CHAPTER 2

FORMULATION AND VERIFICATION OF

ACCOUNTING THEORY

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Accounting Theory Construction,
Formulation and Verification
 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?):
Deductive
Inductive

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Accounting Theory Construction and Formulation

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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Accounting Theory Construction and
Formulation
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.

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Accounting Theory 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
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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 Paradigms in Accounting Research
Pragmatic Theories
 This relation pertains to “the effect of words or symbols on

people”
 How accounting concepts, and their real world

corresponding events or objects, affect people’s behavior.

 Observe how people react to the same message in different

ways – same financial information, some would buy shares,

some would sell shares
 Relates to “decision model” is that accounting information

must satisfy the information needs of users

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Approaches to the Development of Accounting Theory: Paradigms in Accounting Research

 Pragmatic theories
 Syntactic & semantic theories (new concepts)
 Normative theories
 Positive theories

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Recap; Chapter 1

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Paradigms in Accounting Research
Syntactic Theories
 Rules of the language employed
 Refer to rules of grammar & mathematics
 Analytical methodology basically relied upon syllogism
 If the combination of premise is valid, so the conclusion

was also true.

 Do not need to know the meaning of something to see

that the syllogism is logical.

 By themselves, syntactic propositions have no empirical

content.

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Paradigms in Accounting Research
Syntactic Theories

Premise 1: All accounts relating to assets have debit balances.

Premise 2: The accumulated depreciation account relates to assets.
Conclusion: The accumulated depreciation account has a debit balance.

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Paradigms in Accounting Research
Semantic Theories
 Links the basic concepts of a theory to object in the real

world.
 Concern the relationship of a word, sign or symbol to a

real world object or event.

 To make a theory realistic and meaningful.
 For instance, A = L + E is purely abstract, the equation

only realistic and meaningful if we correlate with real

world objects.
 Not concern to the line of logic argument.

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Paradigms in Accounting Research
Semantic Theories

Premise 1: All asset accounts have debit balances.

Premise 2: The sales returns account is not an asset account.
Conclusion: The sales returns account has a debit balance.

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Paradigms in Accounting Research
Normative Theories
 1950s and 1960s ‘golden age’

◦ policy recommendations
◦ what should be
◦ concentrated on deriving:
 true income (profit)
 practices that enhance decision-usefulness
◦ based on analytic and empirical propositions

Financial
Financial statements
statements should
should mean
mean what
what
they
they say
say

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Paradigms in Accounting Research
Normative theories concentration:
 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

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Paradigms in Accounting Research
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 decision-

making
 The main difference between normative and positive

theories is that:
◦ normative theories are prescriptive
◦ positive theories are descriptive, explanatory or
predictive

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Accounting Theory Approaches
 Traditional Approach
 Regulatory Approach
 Positive Approach
 Behavioral Approach
 Paradigm Approach

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 Accounting Theory Approaches

Traditional Approach
1. Non-theoretical Approaches (pragmatic and
authoritarian)
2. Theoretical:
a. Deductive approach
b. Inductive approach
c. Ethical approach
d. Sociological approach
e. Economic approach
f. Eclectic approach
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Accounting Theory Approaches
1. Non-theoretical Approaches

Pragmatic Approach:
 Consists of the construction of a theory that conforms to real-world

practices
 E.g. Observing the practices and techniques of working accountants.
 Also concerns about usefulness & relevance of accounting

information for decision making

 How real world affects people’s behaviour

Authoritarian Approach:
 The formulation of accounting theory, which is employ primarily by

professional organization, consists of issuing pronouncements for the

regulation of accounting practices

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Accounting Theory Approaches
2. Theoretical Approaches
a) Deductive Approach
 Constructions of accounting theory begins with basic

propositions & proceeds to derive logical conclusions about

the subject under considerations
 Move from general to particular

b) Inductive Approach
 The construction of accounting theory begins with

observations & measurements & moves toward generalized

conclusions
 Move from particular to general

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Accounting Theory Approaches
c) 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 misrepresentation

d) 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
 Encourage business entity to account the impact of business activities on

social environment through financial statement.

