ACC721 FRAMEWORK OF ACCOUNTING & REPORT 1

Assignment 2

Name: Miller Bakeoliu

ID: 700028446

Teacher: Maslyn Tauvave

This essay is based on Normative and Positive accounting theories. The three points to be discussed
in this essay are; explaining the differences between the normative accounting theory (NAT) and
positive accounting theory (PAT), state and explain the factors that led to the development of
PAT, and state which of these accounting theories (positive or normative) would be applied when
setting accounting standards. Ending with a conclusion.

Firstly, explain the differences between the normative accounting theory (NAT) and positive
accounting theory (PAT).
Normative (Prescriptive) accounting theory are based upon what the researcher believes should
occur in particular circumstances. These theories describe what financial accounting should be: what
should be regarded as assets, liabilities and so on, and how they should be valued. Since these
theories are not based on observation, they do not necessarily reflect accounting practice (Vorster, 2007,
The theories (normative) serve two primary purposes. The first is to cast a vision for improving financial
p.31).
reporting processes by identifying what ought to be done in practice and the second related purpose is to provide
a basis for identifying weaknesses in the status quo that needs improvement (Miller & Bahnson, 2010, p.2). To serve
both purposes, a normative theory must be shaped without restrictions based on existing technologies, political
power structures, or customary activities. For example, a normative theory states that useful information must be
unbiased. In contrast, current practice includes various situations in which asset value impairments are reported
while value increments are not. The prescriptive theory would suggest that this approach to providing
information should not be applied because its results are biased and therefore not useful (Miller & Bahnson, 2010, p.2).

In addition, normative theories are associated with ontological idealism and epistemological rationalism. They
are a product of the society in which they were created and cannot be regarded as ethically neutral. These
theories consist of recommendations, conclusions, opinions, and judgments about how things should be (the
desired condition). They focus on existing value systems and do not form new ones (Szychta, 2013, p. 256)
(taken from (Rogowska, 2018, p.20)).

On the other hand, Positive (Predictive) accounting theories focus on explaining and predicting
accounting practice, rather than prescribing such practice. Such theories are also based on
observation and they often lead to accounting research that is termed positive accounting research.
Through observation of existing phenomena, they attempt to predict possible future outcomes, such
as, for instance, what particular accounting policies are likely to be adopted by managers in
particular circumstances (Vorster, 2007, p.32).
Predictive theories of accounting do not seek to tell us that what is being done in practice is the most efficient or equitable
process. For example, while we have a (positive) theory of accounting, developed to predict which accounting methods most
accountants will use in particular circumstances (Positive Accounting Theory), this theory will not tell us what we should do
(it is not a ‘prescriptive’ theory), nor will it tell us anything about the efficiency of what is being done. As Watts and
Zimmerman (1986, p. 7) state:

“It [Positive Accounting Theory] is concerned with explaining [accounting] practice. It is designed to explain and predict which firms will
and which firms will not use a particular [accounting method] ... but it says nothing as to which method a firm should use.”
(Taken from (Deegan, 2014, p.156))

Henderson, Peirson and Harris (2004, p. 414) provided a useful description of positive theories. They state:

“A positive theory begins with some assumption(s) and, through logical deduction, enables some prediction(s) to be made about the way
things will be. If the prediction is sufficiently accurate when tested against observations of reality, then the story is regarded as having
provided an explanation of why things are as they are. For example, in climatology, a positive theory of rainfall may yield a prediction that,
if certain conditions are met, then heavy rainfall will be observed. In economics, a positive theory of prices may yield a prediction that, if
certain conditions are met, then rapidly rising prices will be observed. Similarly, a positive theory of accounting may yield a prediction that,
if certain conditions are met, then particular accounting practices will be observed.” (Taken from (Deegan, 2014, p. 9))
In contrast, the usefulness of positive theories depends on their predictive and explanatory power
and on the user’s preferences or objective function. To the extent that the researcher’s values (e.g.
honesty, openness, fairness, objectivity...…etc.) interfere with the theory’s ability to predict and
explain, the theory’s usefulness is reduced (Watts & Zimmerman, p. 147).
Secondly, state and explain the factors that led to the development of Positive accounting theory
(PAT).

