Topic 1: Introduction to

Accounting Theory
Part 2: Theory formulation and
verification

Description

Description :
This topic explains:
* What is an accounting theory?
* Objectives & Importance of accounting theory
*How a theory is constructed and verified?
*Distinction between Inductive and Deductive approaches
*Sources of theories
*Accounting policy and changes to accounting policy

Theory construction
Learning

objectives/outcomes:

What is an accounting theory?

Objectives & Importance of accounting theory

How a theory is constructed and verified?

Distinction between Inductive and Deductive
approaches
Sources of theories
Accounting policy and changes to accounting
policy

What is a theory?
Hendriksens definition:
the coherent (logical and consistent) set of
hypothetical, conceptual and pragmatic
principles forming the general framework of
reference for a field of inquiry.

What is a theory?
1.

A set of statements or principles devised to explain a group of facts

or phenomena, especially one that has been repeatedly tested or is
widely accepted and can be used to make predictions about
natural phenomena.

2. The branch of a science or art consisting of its explanatory

statements, accepted principles, and methods of analysis, as
opposed to practice: a fine musician who had never studied theory.
3. A set of theorems that constitute a systematic view of a branch of
mathematics.
4. A belief or principle that guides action or assists comprehension or
judgment: staked out the house on the theory that criminals usually
return to the scene of the crime.
Source: www.thefreedictionary.com

Why do we need to know how

to construct a theory?
Provides

a rationale or justification for what

accountants do or expect to be doing
A given accounting theory should predict a
phenomena.
A theory is verified when an accounting
phenomena occurs
The theory construction process includes
both building the theory and testing/validating
the accuracy of the theory

What is an Accounting
Theory?
Accounting

is the process of identifying,

measuring and communicating economic
information to permit informed judgments and
decision by users of the information.
Accounting is both an art and a science
Teaching accounting as a social science is
argued to help students better understand
accounting practices, to be prepared for
changes in these practices and, ultimately, to
make better policy decisions.

Scientific Thinking

Social science aims to understand, predict and control

human behaviour as opposed to natural science which
aims to understand, predict and control nature (i.e. the
material world). Accounting is a full fledged social
science. Matz argues:

Accounting deals with enterprises, which are certainly

social groups; it is concerned with transactions and
other economic events which have social consequences,
and influence social relationship; it produces knowledge
that is useful and meaningful to human beings engaged
in activities having social implications; it is primarily
mental in nature. On the basis of guidelines available,
accounting is a social science.

What is an Accounting theory?

According to E. S. Hendriksen:
Accounting theory is logical reasoning in the form of a set
of principles that (a)
Provide a general frame of reference by which
accounting practice can be evaluated; and
(b) Guide the development of new practice and
procedures.
Thus, Accounting theory refers to the brief set of
principles, assumptions conventions, concepts related to
accountancy, evolved by analyzing the accounting
practices.

Accounting theory
McDonald

(1972) argues that a theory must

have three elements:
1) encoding of phenomena to symbolic
representation
2) manipulation or combination according to
rules
3) translation back to real-world phenomena.

Accounting theory

Do the three elements that McDonald states are

necessary for a theory to exist in accounting?
The answer looks yes:
The first obviously exists as we have the symbols of
debits and credits and we have also developed
accounting terminology e.g. depreciation, accruals,
matching, current cost, revaluation etc. all unique to
accounting.
The second also exists as we have a wealth of rules and
regulations for manipulating or combining these debits
and credits.
The Third, translation is evidenced in how we present
these debits and credits to users in the form of nancial
reports

Explanation of Accounting
theory: Summing up
Therefore, Accounting theory is defined as a
coherent set of logical principles that:
a) Provides a better understanding of existing
practices to practitioners, investors, managers,
and students.
Provides a conceptual framework for evaluating
existing accounting practices.
Guides the development of new practices and
procedures.

Objectives of Accounting Theory

To evaluate and explain accounting practices for a

better understanding of them
To simplify a complex phenomenon.
To solve the problems created by the happenings of
various events.
To pre-calculate the effect of an event on future.
To forecast any future event.
To help in investigation, observation, explanation and
conclusion of an event.

