CHAPTER 2 (Part 1)

FORMULATION AND VERIFICATION

OF ACCOUNTING THEORY

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Accounting
• Accounting objectives are maintaining a complete and systematic
record of all transactions, summarizing, reporting and analyzing the
financial performance & position of a business.
• Fundamentals of accounting – to record, summarize, report, analyze
that deals with the Assets, Liabilities & Equities.
• An accounting practice is a routine manner in which the day-to-day
financial activities of a business entity are gathered and recorded and
finally reported and analyzed.
• An accounting process is a series of activities that begins with a
transaction and ends with the closing of the books. Because this
process is repeated each reporting period, it is referred to as the
accounting cycle and includes these major steps: Identify the
transaction or other recognizable event.
• An accounting framework is a published set of criteria that is used to
measure, recognize, present, and disclose the information appearing
in an entity's financial statements.
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• a basic idea or rule that explains or controls how something happens
or works

Principle is a basic idea or rule that explains or controls how something happens or
works 5
History and Evolution of Accounting

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Accounting Theory

• 1.Why do students of financial accounting need to bother with the

study of ‘theories’? Why not just study some more of the numerous
accounting standards (and there are certainly plenty of them!) or
other pronouncements of the accounting profession?
• 2. Why would (or perhaps ‘should’) accounting practitioners and
accounting regulators consider various theories of accounting?

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Theory
“In theory, the journey should take three hours, but in practice it
usually takes four because of roadworks.”
• a formal statement of the rules on which a subject of study is based
or of ideas/ assumptions that are suggested to explain a fact or
event or, more generally, an opinion or explanation

• A concept is any idea.

• “hypothesis” -a rough idea or explanation for an phenomenon you
are going to test). Phenomenon is a situation that is observed to
exist or happen, e.g. There is a relationship between CEO Age and Firm
Performance
• propositions: a statement expresses a judgement or opinion (the act
of proposing) e.g.“the idea that the exam barring rule is a good way
to stop class absenteeism”
• a “theory” (an idea or explanation for a phenomenon (e.g. situation)
that has been repeatedly tested and found to be consistent across a
long span of time). For instance, the theory of gravity.
• Laws tell us what happens. Theories explain how and why
something happens. 8
Agency Theory

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Agency Theory

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Theory
• Theory is used as basis of explanation with regard
to how/why certain phenomena happens the way
they do.

• A theory include propositions linking concepts in the form of

hypotheses to be tested.
• The elements included in a theory are concepts, propositions and
hypothesis, linked in a systematic structure to allow explanation and
prediction.
• “Accounting theory : A cohesive (united) set of conceptual,
hypothetical and pragmatic propositions explaining and guiding the
accountant’s action in identifying, measuring and communicating
economic information.”

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Accounting Theories
• Accounting theory states that all accounting information should be
relevant, reliable, comparable, and consistent

• Accounting theories aim to provide a coherent (logical) and

systematic framework for investigating, understanding and/or
developing various accounting practices, the evaluation of alternative
accounting practices is likely to be much more effective if the person
evaluating these practices has a thorough grasp of accounting theory.
• Simple explanation: Accounting theory provides a guide for effective
accounting and financial reporting.
• Accounting theory, along with political factors and economic
circumstances, is one of the main factors influencing the
development of accounting standards.
• Accounting theory is a continuously evolving subject, and it must
adapt to new ways of doing business, new technological standards,
and gaps that are discovered in reporting mechanisms.

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• Simple explanation: Accounting theory provides a guide for effective
accounting and financial reporting.
Accounting theory is a set of assumptions, frameworks, and
methodologies used in the study and application of financial
reporting principles. The study of accounting theory involves a review
of both the historical foundations of accounting practices, as well as
the way in which accounting practices are changed and added to the
regulatory framework that governs financial statements and financial
reporting.

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Accounting theory : A cohesive (united) set of conceptual,
hypothetical and pragmatic propositions explaining and
guiding the accountant’s action in identifying, measuring and
communicating economic information. 14
 • Financial accounting theory focuses on the “why” of accounting – the
reasons why transactions are reported in certain ways.

• The majority of introductory accounting courses cover the “what”

and “how” of accounting. These include hundreds of journal entries,
gaining familiarity with all the common accounts that companies use,
learning how financial statements are put together, and how to
calculate the proper debit and credit amounts.

• Financial statements issued by companies could then be said to be

100% relevant and 100% reliable. Relevant in the fact that the
information will prove to be useful to external users, and reliable in
the fact that they will be completely free from bias or error.

