Accounting Theory - Comparison between Positive and Normative Approach - Essay Example

Accounting Theory - Comparison between Positive and Normative Approach Table of Contents Introduction 2 Positive Approach 3 Advantages of Positive Approach 4 Disadvantages of Positive Approach 5 Normative Approach 5 Advantages of Normative Approach 6 Disadvantage of Normative Approach 7 Evidence of Positive Approach 8 Efficient Market Hypothesis 9 Agency Theory 10 Contracting Theory 10 Evidence of Normative Approach 10 Historical Cost Accounting 11 Current Purchasing Power Accounting 11 Current Cost Accounting 12 Comparison between Positive and Normative Approach 12 Relationship between Positive and Normative Approach 13 Conclusion 14 Reference 14 Introduction Accounting is practiced within an implied theoretical framework compiled of principles and practices that are accepted because of their supposed usefulness and logic. An accounting theory has been defined as a coherent set of conceptual, hypothetical and pragmatic principles that gives a better consideration of existing practices to investors, practitioners, managers and other users; directs the development of new procedures and practices; and provides a theoretical framework for assessing existing accounting practices (Porwal, 2001, p.7). The study of accounting theory enables to understand our past and provide us a positive reception of how our recent practices and problems came into being. Historical investigation also tells that certain problems are continuing and may not be capable of an everlasting solution for example accounting for intangible and changing price levels. The accounting theory’s development came up because of needs and changes in accounting concepts and techniques. The main purpose of accounting is to plan periodic matching of revenues and cost. The accounting theory is classified into positive and normative accounting theory. This paper will take into consideration the positive and negative approach of accounting theories; their advantages and disadvantages, comparison and relationships between the two and evidence supporting that where each of the approaches might be appropriate in the current economic and business environment. Positive Approach The positive approach in accounting starts with observations of financial information of business firms and on the basis of recurring relationships proceeds to draw overview and principles of accounting. Financial and accounting information, hence, represents recurring relationships leads to the formulation of principles. Different steps involved in positive accounting theory are: doing the observations and then recording of all the observations, analysis and then doing classification of these observations in order to detect recurring relationships, inductive derivation of principles of accounting and generalizations from those observations which signify recurring relationships and last step is the testing of generalizations (Rao, 2006, p.57). This approach is appropriate in the business environment in order to explain and forecast management’s choice of standards through analysing the benefits and costs of particular financial exposures in relation to allocation of resources and to various individuals within the economy. This theory is based on the propositions that shareholders, managers, and politicians or regulators are rational and that they try to make best use of their utility, which is related to their reward and therefore to their wealth. The preference of an accounting policy by any of these groups depends on a comparison of the relative benefits and costs of different accounting procedures in such a way so as to maximize their utility. For example it will be appropriate in such a business environment where it is assumed that management takes into consideration the effects of the reported accounting of numbers on political cost, information production cost, tax regulation, management compensation, and constraints found in bond-indenture provisions. The fundamental idea of positive theory is to develop hypotheses about factors that persuade the accounting practices and to test the legality of these hypotheses empirically. Positive theories presume that the stock price depends on cash flow in spite of on reported earnings. In brief, it is based on developing a general explanation from an assessment of particular cases (Belkaoui, 1996, p.49). Advantages of Positive Approach The advantages of positive accounting theory are that it helps to describe why accounting is what it is; whatever accountants do, why they do; and what consequences these phenomena have on resource utilization and people. It explains and forecast management’s choice of standards by examining the cost and benefit of particular financial exposure in relation to different individuals and to the distribution of resources within the economy. Even without external regulation, companies’ managers are supposed to have an interest in providing reliable accounts to users. This approach is not necessarily controlled by a predetermined model or structure (Higson, 2003, p.26). It takes into consideration why accounting theories have developed in the manner in which they have in order to predict accounting events. It determines the different factors that may inference realistic factors in the accounting field. It establishes a theory that explains observed phenomena (Oseni, Ireghah and Momoh, 2011, p.9). They are developed on the basis of observations i.e. they are empirically based. By making various observations one can predict what will happen in future, say for a example some managers within a particular industry may be studied to envisage what accounting methods they will choose in order to use in particular situations. Positive accounting theory examines that how contractual agreements which is tied to accounting numbers could be put in place in order to reduce agency cost (Deegan and Samkin, n.d., pp2-6). Disadvantages of Positive Approach