The Importance of Positive & Normative Accounting

danhind
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Accounting is all about creating a standard set of rules so that accountants and managers can clearly know the health of their company. But when a manager looks at a spreadsheet, he does not just see numbers. He sees the progress his company has made after years of work, what dreams it wants to attain, and what it has done that has succeeded or failed.

Different theories thus spring out from what we think are the most important aspects of accounting, and two of the most important ideologies are positive and normative accounting. Accountants and managers need to quickly understand what the difference is, when one might prove superior to the other, and how to have them work together for the good of the company.

What is Positive Accounting?

Positive accounting was first developed in the late 1970s, and attempts to describe and explain actual accounting practices. If you ask a layman to describe what he thinks accounting is, his description will probably be closer to positive than normative accounting.

Under positive accounting, an accountant will collect and look at real data such as a company’s revenue and expenses for the past year, and then derive actionable conclusions based off of the financial numbers. As The Motley Fool observes, positive accountants “view a company as the total of the contracts they have entered into” and seek to maximize the efficiency of each contract.

Positive accounting strives for objectivity and most people value objectivity. But from another perspective, positive accounting’s quest for objectivity causes it to set some very subjective parameters for making assumptions. For example, this theory assumes that business owners act out of self-interest and is a strong believer in the heavily criticized Efficient Market Hypothesis. The failures of the market in 2008, when investors and accountants failed to realize that financial securities were losing value before it was too late, is an example of the failure of the EMH.

What is Normative Accounting?

Positive accounting attempts to describe accounting as it is actually done. By contrast, normative accounting attempts to describe accounting as it should be done. It aims to describe what a company or investor should do, often using subjective morality derived from some theory. If the value of an asset has to be radically altered because the traditional methods of analyzing its value using an EPOS system prove to be incorrect (which occurred during the 2008 financial crisis), that would fall under normative accounting as the institution will have to determine the new value based on a principle.

Obviously, the major challenge with normative accounting is determining what principle should be used for each situation. There is a real danger with normative accounting that an accountant may find a principle he likes, and then stick to that principle past the point of all reason. As Bizfluent observes, normative accounting even more than positive accounting is weak to charges of subjectivity and relying on anecdotal evidence that fail to meet academic rigor.

Competition and Cooperation

There are times when either positive or normative accounting are superior to the other. For example, a positive accounting approach is better for bookkeeping or constructing spreadsheets which detail what the company has done, as the company needs the flat numbers more than a normative ideal.

By contrast, normative accounting are best used to decide what accounting and financial practices a business should do going forward. While there may be some disputes about which practices are the best, blithely assuming that your business must make as much money as quickly possible can lead down to extremely dangerous decisions.

Perhaps the most important thing of all is to not declare that one accounting theory is superior to the other, but to work to have them complement each other. Positive accounting works best when it is dealing with the past and data, while normative accounting is useful in detailing what principles accountants should use to make important business decisions going forward. Every business needs both theoretical and practical work to succeed, and so look to use both approaches at the right moments.

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