Topic 1 Accounting Theory

Learning Objectives
Appreciate what is meant by accounting theory and the purpose it has served over time Explain the importance of understanding accounting theories

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Key Terms
Theory Accounting theory Nature and role of accounting Descriptive, normative and positive theories Postulates, concepts and principles Conceptual framework
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Definition of Theory
What is a theory?
the coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry (Hendriksen) theories are composed of words or other symbolsthey are statements and do not have a physical form
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Why do we need theory?

To Systematically Create New Knowledge!

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Accounting Theory
logical reasoning in the form of a set of broad principles that:

provide a general framework of reference by which accounting practice can be evaluated and guide the development of new practices and procedures (Hendriksen).
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What is the Nature of Accounting?

the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of information (AAA, A statement of Basic Accounting Theory)

BAO 3309 Advanced Financial Accounting

The Measurement-Communication System (Sterling 1967)

Message c Decision f

Accountant: Metrician- Transmitter b

Receiver: Decision-Maker e

Identified Objectives: Firm Environment

Picture of the firm

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The Measurement-Communication System (Sterling 1967)

a). The accountant observes the transactions and events of the firm; b). Measures them in a way which is conducive to the preparation of a message in the form of a financial report; c). After the transactions and events have been measured, the accountant prepares a message in the form of a financial report; d). The receiver interprets the message; e). Obtains an image of the firm; f). Which is then used as the basis for decisions.
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The Measurement-Communication System (Sterling 1967)

The system involves HUMAN BEHAVIOUR Accounting practitioners - concerned with procedures largely determined by convention or authority Accounting researchers - systematic study of accounting. Development of theories.
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Function of Theories
Theories which explain (e.g. accountants do not do X because of Y) Theories which predict (e.g. cosmetic accounting policy changes will have no impact on share price) Theories which recommend/ prescribe (e.g. current cost accounting should be used to provide more useful information)
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Accounting Theory Eras

General Scientific Period (up to 1955??)
What is theories (descriptive) Based on observations Empirical analysis e.g. Choose best depreciation method based on the one that has been used the most

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Accounting Theory Eras

Prescriptive/Normative Period 1956 +
What should be (prescriptive) Norms for best practice Not necessarily based on observation e.g. the development of current value accounting systems in the late 1960s - early 1970s

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Some prescriptive theories

Decision usefulness theories
Decision makers: ask the users what they want Decision models: researcher deduces what is necessary for efficient decisions to be made

Measurement Issues and Concept of Income Conceptual framework projects

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Accounting Theory Eras

Positive Period: 1975 +
Specific scientific theory Dissatisfaction with normative theories Normally based on observation Seek to explain and predict

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Some descriptive/positive theories

capital market based research contracting theory behavioural research

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Evaluating theories
Consider logic and evidence Using all instead of some Repeated affirmation Argument by analogy only Use of emotional words False credentials Appeal to authority Change in the meaning of terms during arguments

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Recap
Nature of accounting:
The Measurement Communication System

Accounting theories
prescriptive (normative) descriptive (positive)

NOW
The Conceptual Framework (a prescriptive model) and the Measurement-Communication System
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The Measurement-Communication System (Sterling 1967)

REGULATION Message
Accountant: Metrician- Transmitter

WHO ARE THEY? Decision

Receiver: Decision-Maker

INFORMATION RELEVANT TO e USERS NEEDS?

Identified Objectives: Firm Environment

Picture of the firm

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Historically
Accounting seen as pragmatic, procedural endeavour Rules, practices and procedures developed on an ad-hoc basis usually in response to recording and reporting issues that presented themselves for resolution Repetition and general acceptance has provided support and legitimacy to the practitioners rules.
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GAAP
Think of Generally Accepted Accounting Practices:
What are some conventions? What are some doctrines? What are some principles?

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Hierarchy of the Elements of Structure of Accounting Theory

Objectives of Financial Statements
Postulates of Accounting Principles of Accounting Accounting Techniques Financial BAO 3309 Advanced
Accounting

Theoretical Concepts of Accounting

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Postulates, Concepts and Principles

Difficulty due to lack of precise terminology Each book usually contains a mixture of axioms, conventions, generalisations, methods, rules, postulates, practices, procedures, principles and standards. These terms cannot all be synonymous. Littleton
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Accounting Postulates
Entity Postulate Going Concern Postulate

Accounting Postulates Accounting Period Postulate

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Unit of Measure Postulate

Theoretical Concepts

Theoretical Concepts

Proprietary Theory

Entity Theory

Fund Theory

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Accounting Principles
Cost Revenue Recognition Matching

Accounting Principles Consistency Uniformity & Comparability Conservatism

BAO 3309 Advanced Financial Accounting

Full Disclosure

Materiality
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Criticisms of development of accounting rules

Concern that descriptive method of inferring GAAP from practices gives no guidance for dealing with unusual or different situations Piecemeal approach introduced inconsistencies Creative accounting SO due to

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 problems from a lack of a general theory permissiveness of accounting practice inconsistency of practices defense against political interference a normative method of theory development was proposed (CONCEPTUAL FRAMEWORK). It is premised on user needs driving the formulation of rules and other operational procedures for use in practice.
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What is the conceptual framework?

coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting. (FASB)
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Summary
Meaning of theory History of accounting theories Types of accounting theories Evaluating accounting theories Importance of theory in the development of accounting practices
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