The concept of positive approach is taken from a superfluous philosophy of science and in any case is a misnomer, because the hypothesis of empirical science makes no positive statement of “what is”. It explains which organizations will use and which organizations will not use a particular method but it does not explain that which method a organization should use. Other criticism regarding this approach is that it depends on the argument that positive theories are also normative because they generally mark a conventional ideology in their accounting policy implications. The most remarkable critics are that: the two pillars of accounting practices and value-free study are weak; the scientific and economic support of the theory is mistaken and the achievements have been nil (Oseni, Ireghah and Momoh, 2011, p.10). Normative Approach Normative approach is the process of starting with objectives and hypotheses and from these, developing logical principles that give the bases for practical applications. It based on set of goals that advocates maintain prescribe the way the things should be. The process of normative approach is: specify the objective; set out hypotheses; set out limitations; structure; definitions; generalized statements of policy; and specific applications. In normative accounting approach, the creation of objectives is foremost essential because various objectives might involve completely different structures and result in different principles. It set out what should be done (Higson, 2003, p.24). The three main objectives are: to provide management with the beneficial information useful for planning and control, to provide accountability information valuable for contract monitoring and to provide external users with the efficient information helpful for forecasting the future cash flows. Therefore the main objective is to provide information which is valuable for economic decisions and therefore the most important use of accounting information must be balancing actual performance against predictions. It is applicable in different types of economic and business environment say for example, the stock market analyst can make quite exact estimates of accounting income in the months before the genuine announcements, but it is the actual number from the accounts that is all the time considered as the authoritative figure. It is an approach which is not based on observations; instead it is based on how an accounting process should be done. This theory uses a formula to find out income based on value, not cost. Income is defined as either revenue less expenses or during the period some change in overall net assets. It is obvious that there are quite large measurement errors related with either method of calculating income but for legal and social reasons measurement errors are generally ignored (Unimelb, 2013, p.42). Advantages of Normative Approach The normative approach declares that it is reasonable and advantageous to develop theories of accounting which are free of current practices. It explains detailed characteristics of natural equilibrium states based on mathematical logic. The theoretical studies’ models are used in political arguments to substantiate particular policies that should be followed to accomplish the benefits of the theoretical ideal. One more advantage is that current cost accounting of normative approach states that the unrealized holding gains signify definite economic phenomena which occur in the current period. Even if condition changes, there is a vast possibility that the existing production process would produce more profit than changed processes if change is because of the external factor. It seek to report about what practices could be followed in order to accomplish particular outcomes. For example: a normative approach recommends how asset should be valued for the purpose of financial statement (Kam, 1990, p.5). Normative approaches are concerned effectively with stating detailed objectives which are considered as imperatives. For example, a business income theory should be addressed to the difficulty of deciding the amount which may be allocated to shareholders during the accounting period while guarantying that the capital of the business is not thus diminished. Such a statement of objective symbolizes the variety of proposition on which normative approaches are based. Disadvantage of Normative Approach The disadvantage is that it replicated a degree of lack of expectation with the problem of relating accounting practice to social and economic realities. It reflected an apprehension with the lack of comparability between financial statements which is taking place from the use of a different alternative accounting rules. It is essential to distinguish between system of rules which is related to the theory of accounting and the practice of accounting. A system of rules is essential for the regular practice of any art, and it is beneficial to try to sort out the rules which appear to be followed. Only if the rules are effectively explained it is possible to determine inconsistencies in the system. But the criticism is that the sufficient description does not support in determining that which of the two incoherent rules should be approved and which should be discarded. The main criticism is that if the hypotheses are stated largely enough to protect general agreement, they may be discharged as self-evident. On the other hand, if they are stated exclusively, they may fail to achieve general agreement. Evidence of Positive Approach The objective of positive approach is to describe and predict accounting practices. Description means providing explanation for observed practice. For example, positive approach explains why certain organizations switch between various accounting methods. Prediction means that the hypothesis predicts unnoticed phenomena. Unnoticed phenomena may not essentially the future phenomena; they involve phenomena which have already been occurred but on which