Normative and Positive Theories in Accounting

Normative Theories (1950-1960) golden age

Accounting researcher became more concerned with:

 Policy recommendations &

What should / ought to be done, rather than analyzing and explaining the currently accepted practice.

They are focusing on issue of:

#1. Deriving the true income FYE

• Deriving a single measure for assets and unique profit figure subject to disagreement
• Much of them are discussing on merits and demerits of alternative measurement system

#2. Decision usefulness - Discussing the type of accounting info for economic decision making

• Providing useful and relevant accounting data to aid the users to make decision making
• The users seems to be not in particular group but categorized as all users

Assumptions of normative theorists which are not even tested empirically:

• Accounting should be a measurement system
• Profit and value can be measured reliably and precisely
• Financial accounting is useful in economic decision making
• Market are inefficient / can be fooled by ‘creative accountant’
• Conventional accounting is inefficient 
• There is one unique profit measure

The description of normative theorists

• They think that their assumptions are ideal, and “recommended” to replace HCA with it and to be used by all and sundry.
• They “labelled” their approach to theory formulation scientific & based their theory on analytic (syntactic/logical) and empirical (inductive/pragmatic) propositions
• Their “scope of research is general/holistic” (the whole financial statements, not just specific/narrowed scope such as accounting for doubtful debts)
• They also “made assumptions” about the nature of a firm’s operations based on their “observations”
• They outlining the detailed and precise accounting principles and rules and a “logical explanations outputs”
• Rigorous and consistent deductive framework
• FS “should” mean what they say and “Should have” semantic connections
• Using pragmatic test: observing FS , users should act as though they actually observed the event the FS represented.
• Relies mainly on syntactic relations labelled as ‘hypothetico-deductive’ even though has semantic elements in the methodology.

The main objective of the research: Usefulness of acc data to find answer whether it helped decision makers make the right financial decisions?

• Decision process = decision makers use acc data to make predictions and then decide what to do.
• Comparing the science approach, referring to either instrumentalism or realism

Instrumentalism and Realism

#1. Instrumentalism is a theory has no utility except as an instrument for prediction. According to friedman (probably a normative theorist), theories can only be judged by predictive power. However, this is not applicable in accounting where some problems is identified during the verification test:

• If the prediction is verified, it verifies the prediction model of the user, not accounting system
• If the decision is turns out to be right, it only verifies the decision model and also not accounting system.

Therefore instrumentalism is best describe a normative theory where it only considers on what should be done, decision making by predictions without mentioning the descriptive explanation to verify on what has occurred in the real world.

#2. Realism stressed the explanatory role of science (prediction in reverse), in accounting it means for an accounting theory to be valid, it must be more than an instrument for forecasting, it must also hold as a description of the reality that underlies the accounting phenomena. Its prediction ability is proved from the relevant feedback of what has occurred before.

Therefore realism is best describe a positive theory where the prediction (assumptions) of a normative theory is supported by description in reality.

Validation prediction in a different variables situation (controllable and uncontrollable)

In accounting, controllable variable recognized as accounting figures in financial statements. While uncontrollable variable recognized in economic environments such as inflation, interest rates or consumer confident.

• In validating prediction in a controllable variable situation, we can use scientific test
• In validating prediction in an uncontrollable variable situation, we can use statistic prediction, according to how probable the evidence supporting the prediction is representative.

Therefore, normative theorists only considered on a controllable variation where they can only uses scientific tests because their predicting ability only based on assumptions, not verified into the real world. However positive theorists can work with uncontrollable variable besides controllable variable which is because their predicting ability is based on the past events that has occurred. They can use both scientific test and statistic prediction for their research.

Positive Theories (1970-present)

If before this we know that normative theory is only pursuing on making assumptions, Positive theory is the other way round. Positive theory is heading back to the empirical methodology (also called positive methodology) where the assumptions is turns back into real world. What does it really mean? Actually, positive methodology is about to test assumptions made by the normative theorists and only accept which assumptions that can reflects the reality. Therefore the realism is best describe positive theory.

Example of research made by positive theorists

• Using questionnaires and other survey techniques to determine attitudes to the usefulness of different accounting techniques by gaining key person opinion on the economic decision making process.
•  Test the assumed importance of accounting outputs in the marketplace. Test attempted to determine whether:
• Inflation accounting increase the information efficiency of share markets
• Profit is an important determinant n share valuation
• Cost of gathering finer accounting data outweighed benefits
• Use of different accounting techniques affected value

Today, positive theory is concerned mainly with: 

• Explaining – reason for current practice
• Predicting – 
• role of accounting profession
• accounting information for economic decision making for users

Descriptive Approach by Positive Theory

Positive theory describe how people do behave (regardless of whether it is right or best behavior).

For example, how do positive theorists use their method to test on the accounting techniques used by managers to maximize their bonuses?

Suggested survey questions:

• Do firms substitute alternative ways of financing assets when the rules governing the accounting for leases change?
• Which firm are more likely to use Straight Line Depreciation rather than Diminishing Balance Depreciation? Why?

Suggested answers from management:

• Their incentives to avoid breaching accounting based debt covenants and thereby reducing cost of debt.
• Their Incentives to use accounting techniques to divert attention from their high profits that would lead to government/public scrutiny & also higher tax charged which lead to bad effect to their income.

Summary

NORMATIVE THEORY

POSITIVE THEORY

Policy recommendations, ought/should be done Instrumentalism Prescriptive - normative theory prescribe how people should behave to achieve an outcome that is judged to be right, moral, just, or otherwise a good outcome. Under control (Limited variables)  Info useful for decision making Make assumptions but not tested out Classifications of assumptions: Classical economics  Measurement theories HCA adjusted for inflation

Analyzing, explaining current practice Realism Descriptive - Positive theory describe how people do behave (regardless of whether it is right or best behaviour) Beyond control (many variables) Scientific: questionnaire Feedback received can be a predictive value Test out the assumptions and get feedback using questionnaires