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Chapter 1

Introduction

What is accounting theory? Hendriksen defined it as a logical reasoning in the form of a set
of broad principles that provide a general framework of reference by which accounting
practice can be evacuated and guide the development of new practices and procedures. Its
main purpose are to explain the current accounting practice evolved, make an improvement to
the existing principles, and to provide basis for development in accounting.

Accounting first developed as a set of tools to record transaction, its main focus is on
documenting processes involved not about explaining the basis for the method of recording
used. The purpose itself has led to inconsistensies in its practice. For years, standard setters
have been developing a conceptual framework only for it to justify or support the
inconsistencies rather than solve it, they have proved too general to provide a clean set of
rules for the basis method and choices in preparing accounting reports.

In 1494, Fra Pacioli wrote the book that contain the double entry accounting system
named Summa de Arithmetica Geometria Proportioni et Proportionalita. In the 1800s, the
rapid expansion in technology and business sector sparked an increase of methods of
accounting and the formalization of existing practices in textbook. During this period
accounting theory was progressing rapidly occurred mainly in United Kingdom. After this
period, developments in theories shifted from the United Kingdom to the United States.

The general scientific period which spans from 1800-1955 based on empirical
observation of practices, it provided an explanation of accounting practice. In the 1930s,
standard setters such as American Accounting Association (AAA) and American Institute of
Certified Practising Accountants (AICPA) has made a conceptual theory and accounting
principles that explain the practice with more detailed look at the existing practical viewpoint
of accounting.

The period 1956-70 is labeled the normative period because it was a period when
accounting theorist sought to establish norms for best accounting practice. It was mainly
focused on what should happen, attempting to work on the ideal actions that should be taken
in accounting cases. The normative era began drawing to an end in early 1970s because it had
many shortcomings like the theories do not necessarily involved empirical hypothesis testing
and are based on value judgment as stated by Henderson, Peirson and Brown.

Positive accounting starts to shift to a new form of empiricism called positive theory, it seeks
to explain the accounting practices being observed and predict the reaction of players such as
shareholders, to the actions of managers and to reported accounting information. The
deficiencies are wealth maximization has become the new answer to explain all of accounting
practices and it relies excessively on agency theory and dubious assumptions about the
efficiency of markets.

Academic and professional developments in accounting theory have tended to take

different approaches, academic research focuses on capital markets, agency theory and
behavioural aspects. Meanwhile the profession has sought a more normative approach. Joint
project between IASB & FASB produces an International harmonisation of accounting
practices through a single consistent set of International Financial Reporting Standards
(IFRS), the conceptual framework underpinning the IFRS favours a move toward accounting
practices that provide information for enhancing decision making by investors and others,
recognising all gains and losses in the accounting periods in which they occur and a
measurement using exit values.
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Chapter 2

Accounting Theory Construction

To asses accounting theory we classified them into pragmatic, syntactic, semantic, normative,
positive and naturalistic.

There is two types of pragmatic approach, descriptive and psychological approach.

Descriptive approach is an inductive approach based on observed behavior of accountants,
this theory developed from how accountants act in certain situations tested by observing
whether accountants do act in the way the theory suggests. Several criticism about this
approach including no consideration about the quality of the accountants action, it does not
allow for a change and its focus on accountants behavior not measurement of firms
attributes. Psychological approach is a theory based on observation of the reactions of users
to the accountants output, a reaction is taken as evidence that the outputs are useful and
contain relevant information. Shortcomings of this theory includes some users may react in
illogical manner, have a preconditioned response, and may not react when they should.

Syntatic and semantic theories, the semantic inputs are the transactions and exchanges
recorded in vouchers, journals and ledgers, the inputs are then manipulated on the basis of the
premises and assumptions of historical cost accounting but there is no independent empirical
verification of the calculated outputs and the outputs maybe syntactically accurate but
nevertheless be valueless due to lack of semantic accuracy.

Normative theories are based on analytic and empirical propositions, concentrated on

true income (a single measure of assets, a unique and correct profit figure) and practices that
enhance decision usefulness. The decision process goes from companys accounting system
made into prediction model of user and result in a decision model of user.