methodical evidence has not been collected. For example, envisaging the reaction of organizations to a projected accounting standard and a justification of why organizations would go for and against such a standard, even if the standard has previously released. Testing these theories gives proof that can be used to predict the effect of accounting regulations prior to their implementation. Positive approach has an economic focus and is able to answer the questions such as what is the consequence of reported financial statements on share price. It is based on the assumption regarding individual’s behaviour i.e. investors, managers, lenders and other individuals are rational. The theory explains manager’s preference of accounting techniques in terms of self-interest, how financial accounting can be used in order to reduce cost by aligning opposite interests and the relationships among the stakeholders. It is based on the economic based assumption which states that the action of all individuals is derived by self-centredness and the individuals will act in an opportunistic way to the degree that the actions will enhance their wealth. Through an assumption, self-interest drives all actions of individual, positive approach predicts that firm will put in place methods that aligns the manager’s interest (agent) with the owner’s interest (principal) of the firm. Efficient Market Hypothesis The origin of positive approach is the efficient market hypothesis. It depends on the assumption that capital markets respond in an unbiased and efficient manner towards the publicly available information. The perception is that prices of security reflect the content of publicly available information and this information is not constrained to accounting disclosures. The capital market is taken into account as highly competitive and therefore newly released public information is regarded to be rapidly confiscated into share prices. Manager’s choices under the efficient capital market: Since there are various sources of data that are used by the capital market, if managers make less than the candid disclosures, which are not substantiated or opposed by other available information, in that case, supposing that the market is efficient, the market will make query about the honesty of the managers. Subsequently the market will pay fewer attentions to following accounting disclosures made by the managers. Although supportive of efficient market hypothesis, the literature was not able to explain “why particular accounting techniques may have been chosen in the first place”. For example, if a firm decided to switch its inventory cost flow presumptions and because of this there was an increase in reported income, in that case the market was assumed to be competent to see through this change, and to the level that there were no noticeable cash flow propositions, there would be no share price response. Therefore, if particular method of accounting had no direct taxation insinuation, then it was not possible to explain “why a particular accounting method has been chosen in preference to other”. Agency Theory It provides an essential explanation of why the choice of particular accounting technique might matter, and it also focus on the relationships between agents and principals. It is because of the fact that this relationship had created much ambiguity due to various information asymmetries. This theory accepted that information costs and transaction costs exist. It also considered the conflicts and relationships between principals and agents and how various contractual mechanisms and efficient markets can support in minimizing the cost to the organization of these potential conflicts. Within agency theory, it is assumed, that principles will suppose that the agent will be driven by self-interest, and thus the principle will predict that the manager, if not constrained from doing otherwise, will undertake self-servicing activities that could be unfavourable to the economic welfare of the principle (Higson, 2003, pp.26-27). Contracting Theory This theory ensures that the actions through which the individual is benefited, that action also benefit the organization. Contracting theory is more preferable than agency theory because agency theory does not assume that managers will ever act except in their self-interest, and a solution to a well operating organization is to put in place mechanism. Contracting theory anticipated that markets were efficient and contractual agreements were used in order to control the efforts of self-interested agents. Evidence of Normative Approach It takes into consideration historical cost accounting, current purchasing power accounting, and current cost accounting. Historical Cost Accounting It has been noted that historical cost accounting has too many limitations, mainly in time of rising prices. There were three factors of the modern economy that makes it less applicable: First factor is specific price level changes, occasioned by shifts in consumer preferences and technological advances. Second factor is general price level changes i.e. inflation. And third factor is the exchange rates for currencies fluctuations. Therefore, the book value of a company, as stated in financial statements, simultaneously reflects the current value of assets only. Apart from this, historical cost accounting misrepresents the operating results of current year by taking the income holding gain of current year that actually accumulated in previous periods. Current Purchasing Power Accounting It was developed on the basis of an analysis that if an entity has to allocate unadjusted profits which are based on historical cost, as in times of rising prices, the consequences could be a decrease in the real value of entity. Current purchasing power accounting with its dependence on the use of indices is usually accepted as being less costly and easier to apply than other techniques and methods that actually depend upon current valuation of particular