The first factor to be discussed that led to the development of PAT is based on the flaws found in normative
theory. One of the main reasons why the normative approach is not used is that there is uncertainty
about whether any particular normative theory would be accepted by accounting scholars (Godfrey
et al. 2006:8).Normative research has been regarded as “non-scientific” (Mattessich 2002:186). Thus
the result of the move from normative to positive research was that the focus in accounting research
shifted from the development of accounting principles and what they should be to a more scientific
methodology of explaining and predicting the practice (taken from (Coetsee, 2010, p. 4). Another reason
for the move away from normative theories was the availability of financial economics principles and testing
methods (Godfrey et al. 2006:6; Watts & Zimmerman 1986:5) (taken from (Coetsee, 2010, p. 5).The reason that
normative researchers would not form and test hypotheses is that they are not concerned with explaining or predicting what
is (which could be tested empirically); rather, they are concerned with what should be. Hence, normative researchers do not
necessarily develop any predictive hypotheses.

Another factor is the development of the Efficient Markets Hypothesis (EMH). The EMH was used in a
study performed by Ball and Brown. The study rejected the argument put forward by normative
theorists that present accounting results were misleading and irrelevant and stated that historical
cost accounting is actually useful (Deegan 2000). This was because their study demonstrated that
unexpected accounting earnings produced abnormal returns and losses in capital markets. Watts
and Zimmerman used this research in developing PAT to illustrate that because there was a reaction
in capital markets when accounting information showing abnormal results was released this
information was useful. They claimed that capital markets could see through changes in accounting
policy and see the bigger picture of firms, therefore rendering them impervious to misleading
accounting methods (Watts & Zimmerman 1986).As capital markets could ‘see through’ the
accounting methods being used, regulation was considered little more than an inefficiency that
interfered with the function of free markets and was costly to firms. These firms could determine
the best ways to report for themselves and it is believed under this theory that auditing will also
occur without regulation because users of information will demand audited information so as to give
it some value (Mouck 1992).It is from this theory that the three main parts of Watts and
Zimmerman’s PAT come into existence; the debt hypothesis, the political cost hypothesis and the
bonus plan hypothesis.

Corruption within political democracy and market system also lead to the development of the
positive accounting theory and the revolutionary movement from using normative accounting
theory to PAT.
In the 20th century when normative accounting theories were still being frequently used, a lot of US
politicians, bureaucrats and special interest groups had misused their powers for their own gains and
had succeeded in engaging accounting researchers in support of their “unethical” objectives. In
Watts and Zimmerman’s Controversial 1979 article, they identified the demand for normative
accounting theories as the demand for excuses.
“Government regulation creates a demand for normative accounting theories employing public
interest arguments, that is, for theories purporting to demonstrate that certain accounting
procedures should be used because they lead to better decisions, more efficient capital market etc.”
(Watts and Zimmerman, 1979, p. 282). Relating to the quote above, by turning to accounting theory
as a justification for legislation (with the help of loyal accounting researchers) politicians and
bureaucrats can easily take advantage of the market system by manipulating the legislations to
satisfy their own ambitions and personal gains. Back then normative accounting researchers were
identified as the “enemy” because of their collaboration with politicians. Having pinpoint the
“enemy”, the rhetoric of protest proceeds with the goal of discrediting the normative accounting
researchers and legitimizing the revolutionary movement from using normative theory to using
positive accounting theory. The campaign of discreditation typically employs a “strategy of
vilification” in the effort to “degrade and stigmatize the opposition” (Golden et al. 1989. P.591). the
positive accounting theory movement had employed strategies such as using philosophy of science
as a tool in its campaign to discredit normative researchers.
Normative research is “unscientific”, and normative accounting theory text are referred to as “so-
called accounting theory texts” (Jensen. 1979, p.11). In the argument against normative researchers
Watts and Zimmerman pointed out that the predominant function of the normative accounting
theories was to supply excuses which is to satisfy the demand created by the political process (1979,
p.300). Watts and Zimmerman (1986) further call into question the intellectual integrity of
normative researchers: “if they were serious about their prescriptions, they would be concerned
about the predictive ability of their implicit positive theory” (p. 338). “Positive accounting research
on the other hand, is legitimate because it is Scientific,” say Watts and Zimmerman (1986), “we use
science’s concept of theory (positive theory)” (p. 338).
By contrast, the success of positive accounting theory is largely due to the fact that it has identified
itself with views of Milton Friedman and the Chicago School of Economics. Grieder reports that
“Ronald Reagan was a disciple of Milton Friedman’s” (1987, p. 354), and that Reagan had even been
tutored by Friedman. Furthermore, “Now that Reagan was President, Friedman continued as an
outside economics adviser, one who dropped by the Oval office regularly to offer his analysis and
advice” (p. 379). The Reagan Administration proceeded to carry out possibly the most far-reaching
programme of deregulation in US history. (Taken from (Mouck, 1992, p. 50-52)

