Describe the Report for Positive & Normative Accounting Theory.
The positive Accounting theory refers to the theories that help us to explain and predict the accounting practices that have been followed in by the accounting firms and companies. The positive accounting theories tend to consider the events that took place in the world and based on their interpretation, they convert the same into accounting practices. On the other hand, the approach that has been used in case of normative accounting theories is totally different form that to the positive accounting theories. In case of normative accounting theories, the experts based on the event that has taken place, would provide an accounting solution that needs to be followed in this situation. The positive accounting theory will help to predict the reaction which the companies would have at times when a new accounting standard has been introduced in the market. The positive accounting theory will help to understand the accounting policies that will be adopted by the companies.
The positive accounting theory provides an understanding about the descriptive behavior of the accountants. In case of the positive accounting theory, the management of the company tends to use the approach related to the adoption of the accounting policies and standards that increases there probability of survival in the industry. For example: For the companies who are engaged into the contract adopting business would select the accounting policies that minimizes their contract cost and maximizes their profits. These theories at the same time provide an inbuilt flexibility to the managers of the organization to choose an accounting standard that best suited and which is in their own interest.
The predictions that the managers took place rotate around three hypotheses.
Bonus plan hypothesis: The managers of the organization whose bonus is linked with the performance of the company is likely to choose the accounting standards that help the accountants in the company to shift the future profit that company is expected to realize to the current period.
Debt covenant hypothesis: The companies who are more likely to violet the debt covenant, is expected to select the accounting standards that help the accountants to shift the future profit that company is expected to realize to the current period. In this case, the company would be saved from violating the debt covenant.
Political cost hypothesis: There is something a possibility that company is likely to face some political cost based on the profit they are earning in the current year. Thus in that circumstances, there exist a possibility that the managers adopt an accounting standard that shift the current year profit to future years just to save the coming political cost. High profit may lead to high taxes and sometimes high regulations as well. (Watts, R., Zimmerman, J)
Positive Accounting Theory
On the other hand, the normative accounting theory is more subjective in nature. The approach that has been followed in this case is not based on the observation that has been noted in the based but based on actually how the accounting process should look like. The researchers in case of normative theory tends to adhere to several different approaches that they consider and based on the same they try to reach out to some opinion which can be helped in reaching out to some possible outcome.
The normative theory will help in defining the economic future for the investor as well for the company. As a result of this subjective approach has been introduced in accounting.
It has been believed by the accounting experts that the positive accounting theory that has been followed in for farming the accounting polices does not help in developing and improving the accounting practices. Ross L. Watts and Jerold L. Zimmerman were among the first accounting experts who worked together and give evidences towards the theory of positive accounting. Ross L. Watts and Jerold L. Zimmerman in their article “Towards a positive Theory of the determination of accounting standards” have tried to define the attitude of the management towards the accounting standards. Ross L. Watts and Jerold L. Zimmerman through the help of their article has provided some platform that can be helpful in understanding the factors that are in current date being driving the process of setting accounting standards. The size of the company also affects their opinion towards the standards is also been clearly evident from the article that has been written by the authors. They have stated the relation that exists between the size of the company and the process of setting up of accounting standards. The authors through their research exercise have highlighted the irregularities that existed in the accounting practices. In addition to all above, they have discussed and analyzed the concepts that are behind the agency theory, contracting cost theory and political cost. The authors were of the view that the result that would come out from the research work will improvise the development of accounting theory. They have shown the direct relationship between the cash flow and the prices of the shares.
Positivism as the paradigm has been used by the author for their research relating to this article. However, the use of positivism as their paradigm has been opposed by many researchers. The researchers have a have a strong belief that for understanding the person it is very important to examine the perception they have for their own activities. Factors that affect the management welfare and their decision regarding the consumption of the main resources were like regulatory, tax, political consideration etc. Another main reason for this discomfort was they believe that it is not possible to segregate the social concept from the people in which it exists. Therefore indirectly, these factors affect the accounting standard setting process.
Normative Accounting Theory
The positive accounting theory has been used by the management of the company in order to choose the accounting standards that tends to report low profit and t the same time help to report high cash flow. But at the same time when the bonus and salary payout of the top management is linked to the earnings or performance of the company, in that case they prefer choosing the accounting standard that helps them to transfer the future profit to the current period. In that case, in case of positive accounting theory, the management of the company based on their need and demand of the situation can manipulate the accounting standards.
At times of framing the positive accounting theory, the authors tend to base their results on some assumptions. One of them is the definition of users in relation to the theory. The authors had only considered the impact of such adoption of accounting standards on limited users like listed shareholders, government and creditors. There are several other users such as employees, customers, competitors, advisors which have been ignored. Each user has a separate influence on the firm and they impact the decision of choosing an accounting standard.
The assumptions that have been taken in case of positive accounting theory are majorly driven by self interest which makes the difficult as the self interest of one might not be same for the other making the things a bit worse. Further, all the action that has been taken in place by the positive theory will drive through the desire of maximization of wealth which as per many other authors turns out to be negative enough. The assumption that has been taken in the policy is that an organization is a group of self interested people who in collection form a corporate. Further, in the theory, the concept of loyalty and morality has been ignored. All these assumptions took the theory away from the basic need of developing and improving the current accounting practices.
