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NORMATIVE AND
POSITVE THEORIES OF
ACCOUNTING
At the end of this class, students should be able to:
i. understand what normative theory means
ii. enumerate practical applications of the normative theory
iii.discuss the IASB’s Conceptual Framework
iv. understand what positive theory means
v. enumerate practical applications of the positive theory
vi. compare normative and positive theories
LEARNING OUTCOMES
There are four periods of accounting theory, starting with the Pre-Theory period
from 1492-1800. Then continued with the Pragmatic accounting period (general
scientific period) from 1800-1955. The period 1956-1970 is labeled the 'normative
period'. The last is the period of positive accounting theory from 1970 to the present.
INTRODUCTION
-Normative theory attempts to justify what “ought to be”.
-It will attempt to justify some of the accounting practices that ought to be adopted.
-It favours “theory as preceding practice”.
-It is concerned with specifying the manner in which decisions ought to be made as a
precondition to considering the information requirement.
-It postulates what financial information should be developed and communicated
and how this should be done.
NORMATIVE THEORY EXPLAINED
-A normative accounting theory seeks to prescribe some basis of accounting
measurement, particular accounting procedures, and the contents of financial
reports .
-The essential feature of Normative Theory is the existence of value judgement
(choice of depreciation methods, valuation of inventory, measurement basis).
-Normative Theories tend to justify what ought to be, rather than what it is.
-It imposes on the accountants responsibility of determining what should be reported
rather than merely reporting what someone else has requested (consider Audit
Expectations Gap)
NORMATIVE THEORY EXPLAINED
-Normative accounting theory focuses on prescriptions (norms)

-Instead of looking at what is already happening at companies today, normative

accounting theory tells accounting policy makers what should be done based on a
theoretical principle.

NORMATIVE THEORY EXPLAINED

-Logically, Normative theories are a special case of deductive theories.
-How does deductive reasoning works?
-Deductive reasoning starts with some goal assumptions (accounting premises) and
proceeds to deduce (derive) accounting procedures therefrom.
-it moves from general to specific (e.g. all assets accounts have debit balances;
Motor vehicle & Equipment accounts are asset accounts; then, Motor vehicle &
Equipment accounts have debit balances).
-Thus, there are two important elements of a normative theory: (a) goal assumption
(the premise), and (b) deduction.
-
NORMATIVE THEORY EXPLAINED
-The conceptual frameworks are example of the normative theories since they
provide prescriptions.
-Conceptual Framework is a coherent system of interrelated objectives and
fundamentals that is expected to lead to consistent standards and that prescribes the
nature, function and limits of financial accounting and financial statements.
APPLICATION OF NORMATIVE THEORY
-development of future IFRSs and review of existing ones
-assist national standard-setting bodies in developing national standards
-assist auditors in forming opinion on compliance or otherwise of financial
statements
-assist preparers of financial statements in applying IFRS and dealing with topics yet
to be covered by any IFRS
-provide information about IASB’s approach to the formulation of IFRSs
PURPOSE OF CONCEPTUAL FRAMEWORK
-There is need to develop the practice of financial reporting logically and
consistently;
-without agreement on certain issues accounting standards will be developed in an ad
hoc manner.
• There will be limited consistency between accounting standards in the absence of a
conceptual framework

ISSUES GERMANE TO CF
we need to address and agree upon such issues as:
– what we mean by 'financial reporting' and what should be its scope;
– which organisational characteristics indicate that an entity should produce financial
reports;
– the 'objective' of financial reporting;

ISSUES GERMANE TO CF
-qualitative characteristics financial information should possess for it to be ‘useful’;
– what are the elements of financial reporting; and
– what measurement rule(s) should be employed.