Thirdly, state which of these accounting theories (positive or normative) would be applied
when setting accounting standards. Use conceptual framework for financial reporting and
accounting standards as basis of discussion.
Before stating which accounting theory should be applied when setting accounting standards we must first
understand what an accounting standard is. An accounting standard is a common set of principles,
standards and procedures that define the basis of financial accounting policies and practices. It
relates to all the aspects of an entity’s finances, including assets, liabilities, revenue, expenses and
shareholders' equity. Specific examples of an accounting standard include revenue recognition, asset
classification, allowable methods for depreciation, what is considered depreciable, lease
classifications and outstanding share measurement.
Standard setters around the globe are now setting accounting standards, thus influencing accounting
practice. The two main standard setting bodies are the Financial Accounting Standards Board (FASB)
in the U. S. A. and the International Accounting Standards Board (IASB) that sets international
accounting standards. Both FASB and IASB have developed and adopted conceptual frameworks for
external financial reporting. These bodies now use the frameworks as a basis of setting new
accounting standards and amending the current ones.
Furthermore, the conceptual frameworks mentioned above are largely normative, in approach, for
example, indicating how the elements of accounting (the elements being assets, liabilities, income,
expenses and equity) are defined and when they should be recognised. However, in certain cases,
because of persuasions and threats made by powerful interest groups, parts of some conceptual
frameworks became descriptive of current practice, with limited implications for changing existing
accounting practices.
(Deegan, 2014, P. 128)
Therefore, since accounting setters use conceptual framework as a basis of setting new standards
and amending current ones, and the fact that conceptual framework can be viewed as a normative
accounting theory, it is clear that when setting accounting standards normative theory is most likely
to be applied. In addition, by looking at the definition of the accounting standard mentioned earlier,
there are a lot of evidence of normative theory concepts being used, such as revenue recognition,
asset classification and so forth. .

To conclude, positive accounting theory looks at what is currently happening in a business; it is

based on facts and statistics. PAT examines the real world transactions of a company and compares
the incomings with the outgoings to identify any discrepancies. On the hand, normative accounting
theory advises policy makers on what should be done based on theoretical principles. While PAT
looks at past data, normative works with events in the future. But lately, normative theories have
not received much attention from the accounting academy due to a lot flaws being discovered by
positive accounting researchers. This discovery has led to the development of positive accounting
theory (including other factors mentioned above). Furthermore, though NAT is no longer frequently
used by accounting researchers, it has a huge impact in accounting literature, as already mentioned,
it is applied by accounting setters when setting accounting standards and by contrast, it forms most
of the conceptual framework and the standards.
Bibliography

Voster, Q. (2007, June). The conceptual framework, Accounting principle and what we believe is
true, p. 31-32

Miller, W., B., P., Bahnson, R., P. (2010). Continuing the normative dialog: illuminating the
asset/liability theory, 24(3), 2. doi:10.2308/acch.2010.24.3.419

Rogowska, B. (2018). Ethical aspects of normative theories of accounting, Annales, Ethics in

economic life, 21(8), 20. doi:https://dx.doi.org/10.18778/1899-2226.21.8.02

Deegan, C. (2014). Financial accounting theory (4 th ed.) Water Loo Road, Australia: Jillian & Rosemary

Coetsee, D. (2012). The role of accounting theory in the development of accounting principles.
Mediatory Accounting research, 18(1), 4-5

Watts, L., R., Zimmerman, L., J. (1990). Positive accounting theory: a ten year perspective. The
account review, 65 (1), 147

Mouck, T. (1992). The rhetoric of science and the rhetoric of revolt in the “story” of positive
accounting theory. Accountability journal. 5(4), 50-52

Kabir, H. (2005). Normative accounting theories, Research on normative theory, August, 24.
doi:10.2139/ssrn.765984

Note: All the journals and book above were posted by Maslyn Tauvave in the Solomon Island
National University Moodle. Anyone who have access to login into SINU Moodle can visit the link
below to retrieve such information:

http://elearn.sinu.edu.sb/course/view.php?id=383