assets. While applying current purchasing power accounting, all modifications are made at the end of the period. Under this method, no modification in the purchase power of entity is assumed to take place as a consequence of holding non-monetary assets. Purchasing power losses occur only as a consequence of holding net monetary assets. The critiques are that under Current purchasing power accounting, the information produced might really be confusing to users. Another limitation is that it is not relevant for decision making. Current Cost Accounting It is one of the substitutes to historical cost accounting. A capital maintenance approach to income appreciation was adopted. It verifies valuations on the basis of replacement cost; operating income signifies realized revenues, less the asset’s replacement cost. The unrealized holding gains of current cost accounting signify authentic economic phenomena which takes place in current period and should be identified if there is adequate objective evidence in order to support the price changes. For those items whose market prices are comparatively easy to obtain, the objectivity of their current cost would be suitable to accountant. The critique is that it goes against the traditional realization principle. Some criticism relates to its dependence on replacement costs. Current cost is also not based on real transactions in which the organization is a participant (Deegan, n.d, pp.84-107). Comparison between Positive and Normative Approach The positive approach of accounting theory uses empirical result which is based on actual data analysis and observations in order to characterize the effect of individual policies which are used in existing socioeconomic firms. The outcomes of such empirical research are used in political arguments in order to either justify particular policy changes or to legitimatize existing policies. On the other hand, the normative theory ascertains theoretical models which are based on mathematical logic in order to describe specific features of natural equilibrium states. The theoretical studies’ results are used in political arguments in order to substantiate particular policies that should be followed to achieve the benefits of the theoretical ideal. Normative accounting theories focus on the essential and adequate conditions that accounting information should replicate to fulfil classical criteria of an efficient economic market system. On the other hand, positive accounting theory presumes the existence of efficient markets and makes effort to discover secure relationships between other important economic variables and a firm’s preference of accounting techniques (Bloom and et al, 1994, pp.24-25). Normative approach depends on set of goals that advocate maintains prescribe the way in which the things should be, though, no set of goals is collectively accepted by accountants. As a result, normative approaches are generally acceptable by those individuals who agree with the hypothesis on which they are based. On the other hand, positive accounting theories explain observed phenomena. They depict what is without representing how things should be (Schroeder, Clark and Cathey, 2011, p.123). Relationship between Positive and Normative Approach Positive approach is the explanation to show scientifically the accounting phenomena or the truth of a statement as it is appropriate facts. It explains the theory envisaged and provides answer to the practice of accounting. This approach also predicts various accounting phenomena and telling how the communication between the accounting variables exists in the real world. Validity of positive accounting approach is measured on the basis of compliance with the theory or fact of what in fact happened. Normative accounting approach justifies the viability of a most suitable accounting treatment with the intended purpose. It seek to report about what practices could be followed in order to accomplish particular outcomes. It provides information which is valuable for economic decisions and therefore the most important use of accounting information must be balancing actual performance against predictions. Conclusion Positive approach gives emphasis on observations of the social phenomenon and tracing the observations as they are but it does not make the judgement on the experimental facts whereas normative approach does not rely only on recording facts but also makes a valuable judgement on the experimental facts. It is an approach which is not based on observations; instead it is based on how an accounting process should be done. It provides information which is valuable for economic decisions and therefore the most important use of accounting information must be balancing actual performance against predictions. Thus it helps in decision making and therefore it is more preferable than positive approach. Reference Belkaoui, A.R., 1996. Accounting, a Multiparadigmatic Science. Westport: Greenwood Publishing Group. Bloom, R. and et al., 1994. The Schims in Accounting. Westport: Greenwood Publishing Group. Deegan, C. and Samkin, G., n.d. Financial Accounting. New York: McGraw-Hill Irwin. Higson, A., 2003. Corporate Financial Reporting: Theory and Practice. California: SAGE Publications Ltd. Kam, V., 1990. Accounting Theory. 2nd edn. New York: John Wiley & Sons. Oseni, A.I. Ireghah, M.M. and Momoh, B.A., 2011. Accounting Theory Formulation as a Tool for Enhancing International Harmonization of Accounting Standards. Auchi: Global Research Publishing. Porwal, L.S., 2001. Accounting Theory. 3rd edn. New Delhi: Tata McGraw-Hill Education. Rao, P.M., 2006. Accounting Theory and Standards. New Delhi: Deep & Deep Publications Pvt. Ltd. Schroeder, R.G. Clark, M.W. and Cathey, J.M., 2011. Financial Accounting Theory and Analysis. 10th edn. New York: John Wiley & Sons. Unimelb., 2013. Normative Accounting Theory. [doc]. Available at: people.eng.unimelb.edu.au/peterbs/research/PhD/02-NORMA.doc. [Accessed 12 March 2013]. Read More