CareerPositive vs normative accounting

Positive vs normative accounting

Two common and influential theories are positive accounting and normative accounting. But how do we know which one to follow? And which one provides the most accurate representation of a company's finances?

The rules and regulations we follow, which guide our financial stability, and for many form the basis of entire careers, are not capricious or organically developed. Instead, they are birthed from meticulously formulated ideologies that endeavour to give the most intuitive and economically authentic approach to understanding a corporation’s fiscal efficiency. Two of the most common and influential theories are positive accounting and normative accounting. But how do we know which one to follow? And which one provides the most accurate representation of a company’s finances?

Positive accounting

Positive accounting, most typically utilised within data collection and bookkeeping, takes an objective approach. Using a company’s physical transaction history, it analyses and discerns the ramifications of these expenditures. It compares revenue against expenses to figure out if and why an enterprise is running at a net loss or gain. Building from this knowledge, the theory anticipates how a business will handle future transactions. For example; if an organisation has had a highly successful financial year, the next year they will have the financial stability to boost investor dividend payments. From this, positive accounting theory would deduce that corporate growth causes an increase in shareholder remittance.

Positive accounting starts with specific policies and generates higher level principles based on these, making it the best option for explaining transactions for the past, or a business’ current economic position. However, there are disadvantages to this theory, the largest being that it follows from the assumption that every business owner acts only out of self-interest, rather than looking out for the fiscal security of their firm. Another downfall of positive accounting allows for assets to be inaccurately portrayed. A real-world example of this is the global financial crisis of 2007. Previously to this, banks owned obscure financial securities, which where treated in a similar way to real-estate, meaning that there was no requirement for assets to be “marked to market” or revalued at their market level. This meant that material changes in the value of these assets became hidden. As assets dried up, the unbalance of values became apparent and this became the catalyst that started the fiscal collapse.

Normative accounting

Normative accounting, most commonly found in a company’s business or marketing plan, takes a subjective approach. Based on abstract principles, it endeavours to characterise what the financial future of a firm should look like. Subsequently, by making normative accounting a value judgement, it allows for the use of subjective morality within accountancy practice. For example, if a corporation has previously boosted investor dividend payments, and is now looking to reinvest funds into the firm to ensure its future viability through corporate sustainability measures, then normative accounting would point to issuing new shares as a source of funding. Normative accounting also goes further to signify how much money should be taken from this fund to be invested in such measures.

Normative accounting starts with a theory and deduces specific policies from this, making it the best option for predicting future financial sustainability of a company and advising on how to plan for future events. On the other hand, there are disadvantages to normative accounting, the main issue being that it provides us with several choices, any of which could be correct. For example, when contracts are being signed, should the costs be accounted for at the time of signing, in instalments over a period of months, or as a lump sum at a later date.

A marriage of the two

While a firm may choose one form of accounting over another, it is more common that businesses in general use a combination of both positive and normative accounting. Looking at the bigger picture of accountancy practice as a whole, financial experts create new standardised policies using normative accountancy theory, however these policies are based on the factual justifications found in positive accounting. The objective nature of positive accounting creates the foundation for enterprises to employ normative accountancy theory within their business.

Overall, positive accountancy is a practical approach, which is based on what is currently happening in the business. In comparison, normative accounting is theoretical in its approach, allowing the day-to-day practices to evolve while ensuring that they don’t stray too far from economic theories

Indy Coles, AJ Chambers.

AJ Chambers is the UK’s leading dedicated public practice recruiter.

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