Topic 1Accounting Theory

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Topic 1 Accounting Theory
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Learning Objectives

• Appreciate what is meant by accounting theory
  and the purpose it has served over time
• Explain the importance of understanding
  accounting theories

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Key Terms

• Theory
• Accounting theory
• Nature and role of accounting
• Descriptive, normative and positive theories
• Postulates, concepts and principles
• Conceptual framework

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Definition of Theory

• What is a theory?
• the coherent set of hypothetical, conceptual and
  pragmatic principles forming the general
  framework of reference for a field of inquiry
  (Hendriksen)
• theories are composed of words or other
  symbolsthey are statements and do not have a
  physical form

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Why do we need theory?

• To Systematically Create New Knowledge!

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Accounting Theory

• logical reasoning in the form of a set of broad
  principles that
• provide a general framework of reference by which
  accounting practice can be evaluated and
• guide the development of new practices and
  procedures (Hendriksen).

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What is the Nature of Accounting?

• the process of identifying, measuring and
  communicating economic information to permit
  informed judgements and decisions by users of
  information (AAA, A statement of Basic Accounting
  Theory)

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The Measurement-Communication System (Sterling
1967)
Accountant Metrician- Transmitter
Receiver Decision-Maker
Decision
Message
c
f
e
b
a
d
Identified Objectives Firm Environment
Picture of the firm
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The Measurement-Communication System (Sterling
1967)

• a). The accountant observes the transactions and
  events of the firm
• b). Measures them in a way which is conducive to
  the preparation of a message in the form of a
  financial report
• c). After the transactions and events have been
  measured, the accountant prepares a message in
  the form of a financial report
• d). The receiver interprets the message
• e). Obtains an image of the firm
• f). Which is then used as the basis for
  decisions.

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The Measurement-Communication System (Sterling
1967)

• The system involves HUMAN BEHAVIOUR
• Accounting practitioners - concerned with
  procedures largely determined by convention or
  authority
• Accounting researchers - systematic study of
  accounting. Development of theories.

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Function of Theories

• Theories which explain (e.g. accountants do not
  do X because of Y)
• Theories which predict (e.g. cosmetic accounting
  policy changes will have no impact on share
  price)
• Theories which recommend/ prescribe (e.g. current
  cost accounting should be used to provide more
  useful information)

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Accounting Theory Eras

• General Scientific Period (up to 1955??)
• What is theories (descriptive)
• Based on observations
• Empirical analysis
• e.g. Choose best depreciation method based on
  the one that has been used the most

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Accounting Theory Eras

• Prescriptive/Normative Period 1956
• What should be (prescriptive)
• Norms for best practice
• Not necessarily based on observation
• e.g. the development of current value accounting
  systems in the late 1960s - early 1970s

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Some prescriptive theories

• Decision usefulness theories
• Decision makers ask the users what they want
• Decision models researcher deduces what is
  necessary for efficient decisions to be made
• Measurement Issues and Concept of Income
• Conceptual framework projects

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Accounting Theory Eras

• Positive Period 1975
• Specific scientific theory
• Dissatisfaction with normative theories
• Normally based on observation
• Seek to explain and predict

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Some descriptive/positive theories

• capital market based research
• contracting theory
• behavioural research

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Evaluating theories

• Consider logic and evidence
• Using all instead of some
• Repeated affirmation
• Argument by analogy only

• Use of emotional words
• False credentials
• Appeal to authority
• Change in the meaning of terms during arguments

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Recap

• Nature of accounting
• The Measurement Communication System
• Accounting theories
• prescriptive (normative)
• descriptive (positive)
• NOW
• The Conceptual Framework (a prescriptive model)
  and the Measurement-Communication System

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The Measurement-Communication System (Sterling
1967)
WHO ARE THEY?
REGULATION
Accountant Metrician- Transmitter
Receiver Decision-Maker
Message
Decision
c
f
INFORMATION RELEVANT TO USERS NEEDS?
b
a
d
e
Identified Objectives Firm Environment
Picture of the firm
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Historically

• Accounting seen as pragmatic, procedural
  endeavour
• Rules, practices and procedures developed on an
  ad-hoc basis usually in response to recording and
  reporting issues that presented themselves for
  resolution
• Repetition and general acceptance has provided
  support and legitimacy to the practitioners
  rules.

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GAAP

• Think of Generally Accepted Accounting Practices
• What are some conventions?
• What are some doctrines?
• What are some principles?

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Hierarchy of the Elements of Structure of
Accounting Theory
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Postulates, Concepts and Principles

• Difficulty due to lack of precise terminology
• Each book usually contains a mixture of axioms,
  conventions, generalisations, methods, rules,
  postulates, practices, procedures, principles and
  standards. These terms cannot all be synonymous.
  Littleton

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Accounting Postulates
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Theoretical Concepts
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Accounting Principles
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Criticisms of development of accounting rules

• Concern that descriptive method of inferring GAAP
  from practices gives no guidance for dealing with
  unusual or different situations
• Piecemeal approach introduced inconsistencies
• Creative accounting
• SO due to

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• problems from a lack of a general theory
• permissiveness of accounting practice
• inconsistency of practices
• defense against political interference
• a normative method of theory development was
  proposed (CONCEPTUAL FRAMEWORK). It is premised
  on user needs driving the formulation of rules
  and other operational procedures for use in
  practice.

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What is the conceptual framework?
a coherent system of interrelated objectives
and fundamentals that is expected to lead to
consistent standards and that prescribes the
nature, function and limits of financial
accounting and reporting. (FASB)
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Summary

• Meaning of theory
• History of accounting theories
• Types of accounting theories
• Evaluating accounting theories
• Importance of theory in the development of
  accounting practices