ISSUES GERMANE TO CF
that is early agreement is needed on:
i.What is meant by 'financial reporting‘, and in particular ‘general purpose financial
reporting’?
ii.Definition of a reporting entity
iv. Definition of the users of financial statements (and assumptions of their
accounting knowledge)
v. The objective of financial reporting
• GPFSs are financial statements – intended to meet the information needs common
to users who are unable to command the preparation of reports tailored so as to
satisfy, specifically, all of their information needs

• By contrast, special purpose financial statements are provided to meet the

information demands of a particular user, or group of users

• GPFSs are financial statements that comply with accounting standards and other
generally accepted accounting practices (GAAPs)
GENERAL PURPOSE FS
• Reporting entities are required to produce general purpose financial statements.
A reporting entity is:
a circumscribed area of economic activities whose financial information has the
potential to be useful to existing and potential equity investors, lenders and other
creditors who cannot directly obtain the information they need in making
decisions about providing resources to the entity and in assessing whether
management and the governing board of that entity have made efficient and
effective use of the resources provided.
REPORTING ENTITY
i.Separation of management from those with an economic interest in the entity
ii.The economic or political importance/influence of the entity to/on other parties
iii. The financial characteristics of the entity
POINTERS TO A REPORTING ENTITY
“Many existing and potential investors, lenders and other creditors cannot require
reporting entities to provide information directly to them and must rely on general
purpose financial reports for much of the financial information they need.
Consequently, they are the primary users to whom general purpose financial reports
are directed.”

USERS OF GPFS:
UK: The Corporate Report
– all groups impacted by an organisation's operations have rights to information
about the reporting entity, not necessarily related to resource allocation decisions
USERS OF GPFS
-It is an attempt to justify “what is” by codifying accounting practices.
-This approach favours “theory as stemming from practice”
- Theories developed using this approach are essentially concerned with what accountants do.
- PAT is concerned with explaining accounting practice.
-positive theories do not prescribe what should occur – they focus on explaining or predicting what
does occur
-A positive theory seeks to explain and predict particular phenomena
-Thus, it is both descriptive and predictive in nature.

POSITIVE ACCOUNTING THEORY (PAT)

-Descriptive theory emphasised that accounting theory is to be discovered by
observing the practices of accountants because, in the words of Littleton and
Zimmerman (1962), “accounting theory is primarily a concentrate distilled from
experience. It is experience intelligently analysed that produces logical explanation
and illuminates the practices from which it springs”.
-Positive theories of accounting also enable predictions to be made about how a
particular matter will be treated.
-Thus, it is possible to predict that the receipt of cash will be entered in the debit side
of the cashbook.
POSITIVE ACCOUNTING THEORY (PAT)
-By using an approach that comes from positivism, empirical accounting research is
developed to support and justify various accounting methods or practices in the real
world.
-Logically, positive theory starts with specific policies, and generalizes to the higher-
level principles (inductive approach). Thus, it is the best option for explaining
transactions of the past, or a business’ current economic position.
-Inductive reasoning begins with some observations (accounting premises) and
proceeds toward generalised conclusions.
-it moves from specific to general (e.g. Motor vehicle & Equipment accounts are
assets accounts and have debit balances; then, all assets accounts have debit balances).

POSITIVE ACCOUNTING THEORY (PAT)

-It examines real life occurrences and seeks to understand and then predict how
actual companies address the accounting treatment of those transactions.
-It is designed to explain and predict which firms will and which firms will not use a
particular method … but it says nothing as to which method a firm should use.’
(Watts and Zimmerman 1986, p. 7).
-Using a company’s physical transaction history, PAT analyses and discerns the
ramifications of these expenditures. It compares revenue against expenses to figure
out if and why an enterprise is running at a net loss or gain.
POSITIVE ACCOUNTING THEORY (PAT)
-Building from this knowledge, the theory anticipates how a business will handle
future transactions. For example; if an organisation has had a highly successful
financial year, the next year they will have the financial stability to boost investor
dividend payments.
-From this, positive accounting theory would deduce that corporate growth causes an
increase in shareholders remittance.
-In other words, positive accounting theory looks at actual real world transactions
and events, examines how companies are accounting for those events, and seeks to
understand the economic consequences of those accounting decisions. With that
knowledge, the theory then tries to predict how companies will account for
transactions and events in the future.
POSITIVE ACCOUNTING THEORY (PAT)
PAT focuses on relationships between various individuals and explains how
accounting is used to assist in the functioning of these relationships
• Examples of relationships
– between owners and managers
– between managers and the firm’s debt providers (lenders)
PAT assumes that all individuals’ action is driven by self-interest and individuals
will act in an opportunistic manner to the extent that the actions will increase their
wealth.
– does not incorporate notions of loyalty or morality

