Positive vs Normative Accounting Theory
Unlike normative theory, positive theory is designed to explore current Notice how each paragraph has one main topic area, new topic areas should mean a new paragraph. Provide in? text references where appropriate accounting practice not to prescribe or advise which methods should be used. Normative accounting theories dismiss conventional historic cost accounting as being meaningless or not decision useful and prescribe the use of more ‘useful’ systems of accounting mostly based on inflation adjustments. One of the issues which became the focus of some normative theorists is how to derive the ‘true income’ (profit).
Positive accounting theory had its origins in the late 1950’s and arose out of the dissatisfaction with normative theories. For example there are many conflicting objectives of normative theory including economic efficiency, decision usefulness, predicting future share price, improved quality of Page 1 of 3 Notice how the last sentence of each paragraph should lead into the next paragraph assisting with the flow of the essay financial reports. Deciding the importance of these objectives is problematic and in fact the definition of the objective of accounting has always been defined in very broad terms.
Normative prescriptions are difficult to empirically test unlike positive theories that observe real world practice and positive hypotheses are falsifiable. Positivists attempt to model the connection between financial accounting, firms and markets in a rational economic framework, rather than to take the stance of normative theorists who dismissed current practice and took a prescriptive attitude. The underlying assumption of positive accounting theory is that individuals are considered to be self-interested wealth maximisers and will act opportunistically to increase their wealth.
This assumption is limited in that the notions of loyalty or morality are not considered. Positive accounting theory has its roots in agency theory and theories of the efficient market hypothesis (EMH). The primary objective of positive accounting theory is to focus on the relationships between various individuals and how accounting is used to assist in the functioning of these relationships. In particular, the fulfilment of the stewardship function and the agency relationships between owners and managers, managers and the firm’s debt providers.
This contrasts with the objective of normative accounting which focuses on the notion of decision usefulness. The separation of ownership and control of firms gives rise to agency relationships. An agency relationship is defined by Jensen and Meckling (1976) as a contract under which one or more (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent. In addition, it relies upon traditional economic literature which includes assumptions of self- interest and wealth maximisation.
Due to the separation of ownership and control, agency costs (monitoring, bonding) arise in an attempt to minimise opportunistic behaviour in financial management. Page 2 of 3 Arrange the essay in such a way as that each paragraph flows . Create the scene in the first few paragraphs and provide definitions if appropriate and then tell the story. Best to discuss the most important items first. There are many items you can discuss, pick the ones you think most important and arrange accordingly. Make sure you stick to the word limit.
Agency theory elaborates three primary hypotheses, the bonus plan hypothesis, the debt covenant hypotheses and political cost hypothesis. For example under the bonus plan hypotheses managers may act opportunistically to increase profits if rewards are attached to profits. Under the debt covenant hypothesis if managers are nearing a breach of debt covenants they may undertake measures to avoid a breach such as revaluing assets. Under the political cost hypotheses managers may undertake measures to reduce reported profits to make the firm less politically visible and less likely to attract government attention or taxes.
PAT under the EMH helps predict the reactions of shareholders to the actions of managers and to reported accounting information. For example Ball and Brown found that earnings announcements had information content and impacted share price and provided evidence that historical cost information is useful to the market. However, while supportive of the efficient markets hypothesis, the literature was unable to explain why particular accounting methods may have been selected.
According to Fama (1970), the development of the efficient markets hypothesis is based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information. The capital market is considered to be highly competitive and as it results the public information is expected to be quickly impounded into share prices. In conclusion this essay has provided an overview of PAT including the assumptions and objectives and contrasted the theory with some of the dissatisfaction with normative accounting theory.
PAT postulates that in order to prescribe an appropriate accounting policy, it is necessary to know how the world actually operates. We can then normatively prescribe accounting practice. Therefore the two theories can be complimentary in ensuring appropriate accounting practice under prevailing diverse economic circumstances. Number of words = 885 Page 3 of 3 Conclusion should provide a brief summary of the essay and then make a final statement on the position of the essay or perhaps an opinion of usefulness or whether you agree or disagree to a statement.