Accounting Theory Approach

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 THE NATURE OF ACCOUNTING THEORY
APPROACH

 The primary objective of accounting theory is to provide

a basis for the prediction and explanation of accounting
behavior and events.
 No single comprehensive theory of accounting exists at
present.

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  theory defined as:-
“a set of inter-related constructs (concept), definitions and
propositions (suggestions) that present a systematic view of
phenomena by specifying relations among variables with the
purpose of explaining and predicting phenomena”.

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  The General Acceptance of Accounting Principles
(GAAP) guide the acctg profession to choose acctg
techniques and prepare FS  considered to be good
acctg practice.

 The GAAP are subjected to the reexamination & critical

analysis with regards to the changes in environments,
values and information needs.

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  Changes in principles may occur as a result of providing
solutions to emerging accounting problem and
formulating a theoretical framework.

 Provide a rationale for what accountants do or expect to

be doing.

 The process of theory construction should be completed

by theory of verification or validation.

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  Machlup (1955) defined the process:…

 The statement implies that the theory should be subject to a

logical or empirical testing to verify its accuracy.

 If the theory is mathematically based, the verification should be

predicted based on logical consistency.

 If the theory is based on the physical and social phenomena, the

verification  based on the deduced events & observations in
the real world.

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  Therefore, acctg theory should result from both
process of theory construction and verification.

 A given theory should explain and predict the acctg

phenomena.

 If a given theory is unable to produce the expected

results, it is replace by a better theory.

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 APPROACH IN ACCOUNTING THEORY

1 The Traditional Approach

2 The Regulatory Approach
3 The Positive Approach
4 The Behavioral Approach
5 The Paradigm Approach

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 Traditional approaches to accounting
theory
1. Non-theoretical, practical or pragmatic (informal)
2. Theoretical:
a. Deductive approach
b. Inductive approach
c. Ethical approach
d. Sociological approach
e. Economic approach

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 1. Non-theoretical approaches (P&A)
 The pragmatic approach:
 consists of the construction of a theory that conforms to real-
world practices and suggests practical solutions

 Means “that property which fits something to serve

or facilitate its intended purposes”

 “usefulness to users & relevance for decision making”

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  The authoritarian approach:
 The formulation of AT, which is employ primarily by
professional organization, consists of issuing
pronouncements for the regulation of accounting practices

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  Both approach assume AT (pragmatic & authoritarian) & the
resulting technique must be predicted on the basis ultimate
use of financial reports, if accounting is to have useful
function.

 A theory without practical consequence is a bad theory.

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  However;
 The approaches have been largely unsuccessful in reaching
satisfactory conclusions in their attempt to construct an AT.

 For example; balance sheet approach & profit-oriented;

pragmatic & authoritarian approach absence on theoretical
foundation.

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 2. The Deductive Approach
 Constructions of AT theory begins with basic propositions &
proceeds to derive logical conclusions about the subject
under considerations.

 Move from general to particular

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 Steps used to derive the deductive approach
1. Specifying the objectives of financial statements
2. Selecting the ‘postulates’ of accounting
3. Deriving the ‘principles’ of accounting
4. Developing the ‘techniques’ of accounting

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 3. The Inductive Approach
 The construction of theory begins with observations &
measurements & moves toward generalized conclusions.

 Lead to Positive approach

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 Involved four stages, i.e. :-
1. Recording all observations
2. Analysing and classifying these observations to
detect recurring relationships
3. Inductive derivation of generalisations and
principles of accounting from observations that
depict recurring relationships
4. Testing the generalisations

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 Comparing deductive and inductive
approaches
 In the inductive approach, the truth or falsity of the propositions does not
depend on other propositions, but must be empirically verified

 In the inductive approach the truth of the propositions depends on the

observation of sufficient instances of recurring relationships

 Accounting propositions that result from inductive inference imply

special accounting techniques only with high probability

 Accounting propositions that result from deductive inference lead, on

the other hand, to specific accounting techniques with certainty (confidence)
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  Note;
 The general proposition formulated through inductive process
 Principles & technique from deductive process
 e.g.; Paton (deductive theorist) & Littleton (Inductive theorist)

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 4. The Ethical Approach
 The basic core consists of the concepts of fairness, justice,
equity and truth
 In general, the concept of fairness implies that accounting
statements have not been subject to undue influence or bias
 Justice; equitable treatment of all interested parties
 Truth; with true & accurate accounting without
misreprsentation