Epistemology
The process by which we obtain knowledge is
called epistemology and is usually referred to as
the theory of knowledge and consists of the
rules of how and whether knowledge is
acquired.
Is concerned with validity of knowledge
Concerned with the structure, origin and criteria
of knowledge

( Knowledge is information and skills acquired through

experience or education; the theoretical or practical
understanding of a subject)

Structure of Knowledge
Generalizations

Concepts

Topics

Facts

Facts

Concepts
Topics
Facts

Facts

Facts

Facts

Approaches to theory
construction

Accounting theory itself may be variously

classified: by its level (syntactic, semantic,
pragmatic); by its reasoning (deductive,
inductive); or by its stance (normative,
positive)

Pragmative theories

Descriptive pragmatic approach:

based on observed behaviour of accountants
theory is developed from how accountants act in
certain situations
tested by observing whether accountants do act in
the way the theory suggests
is an inductive approach ( also called positive
theory of accounting).
(Testing recording conservative figures principle
of conservatism or recording similar occurrences in
different ways Principle of diversity)

Pragmatic theories

Probably the oldest and most universally used method

of accounting theory construction.
Criticisms of descriptive pragmatic approach:
does not consider the quality of an accountants action
( no analytical judgement; no assessment of whether
the accountants report in the way he/she should)
does not provide for accounting practices to be
challenged (it does not allow for change)
focuses on accountants behaviour not on measuring
the attributes of the firm (e.g. Whether the firm has
public accountability or not--- if public accountability,
full set of IFRS otherwise accounting standards for
SMEs)

Pragmatic theories

Psychological pragmatic approach:

theory

depends on observations of the

reactions of users to the accountants
outputs e.g. financial reports.
a reaction is taken as evidence that the
outputs are useful and contain relevant
information

Pragmatic theories
Criticisms

of the psychological pragmatic

approach:

some users may react in an illogical manner

some users might have a preconditioned
response
some users may not react when they should

Theories

are therefore tested using large

samples of people rather than concentrating
on the responses of individuals

Syntactic and semantic theories

Syntactical: This represents the logical relations in the

theory. This concerns the rules of the language
employed, e.g., the rules of grammar for English or the
rules of mathematics for a mathematically expressed
theory. Syntactical relations are logical connections that
cement together and explain the important concepts of
the theory.
Semantic inputs are the transactions and exchanges
recorded in vouchers, journals and ledgers

Syntactic and semantic theories

Criticised because there is no independent empirical

verification of the calculated outputs

The outputs may be criticised for poor syntax inaccurate

e.g. different types of monetary measures are added
together (historical and current cost)
The outputs may be syntactically accurate but
nevertheless be valueless due to a lack of semantic
accuracy (a lack of correspondence with real-world
events, transactions or values)

Syntactic and semantic theories

Historic cost accounting may produce accurate outputs

but which nevertheless have little or no utility
That is, they are not useful for economic decision making
except to verify accounting entries
Theory in action 2.1: Do share prices rise when profit
improves ----- Bonuses soften wage freeze page 22.

Normative theories
1950s

and 1960s golden age

policy recommendations
what should be
concentrated on deriving:
true income (profit)
practices that enhance decisionusefulness
based on analytic and empirical propositions

Financial statements should mean what they say

Normative theories
True

income:

a single measure for assets

a unique and correct profit figure

Decision

usefulness:

the basic objective of accounting is to aid the

decision-making process of certain users of
accounting reports by providing useful accounting
data

Normative theories

The decision process

Accounting system of company X

Prediction model of user
Decision model of user

Positive theories

Expanded during the 1970s

Based on experiences or facts of the real world
Explain the reasons for current practice
Predict the role of accounting information in decisionmaking

The

main difference between normative and

positive theories is that

normative theories are prescriptive

positive theories are descriptive, explanatory or
predictive

Different perspective
Scientific

approach: ( highly structured

approach to theory construction)

has an inherent assumption ( prior knowledge)

that the world to be researched is an objective
reality
is carried out by incremental hypotheses
has an implied assumption that a good theory
holds under circumstances that are constant
across firms, industries and time

Different perspective
Criticism

of the scientific method:

large-scale statistical research tends to lump

everything together
it is conducted in environments that are often
remote from the world of or the concerns of
accountants

Different perspective
Naturalistic

approach:

implies that there are no preconceived

assumptions or theories
focuses on firm-specific real-world problems

Different perspectives

Alternative ways of looking at the world:

CATEGORY ASSUMPTION
1.
2.
3.
4.
5.
6.

Reality as a concrete structure

Reality as a concrete process
Reality as a contextual field of information
Reality as a symbolic discourse
Reality as a social construction
Reality as projection of human
imagination

Different perspective

For categories 1 3 it is more appropriate to use the

scientific approach

For categories 4-6 the naturalistic approach is more

appropriate

Different perspectives

Scientific approach applied

to accounting
Misconceptions of purpose
Make scientists out of accounting
practitioners
Researchers = practitioners
The desire for absolute truth

Scientific approach applied

to accounting
The

scientific method does not claim to

provide truth
It attempts to provide persuasive evidence
which may describe, explain or predict

