Accounting is the language of finance, giving managers and investors a standardized system to present the finances of a company in a way that is transparent, consistent, and informative. All of the different accounting rules are not arbitrary or naturally occurring, though.
Today's accounting systems are the result of carefully constructed applications of theories that seek to find the best and most economically accurate methods for representing a company's performance. Two of those theories are positive accounting and normative accounting. Let's dive into a few key differences.
In positive accounting theory, academics view a company as the total of the contracts they have entered into. The theory posits that, because companies are fundamentally about the contracts that dictate its business, a core driver of company success is efficiency. That means minimizing the costs of its contracts to unlock the most value from them.
From that basis, positive accounting examines real life occurrences and seeks to understand and then predict how actual companies address the accounting treatment of those transactions.
In other words, positive accounting theory looks at actual real world transactions and events, examines how companies are accounting for those events, and seeks to understand the economic consequences of those accounting decisions. With that knowledge, the theory then tries to predict how companies will account for transactions and events in the future.
Normative accounting, on the other hand, takes a fundamentally different approach. Instead of looking at what is already happening at companies today, normative accounting theory tells accounting policy makers what should be done based on a theoretical principle.
Logically, normative is more of a deductive process than positive accounting theory. Normative starts with the theory and deduces to specific policies, while positive starts with specific policies, and generalizes to the higher-level principles.
For example, many obscure financial securities owned by banks before the financial crisis were accounted for in a way similar to real estate and other common assets. These assets were not required to be revalued and accounted for at their current market values. However, that changed following the crisis when the market for these assets dried up, and accounting policies were changed to require these assets to be "marked to market" -- or revalued -- on each financial statement. That created new unrealized gains and losses for the banks that proved to be a major driver of profit and loss.
This was a major change in accounting policy driven by a principle, not by the prevailing accounting treatment in place at the banks owning these assets.
Advantages and disadvantages with both theories
The disadvantage with positive accounting theory is illustrated in the example of normative accounting above. The banks were accounting for financial securities in a way that hid material changes in their value that was pertinent to the bank's operation. That change in value was germane to the financials of the companies, and the day-to-day practices were no longer presenting an accurate representation of the company's financial position.
The challenge for normative followers, on the other hand, is establishing what accounting principal should be applied to each situation. When a contract is signed, should the income and costs from that contract be recognized immediately, incrementally over time, or as a lump sum in the future? Depending on the contract, the company, and the goods or services provided, the answer could be any of the three, or any number of combinations of each.
In this way, the two theories complement each other, each filling in for the weaknesses of the other. Positive accounting is very practical, and based on what's actually happening. Normative is more theoretical, ensuring that, as day-to-day practices evolve, they don't diverge from appropriate economic concepts. The result is the accounting system we have today, both practical and principled.
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