Accounting theory involves the assumptions and

methodologies used in financial reporting, requiring a review
of accounting practices and the regulatory framework.
Accounting theory provides a guide for effective accounting
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and financial reporting.
Accounting Theory Construction,
Formulation and Verification
• Formulation is the action of creating .
• Accounting theory objective is to provide a basis for the prediction
and explanation of accounting behavior and events.
• Accounting theory construction is from the need to provide a
rationale for what accountants do or expect to be doing.
• The process of accounting theory construction should be completed
by theory verification or validation. This subject to a empirical testing
to verify its accuracy.
• Many different approaches to theory formulation in accounting
• No single governing theory of accounting 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.
• Basic reasoning in theory formulation (How Theory is
Formulated?):
Inductive
Deductive

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Constructing theory
• The deductive approach in constructing the theory of accounting starts with
specifying the objective. This methodology is usually moving from the general to
the specific. The deductive approach includes formulating assumptions and
testing them via research process.

• The inductive approach emphasizes on observation and deriving conclusions

through observation. It generally moves from specific to general, since the
researcher generalizes his limited observations of specific circumstances to
general conditions. In inductive approach, there is no theory at the beginning of
the research, and theories develop and evolve (e.g. berkembang) as a result of
research. The inductive studies have nothing to do with assumptions.
• The theory of double entry system -The transactions are classified and grouped
according to the principles laid down by a system known as 'double-entry book-
keeping'.
• Inductive approach- Why there is debit side and credit side in accounting -
observation (specific) because of the existence theory of double entry system
(general).
• Deductive approach- theory of double entry system (general) explained all
transaction have to be debited and credited, thus, the transactions are recorded
in debit and credit side (specific).Based on the theory of double entry system,
testing the nature relationship between the debit and credit side of accounting
transactions. 18
Constructing theory
• Accounting theorists generally begin with inductive reasoning and
change their course towards a deductive approach in order to
improve the theory through development of understanding and
explanation power.
• An inductive approach is concerned with the generation of new
theory emerging from the data.
• A deductive approach is aimed and testing theory

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 Accounting Theory Construction, Formulation and Verification

Deductive

• Reasoning from general statements to specific statements

• Example,
• P1: All asset accounts have debit balances.
• P2: The cash account is an asset account
• C : The cash account has a debit balances
• Objective is important part of deductive process. P1 & P2 are
more generalize. C is more specifically to cash account.
• The main objective of theory to provide a framework for the
development of new ideas or new procedures and to help
making choices among alternative procedures.
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 Deductive Approach
A deductive approach is concerned with “developing a hypothesis (or
hypotheses) based on existing theory, and then designing a research
strategy to test the hypothesis”.
Deductive approach offers the following advantages:
• Possibility to explain causal relationships between concepts and
variables
• Possibility to measure concepts quantitatively
• Possibility to generalize research findings to a certain extent.

Deductive research approach explores a known theory or

phenomenon and tests if that theory is valid in given circumstances. It
has been noted that “the deductive approach follows the path of logic
most closely. The reasoning starts with a theory and leads to a new
hypothesis. This hypothesis is put to the test by confronting it with
observations that either lead to a confirmation or a rejection of the
hypothesis”.
Deductive reasoning can be explained as “reasoning from the general
to the particular (specific)”. 21
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 Accounting Theory Construction, Formulation and Verification

Inductive
• Reasoning from the particular to the general
• Example,
P1: The cash account is an asset account and has a
debit balance.
P2: The Vehicles account is an asset account and has
a debit balance.
P3: The land account is an asset account and has a
debit balance.
C : All asset accounts have debit balances
• P1, P2, &P3 is so specific for each account. C is
generalization from all P.
• Arguments begins with a set of a particular examples,
claim that it will representative of some greater whole,
then infer some generalization about that whole. 23
Inductive approach
• In accounting, the inductive approach begins by observing the
financial information of the companies and progresses towards
constructing accounting generalizations and principles out of those
observations and re-occurring relations.
• The early theorists’ preference was to apply the inductive approach
based on the observations of real practices. It is the opposite of
deductive research. Aims at exploring a new theory.
• Inductive approach is flexible as the researcher does not have to
follow any pre-determined information. However, critics would argue
that if observations are incorrect, the researcher would end up in
incorrect conclusions.

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Grounded Theory

• Grounded theory is research method that will

enable you to develop a theory which offers an
explanation about the main concern of the
population of your substantive area and how that
concern is resolved or processed.

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Accounting Theory Construction,
Formulation and Verification
A theory is evaluated to prove the adequacy of
what it proposes. Bases/criteria for theory
verification (or testing a theory) are:
• Dogmatic basis (Dogmatic – follow the rules)
Believe what we read and statements made by
others simply because they have been made by
an authority
Self-evident basis
Reasonableness of a statement based on our
general knowledge, experience and observation.
• Scientific basis
Through testing, research, experimentation and
so on (support with empirical evidence)

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