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Critical Thinking About Positive And Normative Theory

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Question:

Discuss the critical Thinking about Positive and Normative Theory?

 

Answer:

Introduction

Accounting practice involves accounting theory which seeks to explain the methodologies and principles used in the financial reporting.  All the theories used in the study of accounting are covered by conceptual framework.  These theories are based on logical reasoning. Various regulatory bodies such as International Accounting Standards Board (IASB), Financial Accounting Standard Board (FASB) etc. play the role of rule and policy makers in the practice. However, there are beliefs that the accounting theory is said to be originated from behavioural science. On the other hand, few researchers think that accounting theory primarily involves pure science (Alexander, 2013). The paper tries to explain the two basic approaches for the purpose of analysis of the accounting theory. These two approaches are the positive and the normative theory respectively. In the subsequent section of the essay, the paper attempts to differentiate these two theories and finally wraps up with concluding note

 

Critical thinking about positive and normative theory

Positive Accounting Theory (PAT) is the branch of accounting research study. PAT attempts to elucidate the actual accounting practices.  The theory holds the business as combination and nexus of contracts. Different parties involved herein namely shareholders, managers, employees, customers and suppliers etc. have a mutual relationship with each other by way of business contracts.  Accounting, in such case, plays a crucial and critical role to unify all the contracts for the purpose of achievement of greater goals and objectives of the business (Althaus et al. 2012).

The views expressed in the given theory has two perspectives namely efficiency perspective and opportunity perspective.  Efficiency perspective shows that the managers choose the accounting theory and apply the same in the business practices wisely. In other words, management is efficient enough to practically apply the accounting theories that best suit with business expectations and also help to depict true financial performance of the firm (Cervi, 2013).

On the other hand, opportunity perspective holds the view that the management of the business acts in own vested interest. Managers are the agents of the shareholders, being the owners of the business. Such agency issue creates the problem in terms of interest in the business by the respective groups. Managers, for example, are alleged to be intended to show the financial performance better than what actually is. This is because of the fact that the better performance of the business directly has a positive impact on the managerial remuneration (Creedy, 2009). 

Opportunity perspective is based on three hypothesis and these are briefly discussed as herein. Bonus plan hypothesis states that managers have vested interest in the business, which is the reason they show the financial performance of the company better than what actually is. In other words, managerial compensation and firm’s financial performance are directly proportional to each other and this gives rise to the incentive for the managers to inflate the profit and mislead the shareholders, the real owners of the business (Freebairn, 2012). Debt-Equity hypothesis, on the other hand, assumes that the managers tend to show more accounting profit in the income statement if the Debt-Equity level of the firm increases. This is because of the fact that higher debt components in the capital structure of the company mean more payment obligations in terms of interest payment and principal repayment (Gordon, 2014).  Financial institutions including banks want to check the interest coverage of the firm and liquidity

 


position of the business so that the business may enjoy sufficient liquidity to pay off the debt. However, here comes the incentive on the part of the managers to overstate the liquidity position so that business possess debt fund flowing in the business. Political cost hypothesis states the tax implications of the business and corresponding impact on the psychologies of the managers. If the business earns more profit, more tax needs to be paid to the Government. Therefore, managers, for the purpose of evasion of tax liability, may tend to show lower profits than what actually is. In other words, as per the hypothesis, the primary intention of the managers revolves around evading tax by lowering profits so that financial performance of the business does not catch the political eyes including Government (Haffner and Winters, 2015).

                                                       Figure 1: Hierarchy of Positive Accounting Theory

                                                        (Source: Created by author)

Normative Accounting Theory (NAT), on the other hand, is fundamentally different than that of PAT, as discussed above. NAT talks about the optimum accounting theory and practice as against the propositions of PAT which discusses about the actual theories and practices. In other words, NAT discusses what it should be as against the PSAT which talks about what it is. From the viewpoint of logical reasoning, it may be construed that the NAT is more deductive theory than that of PAT.

It may be noted that there have been differences in opinions as to whether the methodologies and procedures as laid down under the natural sciences may be appropriate and hence applicable to the social sciences. In this context, it may be observed that the principles of natural sciences may be used in defining and explaining any social issues or cases (Hewson, 2014). However, it may also be noted identified that two human being may not act in a similar manner in same situations. Furthermore, the human being may not repeat the same action in the same situation. Therefore, there are differences with respect to the application of social science and that of natural science. Though NAT proposes to hold the optimum theories of accounting, NAT is alleged to be superficial and unreal.

 

Difference between positive and normative theory relating with the article

As discussed above, there are differences between PAT and NAT with respect to the prescriptions, principles and practices. PAT is practical, whereas NAT is theoretical. As mentioned earlier, PAT puts emphasis on what it is. NAT, on the other hand, explains what it should be. It may be claimed that the true net worth of the firm should be communicated to all the stakeholders namely shareholders, borrowers, lenders, customers, suppliers, managers, employees etc. However, financial statements do not always tend to report the true picture of the firm. Fixed assets and other non-current assets of the business are recorded under the historical cost method. On the other hand, few securities including derivatives and other financial instruments may be recorded as per fair value method. Therefore, the balance sheet of the firm shows a mix of assets differently valued following different principles (Hogan, 2012). On the other hand, there have been few inductivists who prefer inductive model over the deductive model. Inductivists assume that NAT follows an inductive model. It may be construed that these two theories complement each other and in no way substitute for each other (Lymer and Oats, 2007). 