In case the organization goes in for the positive theory, the method of accounting that has been selected will be explained in base on the opportunistic or efficiency arguments. Further, it has been argued that behind the positive accounting theory there is no scientific data making it difficult for the experts to justify the core reason behind the policy to get accepted by a wide range. Further, many issues has been brought into picture but there does not seems to have any significant development in regards to their improvement.
The three hypotheses which have been put in place by Watts and Zimmerman (1978) under the positive accounting theory are: the bonus plan hypothesis, the debt/equity hypothesis and the political cost hypothesis. By looking at the basic study behind this hypothesis, it is evident that these entire hypotheses that have been are self centered.
Thus, the management of the company can use the approach of positive amounting theory for their own good. In that case, it becomes very difficult to establish a portal that can be used to develop and improve the accounting practice as in case of positive theory the accounting practices are changes based on the requirement of the companies.
On the other hand, the approach that has been used in case of normative accounting theories is totally different form that to the positive accounting theories. In case of normative accounting theories, the experts based on the event that has taken place, would provide an accounting solution that needs to be followed in this situation. It has been stated that the “Normative accounting theory should be the only theory that should be utilized instead”. The normative accounting theories provides necessary guidance which can be used in making the section for the accounting policies which can be considered appropriate for the management. The normative accounting theories at the same time can be used to make recommendations on the current practices which can be used to deviate and make improvements in the same. The approach that has been followed case of normative accounting theories is different from the positive accounting theory. The normative accounting theories does not look in what is currently being happening in the company but based on the theoretical principles in place they provide suggestions to the policy makers about what needs to be done. Normative accounting theories have been considered to be more deductive process as compared to the positive accounting theory. In case of normative theory, the policies tend to be more specific which not the case is in positive accounting theory. For example: Before the financial crisis that occurred all the financial securities that were owned by the banks were accounted in the similar way as we carry out in case of real estates and other assets of the company. As per the policies, the assets do not required to be revalued and no process was there to consider the current market value. But after the financial crisis that took place, the accounting policy was changed and the polices required the assets to be valued at marked to market at times of each financial statements. As result of this approach, the assets were revalued and the associated unrealized gain or loss was moved in to the profit and loss account. This has been regarded as a major change which brought change in the accounting policy as result of the being driven by principle.
Both the accounting theories are complementary to each other; the weakness of one is complemented by the other. It has been provided that the positive accounting theory tends to be more practical enough and takes decisions based on what is actually being happening whereas the normative accounting theories is more theoretical in nature and they do not get impacted or affected by the day to day practices.
In the current market scenario, it is good to be practical in books for selecting the accounting practices but in reality, the situation is no always the same. The accounting approach and the practices cannot be changed based on the change in the day to day practices. The management of the companies considering the present day situation cannot think of making changes in the approach being it is possible that tomorrow the things might be different and the demand of the situation is the same approach that we have followed previously. Thus, in that case it becomes important to consider the theoretical approach as the same will not be changed based on the change in the day to day practices. (Branchmann S)
For a company to carry out an effective financial planning, it is important for the management of the company to consider both the normative as well as the positive accounting theory. Although the normative accounting policies have major stake to play and the accounting experts based considers the financial polices based on the normative statements of accounts. But these statements are based on the financial realities that we have noticed through positive accounting practices. The practices that have been followed in positive accounting theories can be used as a foundation for the normative accounting statements.
Being the normative accounting theory has its plus points, still the same has been has criticized at some formats. The normative accounting theory is based on some or the other value judgment which makes the things a bit different. Further, the normative accounting theory does not involve any empirical hypothesis testing. (Fool M)
In case of normative accounting theories, the experts based on the event that has taken place, would provide an accounting solution that needs to be followed in this situation. On the other hand, the positive Accounting theory refers to the theories that help us to explain and predict the accounting practices that have been followed in by the accounting firms and companies. The positive accounting theories tend to consider the events that took place in the world and based on their interpretation, they convert the same into accounting practices. The management of the company can use the approach of positive amounting theory for their own good. In that case, it becomes very difficult to establish a portal that can be used to develop and improve the accounting practice as in case of positive theory the accounting practices are changes based on the requirement of the companies. The normative accounting theories provides necessary guidance which can be used in making the section for the accounting policies which can be considered appropriate for the management. The normative accounting theories at the same time can be used to make recommendations on the current practices which can be used to deviate and make improvements in the same. Considering all these points, it is evident that the normative accounting theory tends to be used for developing and improving the accounting practices. However, it cannot be purely stated that normative accounting theory is the only theory that is required but we, at the same time require some glimpse of the positive theory as well to base the normative accounting statements.
Watts, R., Zimmerman, J., (1990), Positive accounting theory: A ten year perspective, The Accounting Review 65, 131-156.
Watts, R. L. and J. L. Zimmerman, (1978), towards a positive theory of the determination of accounting standards, The Accounting Review, (January): 112-134.
Roychowdhury, S. (2006) Earnings Management through Real Activities Manipulation, Journal of Accounting and Economics 42, 335-370.
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