The majority of business owners, managers and investors want their company’s finances and performance to be presented to them through a straight-forward system; they want information to be delivered in a comprehensive, yet understandable way. Accountants can provide such a system; it is usually the product of thought-through applications of theories. Today we will be discussing two theories which are commonly used – positive accounting (a practical approach) and normative accounting (a theoretical approach) – and looking at which of the two delivers the best overall picture of a business’ fiscal activity.
Positive accounting theory, known as the ‘practical approach’, looks at what is currently happening in a business; it’s based on cold, hard statistics. This approach is regularly used within bookkeeping and data collection; positive accounting scrutinises the real world transactions of a company and compares the incomings with the outgoings to identify any discrepancies. This approach allows the accountant to see whether a business is making or losing money. The theory provides accountants with a framework from which to predict how the company will account for transactions going forwards. Here is an example of a positive accounting scenario from Pocket Sense – a company that helps individuals manage their personal finances: “if corporate growth allows a company to increase shareholder dividends over previous dividend payments, positive accounting theory would conclude that corporate growth causes a rise in stockholder dividends.”
Unlike positive accounting which is based on observation, normative accounting theory advises policy makers on what should be done based on a theoretical principle; it starts with a theory and deduces specific policies from this. While positive accounting looks at past data, normative works with events in the future. It is most commonly used in a firm’s marketing or business plan and aims to sum up what the future of the company will look like financially while advising on how to plan for future events. It revolves around figuring out what principal should be applied to each situation; normative accounting provides several choices. For example, when it comes to signing contracts, when should the costs be accounted for? Straight away when signing, in a lump sum at a later date, or over a period of months in installments? Depending on the contract, business, and services and products provided, all three answers could be correct.
Positive and Normative Accounting Combined
Both practical and normative accounting are influential theories, but which of the two is preferred and can or should they be used together? Today, although a business may opt for one theory over the other, it’s common place for a company to use a combination of practical and normative; in many cases, the theories complement each other. Those within finance may use normative accounting theory to come up with new policies, but these standardised policies are usually based on the factual explanations identified in positive accounting.
Are you interested in learning more about the many theories used within accounting firms today? An AAT qualification can provide that knowledge and set you on the path to a successful career in the sector. Contact the Aspiring Accountants team today for more information.