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  For example:
 The committee on auditing procedures refers to concept of
‘fairness of presentation’ as:
1. conformity with GAAP
2. disclosure
3. consistency
4. comparability

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 5. The Sociological Approach

 Emphasizes the social effects of accounting

techniques
 According to this approach, a given accounting
principle or technique is evaluated for acceptance on
the basis of its reporting effects on all groups in
society
 Implies that accounting data will be useful in making
social welfare judgments

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  Evolution to new accounting sub discipline, socioeconomic
accounting
 The main obj encourage business to account their impact on
business activities on social environment through
measurement, internalization, & disclosure in their FS.
 Probably play a major role in future formulation of AT.

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 6. The Economic Approach
 Emphasizes controlling the behavior of
macroeconomic indicators that result from the
adoption of various accounting techniques
 The choice of different accounting techniques
depends on their impact on the national economic
good
 Accounting policies and techniques should reflect
‘economic reality’, and the choice of accounting
techniques should depend on ‘economic
consequences’
 e.g. LIFO method during continuing inflation
period
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 The Eclectic (combination) Approach to the Formulation of
Accounting Theory

 In general, the formulation of accounting theory and

the development of accounting principles have
followed an eclectic approach.
  a combination of approaches, rather than just
one approach.

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 Continue to second approach……..

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 The Regulatory Approach

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  Acctg standards dominate accountant’s work.

 Standards are being constantly changed, deleted and/or

added.

 They provide practical & handy rules for the conduct of the
accountant’s work.

 They generally accepted as firm rules, backed by sanction for

nonconformity.

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 Accounting standards usually consist of three parts:
1. a description of the problem to be tackled
2. a reasoned discussion on ways of solving the problem, then,
3. in line with the decision or theory, the prescribed solution

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 Why Examine Theories of Regulation
 Better placed to understand why some accounting
prescriptions become part of legislation while others do not

 accounting standard-setting is a very political process

 while some proposed requirements may be technically sound

and logical, they may not be mandated due to political
‘power’ or influence of some affected parties

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 Theories to Explain Regulation
 Public interest theory

 Capture theory

 Economic interest group theory (private interest theory)

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 To be continue……………………

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 1.Public Interest Theory
 Regulation put in place to benefit society as a whole rather
than vested interests

 regulatory body considered to represent interests of the

society in which it operates, rather than private interests of
the regulators

 assumes that government is a neutral arbiter

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 Criticisms of Public Interest Theory
 Critics question assumptions that economic markets operate
inefficiently if unregulated

 question the assumption that regulation is virtually costless

 others question assumption of government neutrality

 argue that government will only legislate and groups will

only lobby for regulation if it will increase their own wealth

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  The regulated seeks to take charge (capture) the regulator
 seek to ensure rules subsequently released are advantageous
to the parties subject to regulation
 although regulating initially in the public interest, difficult for
regulator to remain independent

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 2. Capture of Accounting Standard-
Setting
 Walker (1987) analysed capture of Australian standard-setting
through the ASRB. Argued that:
 the accounting profession lobbied before the board
established to ensure no independent research capability,
no academic as chair, to receive admin officer not a
research director
 priorities only set after consultation with AARF
 ASRB fast-tracked AARF submissions but not others
 majority of board membership were members of the
accounting profession

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 Criticisms of Capture Theory
 No reason to suggest that regulated industry the only
interest group able to influence the regulator
 No reason why regulated industries only able to
capture existing agencies rather than procure the
creation of an agency
 No reason why regulated couldn’t prevent creation of
the regulatory agency

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 3. Economic Interest Group Theory
 Assumes groups will form to protect particular
economic interests
 groups are often in conflict with each other and will
lobby government to put in place legislation which will
benefit them at the expense of others
 no notion of public interest inherent in the theory
 regulators (and all other individuals) deemed to be
motivated by self interest

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 Economic Interest Group Theory –
cont….
 The regulator is not a neutral arbiter but is seen as
an interest group itself
 regulator motivated to ensure re-election or
maintenance of its position of power
 regulation serves the private interests of politically
effective groups
 those groups with insufficient power will not be able to
effectively lobby for regulation to protect its own
interests