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 Accounting Theory Approaches

e) 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

f) Eclectic (Combination) Approach

 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.
 This approach has given rise to the new approaches such as regulatory,
behavioral and positive
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Accounting Theory Approaches
Regulatory Approach
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
 Theories that explain regulation:

1. Public Interest Theory

2. Capture Theory
3. Economic Interest Group Theory (Private Interest Theory)

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Accounting Theory Approaches
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 (a
person who settles a dispute)

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 Accounting Theory Approaches

2. Capture Theory
◦ This theory was designed by political scientists J.
Hertog.
◦ The theory states that regulations are manipulated
to fit the requirements of those affected by them.
◦ The theory suggests that over a given period of
time regulations serve the interests of the industries
concerned.

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Accounting Theory Approaches

3. Economic Interest Group Theory (Private

Interest 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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Accounting Theory Approaches

Positive Approach
 Based on the work of Ross Watts and Jerold Zimmerman in
1978 and 1986
 This approach focuses on understand, explain and predict

existing accounting practices

 The positive accounting theory is based on the propositions

that managers, shareholders and regulators/politicians are

rational and attempt to maximize their utility or welfare
 Their choice of accounting policy rests on comparing the

relative costs and benefits of alternative accounting

procedures so as to maximize their utility or welfare

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Accounting Theory Approaches
Behavioural Approach
 A new multidisciplinary area in the field of accounting has
been conveniently labeled ‘behavioural accounting’
 The basic objective of behavioural accounting is to explain
and predict behaviour in all possible accounting contexts
 The behavioural approach to accounting theory formulation
is concerned with human behavior as it relates to
accounting information and problems

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Accounting Theory Approaches
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 includes, defines, & interrelates the exemplars,
theories, methods, & instruments that exists within it.

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Accounting Theory Approaches
Accounting literature suggests the following basic
accounting paradigms:
 The anthropological paradigm – accounting

practices as the domain of accounting

 The behavior of the markets paradigm – the capital

market reaction as the domain of accounting

 The economic event paradigm – the prediction of

economic events as the domain of the accounting

 The decision process paradigm – the decision

theories and the decision processes of individual as the

domain of accounting

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Accounting Theory Approaches
 The ideal income paradigm – the measurement of
performance as the domain of accounting
 The information economics paradigm – the

evaluation of information as the domain of

accounting
 The user behavior paradigm – the information

recipients’ behavior as the domain of accounting

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  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

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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)
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  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

3
 2. The true-income / deductive
 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

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 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.

3
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
3
 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

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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.
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Need and Importance of Accounting
Theory
 To provide a basis for prediction and explanation
of accounting behaviours and events and help to
understand current development in accounting
practice.
 Provide general frame of reference by which

accounting practice can be evaluated.

 Guide the development of new practices and

procedures

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Accounting Theory and Policy Making
 The two groups that determine accounting policy
are the government and the accounting profession.
 The government employs legislative process to

ensure minimum level information disclosed in

company’s report.
 Accounting profession as a regulatory body deals

with problems of accounting standards implied in

financial reports.

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Structure of Accounting Theory
 The structure of accounting theory serve as frame of reference that is use
to judge the extend to which a particular accounting technique of
accounting is adequate.
 Based on a set of elements and relationship that govern the development
of accounting technique.
 The five elements in the structure of an accounting theory are:
 Objectives of Financial Statement (True and fair view)
 Accounting Postulates (Assumptions)(Entity, Going Concern, Unit-of-
measure, Accounting Period)
 Accounting Concepts (A=L+OE)
 Accounting Principles (Cost, Revenue, Matching, Objectivity,
Consistency, Full Disclosure, Conservatism, Materiality)
 Accounting Techniques (specific rules derived from the accounting
principles that account for specific transactions and events faced by the
accounting entity)

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