Normative vs Positive Accounting Theory Term Paper

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The examples cited by Thomas and Smith (1997) are the political concern with discrimination in insurance pricing, leading to numerous papers on underwriting; and proposals to change accounting standards for pension costs, leading to a flurry of effort to defend traditional actuarial approaches, or argue for alternative approaches. Another example cited by Thomas and Smith (1997) is that normative accounting theory are stimulated by the emergence of "orphan estates," as a political and media issue, leading to efforts to justify distributions more favorable to shareholders. A second consequence of normative theories' role as excises is that whether a theory proves true or false in the long-term may not be a particularly relevant factor in whether its originators prosper or not (Thomas & Smith, 1997).

Positive accounting theory appears to have the better position in the debate. This is because the first step in economics involves identifying the qualitative nature of a policy's consequences. Positive analysis allows for the assessment of the expected, objective outcomes. According to principles of economics, the distinguishing feature of positive analysis is that it deals with propositions that can be tested with respect to both their underlying logic and the empirical evidence. In other words, it deals with what is, or what might be, without deciding whether something is right or wrong, good or bad. Positive accounting theory supports logical research because it draws on accepted rules of logic and evidence, of both a qualitative and quantitative nature. Research indicates that a normative accounting theory is comparable to a value judgment that is not scientific, and cannot be proved right or wrong by facts, evidence, or logic. These value judgments stem from the value system of each individual making the judgment. Since individuals value judgments differ, they cannot be applied universally across the board. This is a significant problem within the realm of normative accounting theory.

Also revealed in the debate between positive and normative accounting theories is that some researchers have sought to combine the two theories. These researchers have analyzed the existence of one theory without the other, and have found that they operate together. Majone (1996) concludes that positive and normative theories of regulation should be viewed as complementary rather that mutually exclusive. However, neither include an explanation for the institutional framework of regulation; institutions were regarded as "black boxes" from which regulation emerged (Gaffikin, 2007). Such research has indicated that regulation needs the benefits that a combination of both theories has to offer the profession.

GAAP Analyzation and History in relation to Conceptual Framework.

Historically, the general approach of the GAAP was more of a principles-based standard with limited application guidance. This has changed to become more rules-based standards with specific application guidance. Historically, the use of volatility or industry index measurement for non-public entities when it is not practicable to estimate expected volatility was not permitted, but currently is permitted under the new GAAP principles. For the modification of a ward by change in performance condition, historically the GAAP would determine the expense based on the grant date fair value. The current GAAP determines the expense based on fair value at the modification date. Historically, under the GAAP, the definition of a discontinued operation continuing involvement was not addressed. In the current GAAP, the disposing entity should have no continuing cash flows representative of significant continuing involvement (Deloitte, 2007). Finally, for rights and obligations under insurance contracts, the historical GAAP addressed recognition and measurement in only a limited way, or an interim standard pending completion of a project. Under the current GAAP, several comprehensive industry accounting guidelines have been published.

The majority of the literature on the topic indicates that over the years there have been many arguments and debates over the necessity for regulation. For example, those who believe in the efficacy of markets argue that regulation is not necessary as market forces will operate to best serve society and optimize the allocation of resources (Gaffikin, 2007). However, there are many who point out that markets do not always operate in the best interests of societies so some form of intervention in the form of regulation is necessary. An analyzation of the conceptual framework indicates that the history of the accounting profession brought about the need for the GAAP. The GAAP emerged as a natural response to the scandals occurring in the profession and the need for regulation.

The conceptual framework as it relates to the GAAP indicates that there are a number of reasons for regulation. Regulation is considered desirable where there are "windfall profits" - where through some fortuitous event a firm is able to make above "normal" profits (Gaffikin, 2007). For example, the suppliers of equipment to aid search and recovery where there has been a natural disaster can be considered. As a result of the urgent need and the immediate demand, suppliers may attempt to charge higher than normal prices and thus generate above normal profits. Similarly, in the past many costs that are related to certain productive activities were excluded such that the "true" cost was not recognized (Gaffikin, 2007). The regulations were mandated by notable scandals that occurred in the early part of the 1990s.

Although several accounting scandals rocked the business industry in the past decade; however, the fall of global business giant Enron in 2001 is the most notable. That same year, Fortune Magazine had selected Enron as the most innovative company in America, six times in a row, and in just 15 years, Enron grew from nowhere to be America's seventh largest company, employing 21,000 staff in more than 40 countries. As a result of this widespread success, Enron was hailed as a new-economy company that would act as a business model for others to follow. However, also in 2001, Enron filed for bankruptcy, and it was revealed that the firms' success was really attributed to the fraudulent manipulation and unethical management of financial data. Enron engaged in a number of practices that led to their eventual downfall, including the manner in which they modified and traded commodities. This led to the need to manipulate financial data to appear profitable and continue operations. The Enron scandal encompassed a myriad of complex transactions involving mysterious partnerships that allowed Enron to book huge corporate profits and payments to insiders, while simultaneously ignoring any associated financial liabilities.

Enron benefited from this expansion because the greater volume of transactions, the greater Enron's profits would be. However, the financial problems for Enron began when the company started trading for its own accounts. This involved the often simultaneous purchase and sale of the same or equivalent security, in order to profit from price discrepancies. This practice resulted in debt and complicated accounting for Enron, who had no risk control strategies in place. The 2000s marked an era of accounting and financial frauds that occurred as a result of monitoring failures at different levels, including directors, prominent accounting and law firms, shareholders, and securities analysts that escaped detection. These scandals changed the business world forever, and new reforms have been implemented as a result.

Recommendations for Course of Action

In the analyzation for recommendations or for future courses of action, the basic principles underlying theories in general must be taken into consideration. There is not a checklist that determines whether a theory is a good or bad one. According to the research, a theory is considered to be valid and useful if it successfully explains and predicts the phenomena that it is intended to explain and predict. Depending on how well a theory matches the data, the theory is maintained, refined or sometimes even discarded (perhaps in favor of a competing explanation) (Gaffikin, 2007). Gaffikin (2007) concludes that the continual process of testing theories against real-world data is critical to the advancement of any science, not just economics. In testing a theory, it is important to note that imperfection tends to be the norm (Gaffikin, 2007). Positive accounting theory offers a means of focusing academic attention on the study of actuarial practice as it is, rather than normative models of how it should be. Since there does not appear to be one superior method over another to test whether positive or normative accounting theory is better, a combination of the two must be implemented. This way the stronger aspects of both theories can be applied together. For example, a better understanding gained from positive theory could be used to training others for the practice or to standardize the practice.

A future course of action would also combine ethics into both positive and normative accounting theories. Ethics is generally a term used to describe a set of values that describe what is right or wrong, good or bad. From a professional and scientific point-of-view, the ethics of business and the moral code of our society are inseparable, sometimes indistinguishable. Ethics is a branch of philosophy that is concerned with the principles and standards of human conduct. Values and beliefs are cultivated strictly on ethics, which is…[continue]

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