Decision Usefulness Theory

Reasoning is based on usefulness of information to decision models of
specific user groups
e.g. Capital budgeting, going concern, buy vs lease
e.g. decision -usefulness approach whereby accounting reports are an
input into users decisions (e.g., to buy or sell shares, management
decisions on the financial wealth of firms, etc.).
Overall
Overalltheory
theory
of
ofaccounting
accounting

Individual
accounting
system

Prediction
model of
user

Decision
model of user

Uses of financial accounts (May, G.O, 1952)

Financial

accounts are used as

A report of stewardship
A basis of fiscal policy
A criterion for dividends
A basis for the granting of credit
Information for prospective investors
A guide to the value of investments already made
An aid to government supervision
A basis for price or rate regulation
A basis for taxation

Research using decision theory

Capital budgeting
Buy vs lease
Make or buy
Economic Order Quantity (EOQ)
Program Evaluation and Review Technique (PERT)
Linear programming
Bankruptcy
Merger
Bond ratings

Deductive Approach
The under mentioned theories can be
regarded as normative theory/ using
Deductive approach :
Inflation Accounting
Environment Accounting.
Social Responsibility Accounting.
Human Resources Accounting

Approaches to Theory formulation - Deductive

a.

b.

c.

d.

Reasoning from general statements to specific statements,

normative in nature ( e.g. analyze the current practices of
accountants ( inductive ) and then arrive at specific conclusions that
the accountants should do the accounting using a particular
method or technique--- Deductive)
The construction of theory moves from basic propositions or
hypotheses and move to derive specific conclusions
In accounting, observations about the general accounting
environment move to particular accounting principles and then to
specific accounting techniques
The theory is then tested empirically and verified or falsified
e.g. , present value accounting

Deductive approach

Deductive approach begins with propositions and assumptions and

finally ends with logical conclusion about the subject under
consideration.
It helps in developing new accounting practices keeping pace with
the dynamic world. It stresses on what ought to be done.
It helps in formulating normative theories, which helps in solving
crucial problems of accountants.
Normative accounting theory is formulated by deductive approach. It
guides accountants towards better accounting practices.
It suggests what an accountant should do rather than explaining
what he does. It aims towards full disclosure of the information to
the users to safeguard their interest in the firm.
Example: from the general proposition that all cows eat grass, by
observation , we may deduce that some cows eat grass .

Deductive approach
1.The nature of Land & Building account:
Proposition -1: All asset accounts have debit balances.
Proposition-2: The Land & Building account is an asset account
Conclusion: Land & Building has a debit balance
( Starting from generalized statement and arriving at specific
conclusion)
2. P 1: All accountants should prepare their firms financial reports to
satisfy the information requirements of all users of the reports.
P2: All users of financial reports are concerned with the solvency of
the reporting firm.
P3: all accountants should prepare their firms financial reports to
report the solvency of the firm.
P4: The solvency of the firm is indicated only by NRV in their firms
financial reports.
Conclusion: Accountants should measure assets at NRV in their firms
financial reports.

Deductive accounting research

There

is one correct definition of profits in

accounting sense. A profit is an increase in
net wealth. A loss is a decrease in net
wealth. (MacNeal)
Thus any changes in price that increases the
value of an asset is a profit

Approaches to Theory formulation Inductive

a.

b.

c.

d.

e.

Reasoning from the particular to the general, describes extant

accounting practices
The construction of theory moves from specific observations
to generalized conclusion
In accounting, observations about the financial information of
business enterprises could lead to the construction of
generalizations and principles of accounting based on
recurring relationships
It is not a process of falsification, it is a process of observing
sufficient instances of recurring relationships
E.g. income smoothing

Inductive approach: example

The inductive method involves reasoning from the

particular to the general. It is the process of drawing
generalized conclusion from detailed observations and
measurements. If recurring relationship can be found,
the generalization can be formulated.
For example, if every cow which we have observed eats
grass, by induction, we may induct that all cows eat
grass.

Examples of Inductive approach

1. Measuring assets at NRV:
P1: Joshi , Toshi and Moshi (who are accountants) measure assets
at NRV in their firms financial reports
P2: Sonu, Monu and Tonu ( who are all accountants) measure assets
at NRV in their firms financial reports.
Conclusion: All accountants measure assets at NRV in their
firms financial reports.
2. P1: The L & B is an asset account and has a debit balance.
P2: The Motor Vehicles account is an asset account and has a debit
balance
P3: P & M is an asset account and has a debit balance
Conclusion: All assets accounts have debit balances
( starting from specific and arriving at generalized conclusions)

Inductive approach or Descriptive

approach

Inductive approach is useful in framing general rules, principles,

laws of social & physical science and to study natural trend of
human behaviour.
It begins with observations of accountants practice followed by
formulation of hypothesis. If such hypothesis holds good in all
observed cases, then it is considered as a theory.
(RECURRING RELATIONSHIP)
Descriptive Accounting theory is formulated by inductive approach
and it analyses the existing accounting practices.
This theory justifies the existing practices of accountants and
explains how accounting information are collected, analyzed and
communicated to others.
It also explains the probable results of discontinuing any existing
accounting practice.