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 Examples - Application to Accounting Standard-
setting
 Industry groups may lobby to accept or reject a particular
accounting standard
 eg. insurance oil & gas industry
 large politically sensitive firms found to lobby in favour of
general price level accounting in US (led to reduced profits)
 accounting firms lobbying to protect their own interests

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 Accounting Regulation as an output
of a Political Process
 The view that financial accounting should be objective,
neutral and apolitical can be challenged
 will inevitably be political as it affects wealth distribution
within society
 standard-setters encourage affected parties to make
submissions on drafts of proposed standards

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  If standard-setters give consideration to views in submissions,
accounting standards and therefore financial reports are the
result of various social and environmental considerations
 tied to the values, norms and expectations of the society in
which standards are developed
 questionable whether financial accounting can claim to be
neutral and objective

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  Compliance with accounting standards usually seen to
indicate financial statements are ‘true and fair’ ???
 can accounts based upon standards determined from various
economic and social consequences be deemed to be ‘true’?
 Users may not be aware that financial reports are the
outcome of various political pressures
 should regulators consider preparers’ views given that
standards are designed to limit what preparers do?

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 Influence of the Accounting Profession on
Standards
Standards that do not have support from accountants and/or the
business community could result in:
1. lobbying by particular interest groups
2. non-compliance
3. refusal of companies to contribute to or participate in the standard-setting
process
4. threat of governmental regulatory intervention

It is in the AARF’s best interests to issue standards that are accepted

by the business community and the accounting profession

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 Private-sector Regulation of Accounting
Standards
Advantages
 The AASB is responsive to various constituents
 The AASB attracts as members people who possess the
necessary technical knowledge to develop and implement
alternative measurement and disclosure systems
 The AASB is successful in generating a reasonable amount of
response from its constituency base and in responding to this
input

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 Disadvantages
 The AASB lacks statutory authority and faces the challenge of
being overridden by government
 The AASB has been accused of lacking independence from
dominating interests, such as the accounting profession
 The AASB has often been accused of responding too slowly to
major issues that are of crucial importance to some of its
constituents

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 Arguments in favour:
 The ASIC acts as ‘creative irritant’ and as a catalyst for change,
since the private sector and market forces do not provide the
leadership necessary to effect such change
 The structure of securities regulation established by the 1991
Corporations Law serves to protect investors against perceived
abuses

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  The ASIC is motivated by the desire to create a level of public
disclosure deemed necessary and adequate for decision
making
 Unlike the AASB, the ASIC is secured greater legitimacy
through its statutory authority
 Private-sector objectives may sometimes contradict the public
interest.

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 Arguments against:
 There is a high corporate cost for compliance with
government regulation of information
 Bureaucrats have a tendency to maximise the total budget of
their bureau
 There is the danger that standard setting may become
increasingly politicised
 Government regulation backed by police power may hinder
the conduct of research and experimentation of accounting
policy and is not essential to achieving standardisation of
measurement

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 Accounting Standards Overload
 Too many standards
 Too detailed standards
 No rigid standards, making selective application difficult
 General-purpose standards fail to provide for differences in preparers’,
users’ and CPA’s needs
 General-purpose standards fail to provide for differences between:
 public and non-public entities
 annual and interim financial statements
 large and small enterprises
 credited and non-audited financial statements
 Excessive disclosures and/or complex measurements

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 Effects of Accounting Standards
Overload
 Accountants may lose sight of their real jobs because of the
excessive data required to comply with standards
 Audit failures may result because the accountant may forget to
perform basic audit procedures
 The proliferation of complex accounting regulations may lead to
non-compliance

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 Solutions to the Standards Overload
Problem

The AICAP Special Committee on Accounting Standards

evaluated the following possible approaches:
• no change
• a change from the present concept of a set of unitary GAAP
for all businesses, to two sets of GAAP
• change GAAP to simplify application to all business
enterprises
• establish differential disclosure and measurement alternatives

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 • a change in CPAs’ standards for reporting on financial statements
• an alternative to the GAAP as an optional basis for presenting
financial statements

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The Positive Approach

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 The subject matter of positive approach is:
 existing accounting practices
 management’s attitudes towards those practices
 Proponents of the positive approach argue that the techniques can
be derived from and justified on the basis of their tested use, or
that management plays a central role in determining the techniques
to be implemented

