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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