Positive theories expanded during the 1970s are based on experiences or facts of the
real world, explain the reasons for current practice and predict the role of accounting
information in decision making. Positive theories are descriptive, explanatory, or predictive.

Scientific approach has an inherent assumption that the world to be researched is an

objective reality, carried out by incremental hypotheses and has an implied assumption that a
good theory holds under circumstances that are constant across firms, industries and time.
Meanwhile naturalistic approach focuses on firmspecific real world problems and implies
that there are no preconceived assumptions or theories.

Alternative ways of naturalistic approach include reality as a symbolic discourse,

reality as a social construction, reality as projection of human imagination. For scientific
approach, the alternatives are reality as a concrete structure, reality as a concrete process,
reality as a contextual field of information.

The common misconception are assuming researchers same as practitioners and the
absolute truth which scientific method does not claim to provide. The normative era of
accounting coincided with a normative approach to auditing theory and the positive era of
accounting has led to a positive approach approach to auditing theory.
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Chapter 3

Applying Theory To Accounting Regulation

The theories of regulation relevant to accounting and auditing are theory of efficient markets,
agency theory and theories of regulation.

Theory of efficient markets is the forces of supply and demand influence market
behaviour and help keep markets efficient, this applies to the market for accounting
information and should determine what accounting data should be supplied and what
accounting practices should be used to prepare it. Some deficiencies of theory of efficient
market are the market for accounting data is not efficient, the freerider problem distorts the
market, users cannot agree on what they want, accountants cannot agree on procedures, firms
must produce comparable data.

Agency theory considers mainly the stewardship demand for information, a

framework in which to study the relationship between those who provide accounting
information and those who use it. Because of imbalances between data suppliers and data
users, uncertainty and risk exist, resources and risk are likely to be misallocated between the
parties, to the extent the market mechanism is inefficient, accounting regulation is required to
reduce inefficient and inequitable outcomes.

Theories of regulation are divided into three: public interest theory, regulatory capture
theory and private interest theory. Public interest theory requires government regulation in
the public interest whenever there is market failure (inefficiency) due to lack of
competition, barriers to entry, information asymmetry, publicgood products.

Regulatory capture theory applied if the public interest is not protected because those
being regulated come to control or dominate the regulator, the regulated protect or increase
their wealth, professional accounting bodies or the corporate sector seek to control the setting
of accounting standards. Assumes the regulator has no independent role to play but is simply
an arbiter between battling interest groups.

Private interest theory are when governments are not independent arbiters, but are
rationally selfinterested, they seek reelection, and they will sell their power to coerce or
transfer wealth to those most likely to achieve their reelection (if they are elected officials)
or increase their wealth (if they are appointed officials) or both.

Standard setting is a political process because it can affect many conflicting and self
interested groups, the regulator must make a political choice, the regulator must have a
mandate to make social choices, the recognition of doubtful debts can affect entities
differently.
 The adoption of IAS 39 Financial Instruments Recognition and Measurement in the
EU has been a highly political process, forming standards to account for financial instrument
has challenged standard setters for several years. The adoption of IAS 38 Intangible Assets in
Australia illustrates the role of politics in the standard setting process.

A financial reporting environment is made up of legal setting, economic setting,

political setting and social setting. The elements of a regulatory framework are statutory
requirements (company law, securities market law, accounting standards force of law,
taxation law), corporate governance (the structures, processes and institutions within and
around organisations that allocate power and resource control among participants), auditors
and oversight (statutory regulation or selfregulation) and independent enforcement bodies
(European Union, Securities and Exchange Comission).

Institutional structure for setting accounting and auditing standards are as follows:
Formation of IASC 1973 aimed to develop accounting standards for use throughout the
world, IOSCO s support support for a set of core standards standards IASC not independent
so restructured in 2001 into the IASB, in 2002 the EC decided to adopt IASB standards in
2005 in the EU, EU members adopted IFRS on 1 January 2005.

Individual countries must decide the extent to which IASB standards will be followed
by public sector entities. Historically auditing was selfregulated, best auditing practice has
become enshrined in auditing standards, governments have become involved due to market
failure.