set goals. This is regardless of the interest in questions of a normative nature. This includes predicting how the various parties would react to a proposal to change financial reporting practices and how they would react to the changed information if it is produced. Positive accounting theory and the effort to improve financial reporting have a common interest in the reasons the parties support the financial reporting practices they support and to inquire into their incentives. The parties other than the users have had the most influence in establishing financial reporting practices and standards.

Merits and Demerits of Normative and Positive Approaches

There have been major debates about the relative merits of normative and positive approaches to accounting practice. Some people have interpreted accounting theory as providing a complete and transitive ranking of accounting alternatives at the individual level (Higson 2003, p. 27). Generally speaking, it is believed that we can not rely on standards to provide a normative theory of accounting. Departing from individual preferences creates an insurmountable difficulty and no normative theory of accounting can be constructed using any such set of standards such as relevance, usefulness, objectivity, fairness, and variability. The standards are bound incompletely and/or incorrectly to rank the accounting alternatives, thus leading to an incorrect or undefined accounting specification. Some scholars have, however, heavily criticized positive accounting theory for various reasons. Opponents of positive accounting theory have argued that it generally does not in any way offer any form of prescription. This, therefore, implies that the approach can not be used to improve the practice of accounting. According to Porwal (2001, p. 34), the objective of the normative events theory of accounting is to maximize the forecasting accuracy of accounting reports by focusing on the most relevant attributes of events that are crucial to the users. The greatest limitation of the normative events approach is that the users of accounting information may not be able to use it properly in their decision-making. Although a great role has been assigned to users in this approach, they may not be fully equipped to use the information gainfully.

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The positive accounting literature analyzes the use of accounting numbers by various parties that have contractual or regulatory relationships with firms including bondholders, managers, and regulators. The proponents of the positive accounting theory hypothesize that if there are non-zero costs associated with writing and enforcing various contracts that use accounting numbers, managers have reason to care about the policies used in defining and computing accounting numbers. This concern exists even if the stock market can see through the differences in accounting policies of a given firm across time and among different firms at any point in time (Bruns & Kaplan 1987). The most frequently stated hypotheses in the positive accounting literature deal with the effect of management compensation plans, debt covenants, and political costs on accounting policies. Most management compensation plans make the awards contingent upon meeting or exceeding performance as measured by accounting numbers. It is, therefore, hypothesized that managers have incentives to choose or switch accounting policies to affect their compensation awards. This assumes that the compensation committees of the boards of directors do not adjust the reported numbers for the effect of accounting changes. Similarly, since the debt covenants restrictions are often stated in terms of accounting numbers, it is hypothesized that firms have incentives to choose or change accounting policies to meet restrictions that would meet restrictions that they would otherwise violate. Finally, it argued that since reported accounting numbers are used by politicians and other regulators, firms threatened with increased political costs choose policies that reduce current reported earnings and thus minimize political costs.

The Theories and Decision Making

In the early days of accounting practice, it was majorly dominated by the normative theory. The practice back then paid attention to policy regarding prescriptions for better management. Concerns addressed included the treatment of inflation and leases among others. Seemingly, answering these questions requires deep knowledge of how the world behaves. These policy questions are extremely important and they are best answered with knowledge of a wide range of positive theories which is knowledge about how the world behaves. As an example, there has been a great concern among professional accountants about the General Price Level Adjusted accounting (GPLA) (Jensen 1998, p. 127). However, any person intending to realize greater benefits from business operations must be fully aware of how these accounting practices affect performance. It is important to note that both normative and positive accounting practices have very specific questions regarding the effect of GPLA on business operations. While answers directed to questions of a normative nature are entirely based on some form of benchmark, answers to questions of a positive nature are dependent on the general behavior of the world.

Normative accounting theories were ignored due to their prescriptive nature. Positive accounting theories were excluded because they had been used to explain reporting phenomena in a regulated environment (Abeysekera 2008, p. 32). Positive accounting theory is said by its proponents to be the only scientific kind of financial theory. The main objective of positive accounting theory is to explain and predict the accounting practice. The proponents of positive accounting theory also argue that the objective of accounting theory is the provision of prescriptions for regulation of accounting and corporate disclosure (Rosenfield 2006, p. 44). Normative issues in general concern not what people do but what they should do. It is the role of professional knowledge to generate normative propositions about human conduct. According to Banerjee (2010, p. 1221), the normative approach is concerned with establishing what should be. Arguments that are based on the normative approach generally claim that the development of accounting theories that are not related to the current practice of accounting is very critical. This indicates that the normative accounting theory provides an effective mechanism for linking the existing practice of accounting to both economic and social issues. In addition, it seeks to come up with theories of a normative nature that require certain standards about the quality and relevance of the information to be strictly adhered to. This ensures that outputs from the accounting practice conform to the necessary conventions. Normative accounting theories propose procedures and courses of action which should be adopted by accountants to achieve a specific goal or objective.