POSITIVE ACCOUNTING THEORY (PAT)

Started coming to prominence in mid-1960s
– paradigm shift from normative theories
-It focuses on empirically testing some of the assumptions made by normative
accounting theorists.
• PAT became the dominant research paradigm in 1970s and 1980s
a. shift resulted from US reports on business education, and improved computing
facilities enabling large-scale statistical analysis – something common in positive
research
ORIGIN OF PAT
b. Development of Efficient Markets Hypothesis (EMH) by Fama and others
provided an environment suitable for PAT research
– capital markets react in an efficient and unbiased manner to publicly available
information.
c. Ball and Brown (1968) paper was crucial to the acceptance of the positive research
paradigm
– investigated stock market reaction to accounting earnings announcements
– sought to explain market reactions
ORIGIN OF PAT
. Price of a security based on beliefs about present value of future cash flows

• Ball and Brown found that earnings announcements impacted share prices

– evidence that historical cost information is useful to the market

ORIGIN OF PAT
d. Agency theory was crucial to the development of PAT
• Agency theory explained why the selection of particular accounting methods might
matter
• Focused on the relationships between principals and agents
– e.g. between shareholders (principals) and managers (agents)
• Information asymmetries create much uncertainty
– transaction costs and information costs exist
. The ‘agency relationship’ is a central focus of agency theory

ORIGIN OF PAT
• Defined by Jensen and Meckling (1976)
– 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.
•Agency theory key assumptions from the economics literature, such as:
– assumptions of self-interest and wealth maximisation
•In the absence of contractual mechanisms to restrict agents’ potentially
opportunistic behaviour, the principal will pay the agent a lower salary
– compensates principals for adverse actions
ORIGIN OF PAT
Agents will therefore have incentives to enter contracts which appear to limit actions
detrimental to agents.
The Agency Problem
At the core of the analysis is the ‘agency problem’
• The agency problem relates to issues associated with motivating one party (the
agent) to work in the best interests of another party (the principal)
• Agency problems arise because of inefficiencies and information asymmetries
• The agency problem leads to ‘agency costs’
ORIGIN OF PAT
The Agency Costs
•Monitoring costs
– costs of monitoring agents’ behaviour
– e.g. auditing financial statements
• Bonding costs
– costs involved in agents bonding their behaviour to expectations of principals
– e.g. preparing financial statements
• Residual loss
– too costly to remove all opportunistic behaviour
ORIGIN OF PAT
Accounting information is used to address the agency problem and to reduce agency
costs
• Accounting is used as a monitoring and bonding mechanism to control the efforts
of self-interested agents (managers)
ORIGIN OF PAT: ROLE OF ACCOUNTING IN CONTRACTS
•Three key hypotheses frequently used in PAT literature to explain, and predict
support or opposition to, an accounting method
– bonus plan hypothesis
– debt hypothesis
– political cost hypothesis
• Research assumes managers will act opportunistically when selecting methods
ORIGIN OF PAT: KEY HYPOTHESES OF PAT
Managers of firms with bonus plans are more likely to use accounting methods that
increase current period reported income
– also called management compensation hypothesis
– action increases the present value of bonuses paid to management
BONUS PLANS HYPOTHESIS
The higher the firm’s debt/equity ratio, the more likely managers use accounting
methods that increase income
– also called debt/equity hypothesis
– the higher the debt/equity ratio, the closer the firm is to the constraints in debt
covenants
– covenant violation results in costs of technical default

DEBT HYPOTHESIS
Large firms rather than small firms are more likely to use accounting choices that
reduce reported profits
– size is a proxy variable for political attention
– reduction of reported income is hypothesised to reduce the possibility that people
will argue that the organisation is exploiting other parties
POLITICAL COST HYPOTHESIS