Inductive approach
/Descriptive theory
The under mentioned theories can be regarded as descriptive
theory:
The principle of following same accounting methods year after year.
[Consistency]
The superiority of historical cost concept above the current cost
concept. [Historical cost]
* The principle behind accounting for all probable losses and not
recognizing probable gains. [Conservatism]

The principle of considering a firm separate from its owner. [Entity

Inductive accounting research

Manager will select accounting treatments that will

maximize their utility or welfare
Their utility includes increased job security and
compensation according to corporation size
If the company is profitable & stable, shareholders are
happy and they will reward the manager with longer
contract and higher pay
Therefore, manager will choose accounting treatments
that will smoothen income growth rate.

Sources of theories
Observation

Of how accounting reports are prepared

Of how users react to accounting reports
it does not assess the logic of the practice i.e.
why is it done that way?
It does not propose what is the best practice

Experiments

What if? Decision theory model

Proposes alternatives and solutions

Existing accounting theory

There

is no single governing theory

There is a collection of theories
Theories that help to

Explain accounting policy choices

Explain reporting practices
Explain impacts of financial reporting

Characteristics of a Sound/Ideal Theory

The characteristics of an ideal theory may be given as follows:

1.An ideal theory must possess the quality of having an authenticity.
It should be authoritative.
2.A good theory should have wide acceptance.
3.An ideal theory should have the quality of evaluating and
explaining the current events correctly.
4.An ideal theory is likely to possess the potentiality of solving the
problems created by the happening of an event.
5.A good theory should be a verified and confirmed hypothesis.
6.An ideal theory should have the ability of analyzing past events
also.
7.A good theory should also have the quality of being able to
forecast regarding any future event.
8.At last, it can be said that an ideal theory should always have
some descriptive approach in general and a normative approach in
particular.

Successful theory

1. Broader in scope is better. Can it be applied

situations?
2. It should provide good reasoning and
explanations
3. It should be prescriptive
4. It should be consistent in its conclusions
5. The theory should fit well
6. It should be useful------ it should explain
most of the things not all the things

in other

Accounting policy
The

accounting policies of a reporting entity

are the specific accounting principles and
methods of applying those principles that are
judged by the management of the entity to be
the most appropriate in the circumstances to
present fairly the financial position, changes
to the financial position and results of
operations in accordance to generally
accepted accounting principal

Changes to accounting
policies

Changes may be appropriate if

Compliance with regulatory mandates

Consistency with the accounting model
Presentation of economic reality and what is true and
fair
Comparability with other firms in the same industry
Economic consequences to the firm

However, changes can be suspicious as it may

not be in the best interest of the shareholders

Theories about changes to

accounting policies

Income smoothing hypothesis

Management would within the latitude allowed by

accounting rules

Smooth reported income

Smooth the rate of growth in come

Selective financial misrepresentation hypothesis

The manipulation of standard setting process where

managers prefer loose reporting standards (i.e.
arbitrary, complicated and misleading rules) that would
favour their self interest (Bonus attainment, Impressing
shareholders, Job security)

Accounting theory
construction video
http://www.youtube.com/watch?v=KvQKxLR

KjBM

Issues for auditing theory construction

Auditing is a verification process that is applied to the

accounting inputs and processes

Auditors

provide an opinion on

whether the financial statements accord with the

applicable reporting framework
whether the statements give a true and fair view
whether the financial statements accord with the
applicable reporting framework
whether the statements give a true and fair view

Issues for auditing theory construction

The normative era of accounting coincided with a

normative approach to auditing theory
The positive ere of accounting has led to a positive
approach to auditing theory

Summary

What is theory and why is it important for accounting?

How accounting theory is developed?
Many different approaches to theory formulation in
accounting
Evolution of accounting theory
positive v. normative
scientific v. naturalistic

Issues for Auditors

Key terms and concepts

Descriptive pragmatic approach

Psychological pragmatic approach
Syntactic and semantic theories
Historical cost accounting
Normative theories
Positive theories
Scientific approach to theory
Naturalistic approach to theory
Auditing theory

Appendix : Inductive & Deductive approaches

Inductive Approach

Deductive Approach
Theory ( Problem Solution/Reasoning)

Theory
Tentative
Hypothesis

Hypothesis
Observations
Confirmation

Patterns/observations
Data
(Specific to generalized)

(Generalized to specific)
-------------------------------------------Hypothesis is a theory or
proposition that is to be tested