TOPIC 2: FORMULATION AND Normative Theories

VERIFICATION OF ACCOUNTING o Prescribe what should be done

THEORY in accounting practices.
o Based on assumptions about
ideal accounting practices that
Theory Formulation are used to evaluate actual
accounting practices.
 A framework that helps
o Described as a ‘golden age –
researchers understand and
explain complex phenomena by during 1950-1960s.
identifying variables and o More concerned with policy
specifying how they relate to one recommendations and what
another. should be done
 Goal: to make predictions about o Concentrate on derive true
future events or outcomes based income, which accounting
on the relationships among the information that be useful for
variables identified in the theory making economic decision.
o True income: single measure for
assets, correct profit figure.
Characteristic of Ideal Theory o Decision usefulness: to help
certain people who use
1. Must be wide acceptance.
accounting reports make better
2. Have quality of authenticity and
decisions.
also authoritative.
o Assumptions: accounting should
3. Have descriptive approach in
be a measurement system,
general and normative approach
profit & value can be measured,
in particular
useful for making economic
4. Have ability to analyse past
decisions,
events and forecast future events.
o Approach: based on analytic and
5. Verifiable through testing of
empirical (deductive) or based
hypothesis.
on judgement or personal
Accounting Theory is Useful? opinion and it cannot be verified
 Because it helps make things or tested.
more organized and clearer. It o Criticisms: cannot be tested, no
helps people make better use other than as an instrument
decisions, follow rules, be for prediction.
accountable.
 lead to losses, able to increase
knowledge of the accountant to
Positive Theories
improve their skills and can
 Describe and explain what is provide useful information to
happening in accounting accounting regulators and
practices. provide decision useful
 Based on assumptions about information to the users of
how individuals and financial statements.
organizations behave in
accounting contexts.
 Positivism: relate accounting Formulation of Accounting Theory
hypotheses or theories with
a. Deductive Approach
experience or fact in real world.
 Revolves around managers' o Moves from the general to
incentives to maximize bonuses derive a logical conclusion. From
based on their companies' general statements to specific
profits. statements.
o Steps used: specifying the
objectives of FS, derive the
Relation between Normative and
principles of accounting and
Positive Theory
develop technique of
 Both are valuable to theory accounting.
development and testing.
b. Inductive Approach
 Positive accounting theory helps
to keep normative research on o Moves from observation to
track through empirical testing. generalised conclusion. From
particular statement to general
statement.
Behavioural Theories o Steps used: record all
 Derived from disciplines such as observation, analyse, classify
psychology, sociology, and and explain the observation,
organizational theories. testing the generalisation.
 Importance: to identifies how
people use and process
accounting information,
provides valuable insight, can
avoid making bad decisions that
  Implies that accounting data will
be useful in making social
Deductive VS Inductive
welfare judgments.
Deductive:
e. Economic Approach
 Follow a logical argument.
 Focuses on managing the impact
 This method more reliable in
of different accounting methods
terms of validity.
on the overall economic
indicators.
Inductive:  Accounting technique depends
on their impact on the national
 Do not follow logical argument economic good.
but use patterns and trends to  Accounting policies and
arrive general conclusion. technique should reflect
 This method less reliable in term economic reality.
of validity since the conclusion
based on observation and
generalisation which not always f. Eclectic Approach
be true.  Accounting theory and
principles have been developed
using a combination of different
c. Ethical Approach approaches, rather than just
 Consists concepts of fairness, one.
justice, equity and truth.
 FS does not subject to undue
influence or bias. g. Pragmatic Approach
 Audit committee refers to  Accounting principles and
fairness of presentation as practices that actually work in
conformity. real-world situations, rather
than strictly following a specific
theory or ideology.
d. Sociological Approach
 Evaluated for acceptance on the
basis of its reporting effects on Descriptive Pragmatic Approach
all groups in society.  Inductive (specific to general)
approach.
 Theory develops based on
observation of accountants’ act.

Criticisms Descriptive Approach

o Not include analytical
Positive Accounting Theory
judgement.
o Focus on accountants’ Positive VS Normative
behaviour, not on attributes of Positive Theory
the firm.
 Explain and predict particular
phenomena
Psychological Pragmatic Approach
 Theory develops based on Normative Theory
observation of the reactions of
users to FS. o Prescribe how a practice should
 Taken as evidence that useful be undertaken
and contain relevant info.

Positive Accounting Theory

Criticisms Psychological Pragmatic  Focus on explain and predict
Approach what does occur.
 Some users react in illogical  Focus on relationships between
manner. various individuals and explains
 Some users may not react when how accounting is used.
they should.  Eg: relationship between owners
and managers, managers and
the firm’s debt providers
Behavioral Approach - refer 
Behavioural Theories