In the context of given two articles, it may be observed that the articles discuss two different types of accounting theory. One article talks about accounting as a positive theory. Md. Humayun Kabir, in the article, has mentioned different aspects and anomalies related with positive accounting theory. The paper rightly expresses the different opinions on methodologies followed in accounting practices. The research also portrays gaps identified in the positivism concept in the field of accounting.

On the other hand, the second article, written by the same author, showcases different aspects associated with normative accounting theories. The article, as mentioned previously in this paper, presents few differing theories propagated by both inductivists and deductivists researchers under normative accounting framework. These theories, though mutually contradictory at times, present a holistic idea about the accounting theory and practical application of accounting principles.  The article by Md. Humayun Kabir on Normative Accounting Theories reviews the exemplary works of different types of theorists (both for inductive and deductive) with respect to accounting. The article shows that one of the approaches in NAT is that the same is based on both deductive and inductive model as well.

There are works of various scholars which analyse accounting theory from the viewpoint of both the models namely inductive and deductive. However, it may be mentioned that almost all the works and approaches contain assumptions for the purpose of practical application of these theories and models in the practices. There are separate viewpoints and perspectives to evaluate NAT. Accounting theory may be viewed as a part of normative science from the cost perspective (Lymer and Oats, 2013). Few theorists hold accounting under historical cost method; few others consider market price or current cost model. In addition, few researchers also put reliance on the realisable value or replacement cost. The followers of historical cost convention possess opinion that these market-linked values such as realisable value or resale price are relevant only for few specific types of decision making and not for reporting as a whole.  Furthermore, there are dissimilarities between the propositions by different theorists advocating normative accounting theory. For example, the researchers belonging to historical cost’s school of thought place critical consideration on the concept of objectivity and verifiability (Mangioni, 2014). In other words, it is opined that the accounting process is objective and does not require enough corroboration by way of assumptions to be validated. 

 

Conclusion

From the discussion made above, it may be observed that the variations and approaches on accounting theory are the vast areas of entire accounting study. There are various types of perspectives emerged time to time to substantiate the theories and relate the same to practices. It may be construed that reliability is one of the basic and fundamental assumptions and components behind accounting theories (Metcalf, 2007). Financial statements present financial performance of the business to the targeted audiences so that decision making process of every stakeholder associated may be smooth and efficient. In other words, the primary objective of accounting is said to present economic truth to the users of financial statements. Therefore, primary requisite of the financial statements is to be reliable. Accounting theory may be analysed as a positive theory or normative theory. However, the financial reporting should be efficient and it needs to be kept in mind that the accounting information helps the management and stakeholders to evaluate the business and take necessary decision accordingly. Lastly, it may be construed that the accounting theories and practices emerge as a part of both social science and natural science. Simultaneous inclusion of measurement and disclosure in the accounting framework makes the subject as a balanced mix of both human science and natural science (Waller, 2007).  Therefore, it may be concluded that PAT and NAT support each other. The drawback of NAT has been eliminated, to a greater extent, in PAT. However, NAT provides the theoretical and principle-based framework which is utmost critical for any practices or operations.  The combination of both normative and positive theories makes accounting one of the most useful subjects in today's world, which is both practical and based on principles (Woellner et al. 2012).

 

References

Alexander, R. M. (2013). Tax transparency. Business Horizons, 56(5), 543–549.

Althaus, C., Bridgman, P., and Davis, G. (2012). The Australian policy handbook. Australia: Independent Pub Group.

Cervi, B. (2013). Buisness focus: Corporate split-up leads to new union. Engineering and Technology, 8(8), 20–22.

Creedy, J. (2009). Personal income taxation: From theory to policy. Australian Economic Review, 42(4), 496–506.

Freebairn, J. (2012). Personal income taxation. Economic Papers: A journal of applied economics and policy, 31(1), 18–23.

Gordon, R. N. (2014). Making hedge funds more tax-efficient. The Journal of Wealth Management, 7(1), 75–80.

Haffner, M., and Winters, S. (2015). Homeownership taxation in Flanders: Moving towards “optimal taxation”? International Journal of Housing Policy, 159-168(4), 1–18.

Hewson, J. (2014). The politics of tax reform in Australia. Asia and the Pacific Policy Studies, 1(3), 590–599.

Hogan, L. (2012). Non-renewable resource taxation: Policy reform in Australia*. Australian Journal of Agricultural and Resource Economics, 56(2), 244–259.

Lymer, A., and Oats, L. (2007). Taxation - policy and practice 2007-2008: 2007-2008 (14th ed.). Birmingham: Fiscal Publications.

Lymer, A., and Oats, L. (2013). Taxation: Policy and practice: 2013/14 (20th ed.). Birmingham: Fiscal Publications.

Mangioni, V. (2014). Emerging trends of state land tax and local government rate revenue in Australia. Pacific Rim Property Research Journal, 20(2), 145–160.

Metcalf, G. E. (2007). Federal tax policy towards energy. Tax Policy and the Economy, 21(4), 145–184.

Waller, V. (2007). The challenge of institutional integrity in responsive regulation: Field inspections by the Australian taxation office. Law and Policy, 29(1), 67–83.

Woellner, Woellner, R., Barkoczy, S., and Pinto, D. (2012). Australian taxation law 2012 (23rd ed.). Australia: CCH Australia.

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