Term Paper on "Normative Versus Positive Accounting Theory"

Term Paper 12 pages (3248 words) Sources: 6

[EXCERPT] . . . .

Normative vs. Positive Accounting Theory

In the past few decades, accounting theory has slowly evolved; as a result, various research methodologies have been utilized to study the development of accounting theory. As accounting theory has developed, debates have emerged regarding the manner in which financial theory should be developed and applied in the accounting profession. This has been essentially a normative, philosophical exercise, imposing a view of how actuarial practice should progress (Thomas & Smith, 1997). In recent years, the differences in application between normative vs. positive accounting theories have become the subject of much debate, raising the awareness of those involved in the accounting profession. The underlying basis of normative theory is that it assists in standardizing the practice and thus facilitates the teaching of practice in a more coherent manner. The underlying basis of positive theory is intellectual justification; models are derived from observed behavior.

This paper discusses all aspects of accounting theory and the history of regulation in the accounting profession that has been implemented as a result of notable financial accounting scandals. It will analyze and synthesize the normative and positive accounting theories, beginning with the historical background of each theory and a discussion of the suggested changes and problem areas revealed in the debate. It will analyze the GAAP in relation to the conceptual framework and will conclude with recommendations toward an appropriate course of action.

Historical Development of Normative and Positive Accounting Theories

Normative and positive accounting theories grew out of economic theory, as tools for understanding relationships in the economy. Economic theory can be used to explain the behavior of market actors, but it cannot determine which public policies are desirable and which are not. Economic and accounting theories have been traced very far back by researchers searching for a correlation between the cultural significance of accounting and the discipline's substantial impact on society. According to research by Mattessich (1995), the origins of accounting go back to prehistoric times and actually precede the invention of writing. Mattesich (1995) explains that hollow clay tokens were transferred in and out of a clay envelope. This practice originated over 8,000 years ago and evinces a form of double-entry recording (Mattessich, 1995). Other researcher's attribute the origins of accounting to the 1914 work of John Dewey's "pragmatic" educational philosophy that led to both the laboratory method and the case method used to study accounting (Mitchell, 2005). Comparable to present day "practice sets," the accounting laboratory contained bookkeeping machines, records, minute books, "model" sets of books and collateral records, stock certificate books, transfer books, organization charts, statistical data and other documents.

In 1916, academicians formed their own group called the Accounting Academicians, concurrently with the American Economic Association. Practitioners belonged to the American Association of Public Accountants; while academicians felt more comfortable with other faculty; this organization later became known as the American Accounting Association (Mitchell, 2005). Positive accounting theory has been traced back to the research conducted by Watts and Zimmerman (1978), which provided the theoretical basis for a number of social disclosure studies. Research by Watts and Zimmerman (1978) concluded that individuals acted to maximize their own utility, and that managers have greater incentives to choose accounting standards which report lower earnings, thereby increasing cash flows, firm value, and their welfare. Watts and Zimmerman's research was based on three main hypotheses: 1) Managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period, 2) the larger a firm's debut/equity ratio, the more likely the firm's manager is to select accounting procedures that shift reported earnings from future periods to the current period, and 3) the larger the firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current o future periods (Milne, 2001). In 1989, researchers Belkaoui and Karpik tested watts and Zimmerman's arguments through the use of an index of social disclosure. Belkaoui and Karpik's (1989) research remained consistent with that of Watts and Zimmerman, arguing that levels of social spending are a way for self-interested managers to reduce current period income; however this proposition was not tested in heir research. Many other researchers built off the work of these and other researchers of the prior decades.

Current GAAP Discussion

Research by Gaffikin (2007), indicates that for most of the twentieth century the accounting profession sought to maintain a regime of self-regulation. Accounting professional bodies worked hard to avoid the imposition of regulation on the discipline (Gaffikin, 2007). The Generally Accepted Accounting Principles (GAAP) were developed, followed by an attempt at a conceptual framework that would serve as the basis of an accounting theory. A review of the literature indicates that the search for GAAP and a theoretical framework has been a struggle for the discipline and its Members, a result of widely differing viewpoints on the necessity and form of regulation. The financial accounting scandals in the prior decades have spurred the need for reform and strictly adhered-to accounting regulations. Public interest and awareness resulting from the notable and widespread scandals demanded such regulations, and the GAAP was amended and implemented.

A review of the literature indicates that much as been written about the Generally Accepted Accounting principles (GAAP). For example, the current GAAP is more "rules-based" standards with specific application guidance than the earlier versions. According to Deloitte (2007), the significance of the differences of the current GAAP varies with respect to individual entities depending on factors such as the nature of the entity's operations, the industry in which it operates, and the accounting policy choices it has made. Under first time adoption in the current GAAP, there is not a specific standard, and the practice is generally full retrospective application unless the transitional provisions in a specific standard require otherwise. The current GAAP permits the use of historical volatility or industry index measurement for non-public entities when it is not practicable to estimate expected volatility (Deloitte, 2007). Under the current GAAP, for share-based payments with graded vesting features, an accounting policy choice exists for awards with a service condition only to either: a) amortize the entire grant on a straight line basis over the longest vesting period, or b) recognize a charge similar to IFRSs (Deloitte, 2007).

Other example of the current GAAP in practice are that a liability for a planned post-acquisition restructuring can be recognized if the restructuring relates to the acquired business and certain conditions are met. For purchased in-process R&D, the current GAAP determines the fair market value of in-process R&D and expense immediately unless it has an alternative future use. For combinations of entities under common control, the current GAAP requires the pooling of interests method (Deloitte, 20070. For comparative prior year financial statements, there is no specific requirement under the current GAAP to present comparatives. Generally at least one year of comparative financial information is presented (Deloitte, 2007). Public companies are subject to SEC rules and regulations, which generally require two years of comparative financial information for income statement, statements of equity and cash flows (Deloitte, 2007). There are many other differences and requirements underneath current GAAP.

Positive Accounting Theory vs. Normative Accounting Theory distinction is made by many people between positive accounting theory and normative accounting theory, leading to a debate between the two theories. In discussing market failure and regulation a similar distinction is made by some; there are analyses of regulation which are derived from positive economics and some from normative assumptions (Gaffikin, 2007). Normative accounting theories are described as long-term values of economic parameters that cannot be confirmed or refuted by data. They cannot be confirmed by data because the long-term refers to a time so far ahead that it is impractical to conduct any objective tests. Normative theory involves prescribing a "right" approach. Positive theory, on the other hand, is not concerned with prescribing a "right" approach (Thomas and Smith, 1997). Positive theory involves observing the environment in which actuarial decisions are made and seek to model that environment and generate hypotheses which could be tested against data. Positive theory considers factors such as risks faced by the actuary, such as legal liability, professional censure, or the loss of the client. Positive accounting theory aims to provide explanations of practice, through observation and the generation of hypothesis. On the other hand, normative accounting theory aims to provide prescriptions for practice, through the codification of practice and premises to prescriptions. The methods of both theories are different; positive accounting theory places emphasis on testing, whereas normative accounting theory is concerned with little testing. The uses of positive accounting theory is that it leads to better understanding and better predictions. The uses of normative accounting theory are the standardization of practice, training for practice, and the market for excuses.

Changes and Problems Revealed in the Debate

Normative accounting theory has been categorized as being stimulated by the demand for excuses. Thomas and Smith (1997) state that normative accounting theory follows where the political or… READ MORE

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