The nature of any theory is to provide a logical basis for the practice or procedure to which the theory is applied. Accounting theory has evolved over a long passage of time during which substantial changes in human behaviour and market structures have taken place.
There are two main types of accounting theory that impact the practice of accounting: Normative theory concerns how things should be done. For example, ideas about the meaning of economic income can influence the way in which regulators decide that accounting systems should measure profit.
In contrast, positive accounting theory tries to explain why things are the way they are. For example, why managers choose a particular accounting method over another, or choose not to invest in research and development activities. For policy-makers to make changes to accounting systems, they not only need to know what they are trying to achieve, they also need to understand why people are currently behaving differently and how any changes will
affect them. They will refer to normative theory for the former, and positive theory for the latter. Positive accounting theory is tested by gathering and analysing data. Usually, researchers either study a single organisation in great depth over a long period of time, or they collect a smaller amount of data about a much larger number of organisations. Analysing a single organisation may mean that the research findings are not generalizable to other organisations. However, analysing a large number of organisations to reach conclusions about the ‘average’ organisation, does not tell very much about individual cases.
Usually financial reporting provides information to users who are not normally involved in actually running the organisation. These users are external to the business. They include actual and potential shareholders, lenders and other investors. They may also include customers, suppliers, the government, and the general public. We have also seen that management use accounting information themselves. Directors, other managers, and employees are internal to the business, and use information to make economic decisions.
External users may wish to make both economic decisions and legal/stewardship decisions
These different types of decisions require different types of information. There is usually a trade-off between:
relevant information that can influence decisions about the future or confirm the outcome of a past transaction, and reliable information that is free from errors and bias and which faithfully represents economic reality. Economic decisions need forward-looking information. This information is unlikely to be reliable as no one has a crystal thought that can predict the future with total accuracy! Legal and stewardship decisions need information about the past. It is usually important that this information is very reliable, as getting it wrong may result in fines and penalties.
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