QUESTION 1 a. What are the main differences between normative and positive
theories of accounting?
Answer:
Although there is not generally accepted definition of the term ‘accounting theory’
(Deegan, 2016), a widely cited definition of accounting theory has been provided by
Hendriksen (1970, p.1), stating that accounting theory is ‘a coherent set of
hypothetical, conceptual, and pragmatic principles forming the general framework of
reference for a field of inquiry’.
Accounting theories normally either prescribe specific accounting practices, or these
theories clarify and/or predict accounting practices, and thus these accounting theories
are normally known as normative and positive accounting theories respectively.
Normative accounting theories aim to prescribe the accounting policies and
procedures for implementation, and thus they aim to inform others regarding specific
practices that should be followed for achieving specific outcomes (Deegan, 2016). For
instance, a normative accounting theory may, provided that specific critical
assumptions regarding the objective and characteristic of accounting, prescribe how
to measure assets for the purposes of financial accounting. These prescriptions
regarding what should be carried out may represent considerable deviations from the
existing accounting practices, for instance, for a long time, Raymond Chambers
supported a theory of accounting to measure assets at market value, during a period
when historical costs were mainly used by the entities (Deegan, 2016). Henderson,
Peirson, and Brown (1992) provided two main criticisms of normative accounting
theories, such as normative accounting theories are not based on evaluation of values,
and they do not incorporate testing of hypothesis.
In contrast, positive accounting theories aim to explain and predict the accounting
practices of specific phenomena, and thus they do not aim to prescribe specific
actions. Watts and Zimmerman (1986, p.7) stated that positive accounting theories
aim to explain accounting practices, and they are designed to explain and predict
which firms would and which firms would not use specific accounting methods, but
they ‘say nothing as to which method a firm should use’. Henderson et al. (1992) stated
that positive accounting theories begin with some assumptions and logical deductions,
which enable to provide some predictions regarding the ways things would be. The
view of positive accounting theory is that by observing numerous phenomena, we are
in a better position to predict what would occur in the future, for example when
assessing managers behaviours within a specific industry to predict why they use
specific accounting methods on specific contexts. However, normative accounting
theorists have criticised the positive accounting theories on the basis that the latter do
not provide any guidance to the practitioners, although they attempt to explain the
likelihood of economic implications for selecting specific accounting policies.
Thus, in conclusion, normative accounting theory prescribes what should happen,
assuming that we want some particular outcomes like prosperity, while positive
accounting theory explains or predict facts and does not assume that we want any
specific outcome.
QUESTION 1
b. Which type of theory is used in empirical research of accounting? Provide an
example and discuss the main features of the theory?
Answer:
It has been previously mentioned that positive theories aim to explain and predict
specific phenomena, and they are normally developed and supported by the
observations, and thus positive accounting theories are empirical-based. According to
Deegan (2016), a number of positive accounting theories, such as stakeholder theory,
institutional theory, and legitimacy theory have been popularised by Watts and
Zimmerman. Watts and Zimmerman (1986) noted that positive accounting theories
have two main components, such as assumptions, and hypotheses. Thus,
assumptions are the starting point for a researcher to start his/her research, and thus
he/she can sue assumptions for regulating, analysing, and understanding empirical
phenomena that are associated with research issues, for example the applications of
FIFO and LIFO methods for minimising tax obligations. Thus, from these assumptions,
a researcher can apply hypotheses that should be tested empirically. The assumptions
used in positive accounting theories are the agreement that the capital markets are
efficient, have opportunistic behaviours, and view accounting information as economic
commodities and political commodities, and every individual can act base on their selfrationalities. Thus, the positive accounting theories have three hypotheses (Watts and
Zimmerman, 1986), which are:
 The bonus plan hypothesis: This hypothesis posits that managers would select
accounting procedures that would transform probable income to the current
period with an aim to get bonuses.
 The debt agreement hypothesis: This hypothesis assumes that companies that
violate debt agreements, the managers in those companies have likelihood of
selecting accounting procedures that transform probable income to the existing
period for increasing net incomes and avoiding technical errors at the end.
 Political cost hypothesis: This hypothesis assumes that firms that experience
higher levels of profitability would have likelihood of transforming their incomes
from the current period to the future periods for avoiding political costs.
In addition to these three hypotheses, Deegan (2016) noted that positive accounting
theories have efficiency and opportunistic perspectives. According to Deegan (2016),
the efficiency perspective can explain how differing contracting tools could be applied
for minimising the agency costs for firms, or the costs related to the assigning of
decision-making process for the agents, and thus the efficiency perspective is normally
referred to as the ex-ante perspective. In contrast, the opportunistic perspective
assumes that providing the negotiated contractual arrangements of firms, this
perspective aims to explain and predict specific opportunistic behaviours that would
eventually occur, and thus this perspective is frequently referred to as ex-post
perspective.
As an example of positive accounting theory, the disclosure of assets and liabilities in
the financial statements can be provided, and the FASB (Financial Accounting
Standard Board) used to measure the values of assets and liabilities based on their
initial acquisition costs. This assumption was based on that the entity would be as a
going concern, and thus when the entity is liquidated, the values contained in the
historical cost concept are not liquidation values. Considering the financial statements
of becoming relevant, useful, and reliable, the IASB (International Accounting
Standard Board) has established fair value as a basis to measure assets and liabilities.
There are a number of criticisms of positive accounting theories, as noted by Deegan
(2016). For example, Deegan (2016) noted that positive accounting theories do not
prescribe and thus they do not provide a means to enhance accounting practices.
Additionally, the positive accounting theories are not value-free, and thus there are not
guidelines as what need to be carried out (Deegan, 2016). Moreover, the positive
accounting theories are associated with the assumption that all actions of individuals
are influenced by the desire for maximising one’s own welfare (Deegan, 2016). Finally,
the positive accounting theories are scientifically flawed, as when hypotheses
generate pursuits for positive accounting theories, these hypotheses are not
supported, and thus they are rejected scientifically.
References
Deegan, C. M., (2016), Financial Accounting, 8th ed., NSW, Australia: McGraw-Hill.
Henderson, S., Peirson, G., and Brown, R., (1992), Financial Accounting Theory: Its
Nature and Development, 2nd ed., Melbourne: Longman Cheshire.
Hendriksen, E., (1970), Accounting Theory, Illinois: Richard D Irwin.
Watts, R. L., and Zimmerman, J. L., (1986), Positive Accounting Theory, Englewood
Cliff, NJ: Prentice Hall.