Normative or Positive Accounting Theory

In the professional world of accounting, the belief is widely held that accounting is an art that can not be formalized and that the methodology traditionally used in the formulation of an accounting theory is an attempt to justify what is by codifying accounting practices. It is possible to assume that, given the complex nature of accounting phenomena and issues, both normative and positive accounting theories may be used. Based on the fact that positive accounting theory is a great improvement to normative accounting theory, it is certainly a superior option to and should be used in the practice of accounting. If senior managers are in the market for theories that will serve their interests, then any theory which finds favor does so not because of its public interest qualities but because of its sectional value.

Well, intentioned accounting theorists committed to the development of normative accounting theories characterize them as supplying the excuses which are in great demand from self-interested parties. Appeals to the public interest which emanate from industry or commerce must be recognized as attempts to cover up sectional interests. As a result, any theory which promises benefits to a particular party will always gain its support. As noted earlier, positive theorists embrace the position of not passing judgment on the market for excuses. Their motivation is to observe, analyze, and then explain what is in place and not to offer any judgment about what might exist as an alternative. According to proponents of positive accounting theory, it relates more closely to many activities of the accounting practice. It is more practical and addresses most issues of greater concern. However, the sole purpose of selecting an accounting approach is dependent on the senior managers. The general argument is that it is in the interest of senior management to reduce costs for reasons of self-benefit. Despite this, it is imperative to ensure that the best approach to accounting practice, and one that is more beneficial, is adopted.

Conclusion

Today’s understanding of the determinants of a firm’s accounting policy choices and changes is still limited. Interpretation of the empirical evidence is considered difficult. Further progress is, therefore, needed and depends on innovation in theory and empirical tests. Even if the stock market sees through the effects of whatever accounting principles are being used, there is still a need for managers to be concerned about settling for the best approach with greater promises. It may be appropriate to reexamine whether managers do make accounting decisions believing that capital markets are fully efficient. Many managers seem unconvinced by the impressive evidence academic literature has come up with regarding the efficiency of different accounting theories. The positive approach in accounting serves to provide a theory of accounting that can be derived from the particular individual instances that occur in practice. It is a theory based on deriving a general explanation from an examination of particular cases. It is experiencing a period of primacy as an accounting field of inquiry and is expected to continue gaining popularity (Riahi-Belkaoui 1996, p. 59).

References

Abeysekera, I 2008, Intellectual Capital Accounting: Practices in a Developing Country, Routledge, New York, NY.

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Banerjee, BK 2010, Financial Accounting: Concepts, Analyses, Methods and Uses, 1/e, PHI Learning Pvt. Ltd., New Delhi, India.

Belkaoui, AR 2004, Accounting Theory, Cengage Learning EMEA, Bedford Row, London.

Bloom, R 1994, The Schism in Accounting, Greenwood Publishing Group, Westport, CT.

Bruns, WJA & Kaplan, RSA 1987, Accounting & Management: Field Study Perspectives, Harvard Business Press, Boston, MA.

Higson, 2003, Corporate Financial Reporting: Theory and Practice, SAGE Publications Ltd, New Delhi, India.

Jensen, MC 1998, Foundations of Organizational Strategy, Harvard Business Press, Boston, MA.

Porwal, LS 2001, Accounting Theory, 3e, Tata McGraw-Hill Education, New Delhi, India.

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Riahi-Belkaoui, 1996, Accounting, a Multiparadigmatic Science, Greenwood Publishing Group, Westport, CT.

Rosenfield, P 2006, Contemporary Issues in Financial Reporting: A User-Oriented Approach, Routledge, New York, NY.

Schroeder, RG, Clark, MW & Cathey, JM 2011, Financial Accounting Theory and Analysis: Text and Cases, John Wiley and Sons, Hoboken, NJ.

Whittington, G 2007, Profitability, Accounting Theory, and Methodology: The Selected Essays of Geoffrey Whittington, Routledge, New York, NY.

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