Exam 4: Research Methodology and Theories on the Uses of Accounting Information

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There are two basic types of theory: normative and positive. Normative theories are based on sets of goals that proponents maintain prescribe the way things should be. However, there is no set of goals that is universally accepted by accountants. As a consequence, normative accounting theories are usually acceptable only to those individuals who agree with the assumptions on which they are based. Nevertheless, most accounting theories are normative because they are based on certain objectives of financial reporting.
Positive theories attempt to explain observed phenomena. They describe what is without indicating how things should be. The extreme diversity of accounting practices and application has made development of a comprehensive description of accounting difficult. Concurrently, to become a theory, description must have explanatory value. For example, not only must the use of historical cost be observed, but under positive theory that use must also be explained. Positive accounting theory has arisen because existing theory does not fully explain accounting practice.

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Prospect theory is characterized by the following:
Certainty: People have a strong preference for certainty and are willing to sacrifice income to achieve more certainty. For example, if option A is a guaranteed win of $1,000, and option B is an 80 percent chance of winning $1400 but a 20 percent chance of winning nothing, people tend to prefer option A.
Loss aversion: People tend to give losses more weight than gains: They're loss‐averse. So, if you gain $100 and lose $80, it may be considered a net loss in terms of satisfaction, even though you came out $20 ahead, because you tend to focus on how much you lost, not on how much you gained.
Relative positioning: People tend to be most interested in their relative gains and losses as opposed to their final income and wealth. If your relative position doesn't improve, you won't feel any better off, even if your income increases dramatically. In other words, if you get a 10 percent raise and your neighbor gets a 10 percent raise, you won't feel better off. But if you get a 10 percent raise and your neighbor doesn't get a raise at all, you'll feel rich.
Small probabilities: People tend to underreact to low‐probability events. For example, you might completely discount the probability of losing all your wealth if the probability is very small. This tendency can result in people making very risky choices.