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Inductive and
deductive approaches
to accounting theory
Figure 1
Comparison of approaches to theory development
INDUCTIVE
(specific general)
DEDUCTIVE
(general specific)
Objectives
Objectives
Assumptions
Assumptions
Principles
Principles
Definitions/Actions
Definitions/Actions
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Example
To illustrate an inductive approach, let us consider how we might develop
a theory to explain why some gains and losses are recognised in profit or
loss, while others are recognised as part of other comprehensive income,
thatis, recognised directly in equity. The theory will be going beyond a simple
explanation of compliance with accounting standards, to derive underlying
principles and objectives reflected in the accounting treatment prescribed or
permitted by accounting standards.
Actions
Under the deductive approach, we would commence with observations of gains/
losses that are recognised in profit and gains/losses recognised directly in equity.
For simplicity, we will just consider a few observations of accounting treatment
(actions).
Gains/losses recognised in profit
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For the sake of the illustration, we will now assume that we have derived the
following principles from our observations:
1 All fair value adjustments should be recognised in profit if they:
relate to assets that are held-for-trading and which can be traded in a
highly liquid market; or
capture biological transformation that reflects the performance of the entity
during the period.
2 Other fair value adjustments should be recognised in equity if the fair value is
easily determined.
3 Where the fair value is not easily determined, the use of fair value should be
discouraged by requiring downward revaluations to be charged against profit
while not allowing upward revaluations to be included in profit. (Please note,
these principles are merely made up for the purpose of illustrating inductive
reasoning, and are not intended to suggest that these were the basis for the
conclusions of the standard setters.)
n
Assumptions
Identify assumptions that have been made in identifying the principles, such as
assumptions about performance measurement, what is meant by profit and the
rationale for the observed actions. For example, the first principle assumes that
profit is more relevant to measuring performance than is comprehensive income
(in fact, the alternative proposition is made in accounting standards). Thesecond
and third principles assume that the measurement of the fair value of financial
instruments iseasily determined, while the fair value of property, plant and
equipment is not easily determined.
Objectives
Lastly, broader generalisations are made from the principles and assumptions
reached by the researcher or theorist. For example, a broad generalisation may
be made about the objectives for the reporting of profit and comprehensive
income, and about what they should comprise. This would provide general rules
that could then be applied to new observations or emerging issues, such as
how to account for changes in the fair value of assets arising from emissions
tradingschemes.
Limitations of an inductive approach
Inductive logic is useful for developing theories to describe and explain accounting practice.
It is not well suited to the development of a set of conceptual and pragmatic principles that
provide a general framework for accounting. The limitations of descriptive accounting theory
indeveloping a conceptual framework include:
A tendency to maintain the status quo. The inductive approach does not question
whether there might be better ways of doing things. Accounting is defined as
whataccountantsdo.
Lack of guidance on how to handle new or emerging issues and situations. As a
consequence, inductively derived descriptive accounting theories encourage an adhoc
approach to problem-solving. It is clear from this that inductive accounting theories do
notcope well with new ways of doing business.
There is no guarantee that descriptive accounting theories will produce internal consistency
from a logical perspective. Contradictions can, and do, arise in that similar events could be
treated differently in different circumstances.
Practice leads theoretical development, so that undesirable practices emerge in advance
of the development of a principle, or principles, that may have prevented the emergence
ofthe practices in the first place.
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