Normative and formative accounting are two accounting theories which play an important role in the accounting systems used today by finance managers and investors.
Both these theories attempt to discover the ideal, most economically accurate methods for expressing a business’ performance. Let’s take a look at what makes each so different.
Under this more practical method, a company is viewed as the total of the contracts they have engaged in.
The cornerstone of positive accounting theory is that a company is essentially all about its contracts that direct their business and as such, efficiency is the main driver of business success. This entails reducing the contract rate to release the most value.
Positive accounting theory examines business events & transactions in the real world, analysing how businesses are accounting for these and attempts to understand the economic repercussions of these financial decisions. Once it has deduced all this, the theory strives to forecast how businesses will deal with these events & transactions further down the track.
Normative accounting is radically different and much more theoretical. This theory advises policymakers on what should be carried out using a theoretical principle as a basis.
It could be said that normative accounting represents more of a logical, deductive process compared to positive accounting as it begins with the accounting theory, deducing down to specific policies, unlike positive theory which commences with precise policies before opening up its scope, generalising to higher level principles.
A real world example is required to properly explain the disadvantage of positive accounting theory:
After the Global Financial Crisis hit, many banks who owned obscure financial securities vital to their proper functioning were accounting for them in a manner which hid-away material changes in the value of these assets.
Positive accounting theory enabled these banks to present the world with an inaccurate picture of their financial position.
Normative accounting theory revolves around figuring out just what accounting principal should be used for each different situation.
When it comes to signing contracts: should the resulting revenue and costs be recognised straight away, in time increments over a set period, or as a lump sum at some point in the future?
Which option is best, or which combination of the 3 is most ideal requires deliberation and will depend upon the contract, the business and the services engaged, or products provided.