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• Basic subject matter:
– information is an economic commodity
– acquisition of information amounts to a problem of economic
choice
• Accounting information is evaluated in terms of its
ability to improve the quality of the optimal choice in a
basic-choice problem that must be resolved by an
individual
• The information system with the highest expected
utility is preferred

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Positive theory of accounting
 The positive theory of accounting is based on the
propositions that managers, shareholders and
regulators/politicians are rational and attempt to maximize
their utility
 Their choice of accounting policy rests on comparing the
relative costs and benefits of alternative accounting
procedures so as to maximize their utility

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 We move to third approach……..PAT

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The central ideal of the positive
approach
1. To enhance the reliability of prediction, based on the
observed smoothed series of accounting numbers
along a trend considered best or normal by
management
2. To reduce the uncertainty resulting from the
fluctuations of income numbers in general and the
reduction of systematic risk in particular by
reducing the covariance of the firm’s returns with
market returns

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 The central problem in positive
theories
• The central problem is to determine how accounting
procedures affect cash flows, and therefore management’s
utility
• Theoretical assumptions guiding resolution of the problem
are:
– the agency theory evolves to a view of the firm as a ‘nexus of
contracts’
– given this ‘nexus of contracts’ perspective, the role of accounting
information is to monitor and enforce these contracts to reduce the
agency costs of certain conflicts of interest

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The agency problem (dominant theory in positive
approach)

The basic agency problem is enriched by different

options concerning:
1. the initial distribution of information and beliefs
2. the description of the number of periods
3. the description of the firm’s production function in terms
of:
 amount of capital supplied by the principal
 agent’s level of effort
 an exogenously determined, uncertain-state realisation

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4. the description of the feasible set of actions from which
the agent chooses
5. the description of the labour and capital markets
6. the description of the feasible set of information
systems
7. the description of the legal system that specifies the
type of behavior that can be legally enforced, and what
is admissible evidence
8. the description of the feasible set of payment systems

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 9. the description of the solution to the basic agency
model
10. the role of self-interest
11. the solution concept and the nature of optimality

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Income smoothing
Propositions on income smoothing
1. The criterion a corporate management uses to select
among accounting principles is the maximisation of its
utility or welfare
2. The utility (effectiveness) of management increases with:
 job security
 the level and rate of growth in management’s
income
 the level and rate of growth in the corporation’s size

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3. The achievement of the management goals stated in
proposition to depends in part on the stockholders’
satisfaction with the corporation’s performance
4. Stockholders’ satisfaction increases with the average rate of
growth in the corporation’s income

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Gordon’s Theorem

Given that Gordon’s four propositions are true,

management would within the limits of its power:
1. Smooth (persuasive) reported income
2. smooth the rate of growth in income

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Motivations for smoothing
 According to Heyworth, motivations for smoothing
include improvements of relations with creditors,
investors and workers, as well as dampening of business
cycles through psychological processes
 Beidelman’s two motivating reasons:
1. a stable earnings stream is capable of supporting a higher
level of dividends, having a favourable effect on the value of
the firm’s shares
2. smoothing counters the cyclical nature of reported earnings
and reduces the correlation of a firm’s expected returns with
returns on the market portfolio

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Constraints leading to smoothing
Three constraints are presumed to lead managers to
smooth:
1. the competitive market mechanisms, which reduce options
available to management
2. the management compensation scheme, which is linked
directly to the firm’s performance
3. the threat of management displacement

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Dimensions of smoothing
Barnea and others distinguished between three
dimensions:
1. smoothing through events’ occurrence and/or recognition
2. smoothing through allocation over time
3. smoothing through classification

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The accounting choice

 The accounting choice rests on variables that

represent management’s incentives to choose
accounting methods under bonus plans, debt
contracts and the political process
 There are three hypotheses:
1. The bonus plan hypothesis maintains that managers of
firms with bonus plans are more likely to use
accounting methods that increase current-period
reported income

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The accounting choice (cont’d)

2. The debt/equity hypothesis maintains that the higher

the firm’s debt/equity, the more likely managers are
to use accounting methods that increase income
3. The political cost hypothesis maintains that large firms
rather than small firms are more likely to use
accounting choices that reduce reported profits

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 We have finished
1. Non theoretical approach
2. Regulatory Approach
3. Positive Accounting Theory
4. ………………………………

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 The Behavioural Approach

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 Most traditional approaches accounting theory construction
have failed to consider user behavior in particular and
behavioral assumptions in general

