Week 2: Topic 1: Financial Accounting Theory & the Reporting Environment GHTHH Chapter 2
5. Researchers who develop positive theories and researchers who develop normative theories often do not share the same views about the roles of their respective approaches to theory construction. (a) How do positive and normative theories differ? (b) Can positive theories assist normative theories, or vice versa? If yes, give an example. If not, why not? Normative accounting research makes policy recommendations and is concerned with what should be done in contrast to explaining why current practice is carried out in the manner that it is (positive theory). Normative theorists usually attempt to derive either the ‘true income’ or adopt the ‘decision — usefulness’ approach whereby accounting reports are an input into users’ decisions (e.g., to buy or sell shares, management decisions on the financial wealth of firms, etc.). The major issues are the impact of the changing price environment (prices) and the impact on income, assets, liabilities and equity. As a consequence many normative theorists are measurement theorists who attempt to incorporate the effects of inflation into accounting reports. In this sense they take a semantic viewpoint — relating the figures in the accounting reports to actual objects (assets, liabilities) or events (changes in inflation). To some extent the approach of the IASB is a normative approach. Positive accounting theory was a reversion to testing or relating accounting theories back to the ‘facts’ or ‘experiences’ of the real world. Examples of such research were questionnaires and surveys of bank officers or investors regarding their use of financial reports for decision making; or whether inflation adjusted accounting reports actually aided decision making. Current positive accounting research is aimed at explaining the reasons for actual accounting practices and in predicting the role of accounting data in economic, political and social decision making. Positive theory has expanded accounting theory from the purely decision making focus of normative theorists into analysis of political and economic factors. Using the normative recommendation of IFRS, that fair values should be used in financial statements, a positive theorists would first undertake a number of empirical tests to see if they are actually useful/used by decision makers in their valuation models. In this sense they complement each other – normative theory the deductive analysis with positive theory the empirical verification.
Classify the following hypotheses according to whether they are conclusions of positive or normative theories. Explain your answers. (a) Historical cost accounting should be replaced by a market value system. (b) Historical cost accounting provides information used by creditors. (c) Historical cost accounting is used by many managers to allocate costs in determining divisional performance. (a) normative (b) positive (c) positive
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The decision-usefulness approach to theory development can be used to develop theories of accounting. a) Explain what is meant by the decision-usefulness approach to theory development. b) How can the decision-usefulness approach relate to accounting theory formulation? c) Give two examples of decisions that require data obtained from accounting reports.
The decision-usefulness approach is an instrumentalist approach (see diagram p.25). In a narrower sense, one direct test of an overall theory of accounting would be to determine whether the output data of the accounting systems, which are constructed on the basis of the overall theory, are useful to users. The data of the accounting systems are utilised by users in their prediction models, and the conclusions (predictions) are then used in their decision models. The problem is that if the prediction is verified, it verifies the prediction model, not the accounting system and its output. There are...
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