Question

Short Question!

Can you explain what is the different between Positive and Normative Accounting theory ? Which want do you think it is more important than the other?

150-200 words if possible. Thanks!

Answer 1

In positive accounting theory, academics view a company as the total of the contracts they have entered into. The theory posits that, because companies are fundamentally about the contracts that dictate its business, a core driver of company success is efficiency. That means minimizing the costs of its contracts to unlock the most value from them.

From that basis, positive accounting examines real life occurrences and seeks to understand and then predict how actual companies address the accounting treatment of those transactions.

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.

Normative accounting
Normative accounting, on the other hand, takes a fundamentally different approach. 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.

Logically, normative is more of a deductive process than positive accounting theory. Normative starts with the theory and deduces to specific policies, while positive starts with specific policies, and generalizes to the higher-level principles.

For example, many obscure financial securities owned by banks before the financial crisis were accounted for in a way similar to real estate and other common assets. These assets were not required to be revalued and accounted for at their current market values. However, that changed following the crisis when the market for these assets dried up, and accounting policies were changed to require these assets to be "marked to market" -- or revalued -- on each financial statement. That created new unrealized gains and losses for the banks that proved to be a major driver of profit and loss.

This was a major change in accounting policy driven by a principle, not by the prevailing accounting treatment in place at the banks owning these assets.