 The behavioral approach to accounting theory formulation

emphasizes the relevance to decision-making of the
information being communicated, and of the individual and
group behavior caused by the information being
communicated

 The behavioral approach to accounting theory formulation is

concerned with human behavior as it relates to accounting
information and problems

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 A new multidisciplinary area in the field of accounting
has been conveniently labeled ‘behavioral accounting’

 The basic objective of behavioral accounting is to

explain and predict behavior in all possible accounting
contexts

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 Behavioural effects of accounting
information
 A more recent and exhaustive attempt by Dyckman, Gibbins
and Swieringa illustrates the nature of studies of the
behavioral effects of accounting information

 We may divide these studies into five general classes:

1. adequacy of disclosure
2. usefulness of financial statement data
3. attitudes about corporate reporting practices
4. materiality judgements
5. linguistic effects of alternative accounting procedures

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 (1) Adequacy of disclosure
 Three approaches were used to examine the adequacy of
disclosure:
1. the first examined the patterns of use of data from the
viewpoint of resolving controversial issues concerning the
inclusion of certain information
2. the second examined the perceptions and attitudes of different
interest groups
3. the third examined the extent to which different information
items were disclosed in annual reports and the determinants of
any significant differences in the adequacy of financial
disclosure among companies

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 The research on disclosure adequacy and use showed:
 general acceptance of the adequacy among financial statements
 recognition that the differences in disclosure adequacy among
financial statements are due to such variables as company size,
profitability, and size and listing status of the auditing firm

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(2) The usefulness of financial statement data
 Two approaches were used to examine the usefulness of
financial statement data:
1. the first examined the relative importance of the investment
analysis of different information items to both users and
preparers of financial information
2. the second examined the relevance of financial statements to
decision-making, based on laboratory communication of
financial statement data in terms of readability and meaning to
users in general

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 The overall conclusions of these studies were
that:
 some consensus (agreement) exists between users and
preparers regarding the relative importance of the
information items disclosed in financial statements
 users do not rely solely on financial statements when
making their decisions

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(3) Attitudes about corporate reporting
practices
 Two approaches were used to examine attitudes about corporate
reporting practices:
1. the first examined preferences for alternative accounting
techniques
2. the second examined attitudes about general reporting issues,
such as how much information should be available, how much
information is available, and the importance of certain items

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 These research items showed the extent to which some
accounting techniques proposed by the authoritative bodies
are accepted, and also brought to light some attitude (stance)
differences among professional groups concerning reporting
issues

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(4) Materiality judgments
 Two approaches were used to examine materiality
judgments
1. the first examined the main factors determining the
collection, classification and summarisation of accounting
data
2. the second focused on what items people consider to be
material, and sought to determine the degree of
difference in accounting data that is required before the
difference is perceived as material
 These studies indicated that several factors appear to
affect materiality judgements, and that these
judgements differ among individuals

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 (5) Linguistic effects of accounting data
and techniques
 Linguistics and accounting have many similarities
 Belkaoui argues that accounting is a language and that
according to the Sapir-Whorf hypothesis its lexical
(relating to words) characteristics and grammatical rules will
affect both the linguistic and the non-linguistic
behavior of users

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Linguistic effects of accounting data and techniques
(cont’d)

 Four propositions derived from the linguistic relativity

paradigm to conceptually integrate the research
findings of the impact of accounting information on
the user’s behavior, are as follows:
1. users who make certain lexical (relating to word)
distinctions in accounting are enabled to talk and/or solve
problems that cannot be solved by users who do not
2. users who make certain lexical distinctions in accounting
are enabled to perform tasks more rapidly or more
completely than those who do not

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Linguistic effects of accounting data and techniques (cont’d)

3. users who possess the accounting (grammatical) rules are

more predisposed (liable) to different managerial styles or
emphases than those who do not.

4. accounting techniques may tend to facilitate or render more

difficult various managerial behaviors on the part of users.

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Reasons for cross-cultural research
Cross-cultural research is needed in
accounting for the following five reasons:
1. it would establish the boundary conditions for
accounting models and theories
2. it would enable evaluation of the impact of
cultural and ecological factors on behaviour in
accounting

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Reasons for cross-cultural research (cont’d)

3. although variables are often generally confounded

(confuse), the confounding is not complete, as a few
‘culturist’ may present deviant (abnormal) cases

4. cultures act as ‘natural grain-experiments’ by being

high or low on variables of particular interest

5. cultures determine aspects of psychological

functioning

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 Last…….combined any 1 to 4……

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Accounting Paradigms
 A paradigm is a fundamental image of the subject matter of
science.

 It serve to define what should be asked, & what rules should be

followed in interpreting the answer obtained.

 The paradigm is the broadest unit of consensus within a science &

serves to differentiate one scientific community from another.

 It subsumes, defines, & interrelates the exemplars, theories,

methods, & instruments that exists within it.
 The value of the predication of a theory to users influences its
uses, it does not solely determined the success

 Because cost of errors & the implementing vary, several theories

about the phenomena can exist simultaneously for predictive
purposes.

 However, only one will generally accepted by theorist.

 In accepting one theory over another, theorist will be influenced

by the intuitive appeal of the theory’s explanation for the
phenomena & the range of phenomena it can explain & predict as
well as by the usefulness of the predictions to users.
 AAA publication of Statement of Accounting Theory &
Theory Acceptance;
1. The anthropological / inductive paradigm
2. The true-income / deductive paradigm
3. The decision usefulness / decision-model paradigm
4. The decision usefulness / decision – maker/ aggregate –
market- behavior paradigm
5. The decision usefulness / decision-maker/ individual user
paradigm
6. The information / economic paradigm
 1. The anthropological / inductive
paradigm
 Concern for inductive approach to construction of accounting
theory & a believe the value of accounting practice.
 The research concern on significance of historical cost in term of
accountability & decision making.
 Those who adopt this paradigm, the basic subject mater is;
 Existing accounting practice
 Management attitude towards those practice (management plays a
central role in determined technique to be implemented)
 Four theories under this paradigm
I. Information economics
II. The agency model
III. The income smoothing / earning management hypothesis
IV. The positive theory of accounting
2. The true-income / deductive paradigm
 The basic subject matter is a concept of ideal income based on
some other method than the historical cost method.
 It generally employed analytic reasoning to justify the
construction of an accounting theory or to argue the advantage of
particular asset-valuation / income determination model other
than historical-coat accounting.
 The theories;
I. Price level adjusted accounting;
II. Replacement –cost accounting;
III. Deprival-value accounting
IV. Net realizable value accounting
V. Present-value accounting
 3. The decision usefulness / decision-model paradigm
 Rely on empirical technique to determined predictive ability of
selected items of information.
 Two related theories;
i. Decision models associated with business decision making
(EOQ, Capital Budgeting etc.)
ii. Deals with different economic events that may effect a going
concern.
 4. The decision usefulness / decision – maker/ aggregate – market- behavior
paradigm

 Important relationship between accounting data and market

behavior.
 Aggregate market behavior & accounting variables is based on
theory market efficiency.
 Those theory include;
I. The efficient market model
II. The efficient market hypothesis
III. The capital asset pricing model
IV. The arbitrage pricing theory
V. The equilibrium theory of option pricing
 5. The decision usefulness / decision-
maker/ individual user paradigm

 Is the study of how accounting functions & reports influence the

behavior of accountants & non accountants.
 The basic subject matter is the individual-user response to accounting
variables.
 The objective is to understand, explain & predict human behavior
within an accounting context.
 The theories include;
I. Cognitive relativism in accounting
II. Cultural relativism in accounting
III. Behavioral effect of accounting information
IV. Linguistic relativism in accounting
6. The information / economic paradigm
 The usefulness of information to the future development of
accounting theory.
 The basic subject matter is;
 Information is an economic commodity
 The acquisition of information amounts to a problem of economic
choice
 Generally employ analytic reasoning based on statistical decision
theory & economic theory of choice.
 Central to the information/economic paradigm is the traditional
economic assumption of consistent, rational choice behavior.
 Conclusion

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  As a conclusion;
 No single governing theory of acctg is rich enough to
encompass the full range of user-environment specifications
effectively;

 Their existence in accounting literature not a theory of

accounting but collections of theories which can be array
over the differences in user environment specification.

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 To test the theory, according to Propper;
1. Internal consistency
2. Logical form (empirical or scientific theory)
3. Survive of various test
4. Demands from practice

 No necessarily adopt the same steps; theorists ???

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 END OF CHAPTER ONE

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