Chapter 1
Introduction to
financial
accounting theory
Learning Objectives
In this chapter you will:
– Appreciate how knowledge of different financial accounting
theories increases our ability to understand and evaluate various
alternative financial accounting practices.
– Understand that there are many theories of financial accounting.
– Understand that the different theories of financial accounting are
often developed to perform different functions, such as to
describe accounting practice, or to prescribe particular
accounting practices.
– Understand that theories, including theories of accounting, are
developed as a result of applying various value judgements and
that acceptance of one theory, in preference to others, will in
part be tied to one’s own value judgements.
– Be aware that we should critically evaluate theories before
accepting them.
– Understand why students of accounting should study accounting
theories as part of their broader accounting education.
What is a theory?
• ‘a scheme or system of ideas or statements held as an
explanation or account of a group of facts or phenomena’
(Oxford English Dictionary)
• Accounting theory is ‘a coherent set of hypothetical,
conceptual and pragmatic principles forming the general
framework of reference for a field of inquiry’ (Hendriksen
1970, p. 1)
– based on logical (coherent) reasoning
Examples of uses of accounting theories
• Theories might:
– prescribe how assets should be valued
– predict why managers will choose particular accounting
methods
– explain how an individual’s cultural background affects
accounting information provided
– prescribe what accounting information should be provided
to particular classes of stakeholders
– predict that the relative power of a stakeholder group will
affect the accounting information it receives
– predict that accounting information is used to present
organisations as legitimate
Why study accounting theories?
• Essentially, to improve understanding of accounting
practice.
• Learning the rules of financial accounting without
considering the implications of accounting information
not recommended.
• In the wake of the sub-prime banking crisis of 2007-
2009, where it has been claimed that the financial
accounts of several financial institutions did not
communicate the underlying financial assets, liabilities
and risks.
Early development of accounting theory
• Inductive approach:
• Relied upon the process of induction
– development of ideas or theories through
observation
• 1920s to 1960s theories developed from
observing what accountants did in practice
– codified as doctrines or conventions of accounting
like historical cost and conservatism
Criticisms of inductive method
• reactionary in attitude for the current practice
• assumes what is done by the majority is the
most appropriate practice
• No improvement of the current practice is
suggested
Theory development - 1960s and 1970s
• Prescriptive approach:
• Sought to prescribe particular accounting
practices
– known as normative theories
• Theories were based on arguments about what
accountants should do – deductive reasoning.
• Not driven by existing practices
• Not developed by observing what accountants
were doing
Example of prescriptive (normative) theory
• 1961 and 1962 studies by Moonitz, and Sprouse
and Moonitz commissioned by the Accounting
Research Division of the AICPA
• Authors proposed that accounting measurement
systems be changed from historical cost to a
system based on current values
• Not supported by AICPA as too radically different
from current practice
Normative theories
• based on what the researcher believes should
occur in particular circumstances
– not based upon observation
• example of normative theory:
– Conceptual Framework
• should not be evaluated on whether they
reflect actual accounting practice
Classifications of normative theories
• true income theories
– make assumptions about the role of accounting
then seek to provide a single ‘best measure’ of
profits
• decision usefulness theories
– ascribe a particular type of information for
particular classes of users on the basis of assumed
decision making needs
Decision usefulness theories
• decision-makers emphasis
– undertaking research that seeks to ask decision-
makers what information they want
– knowledge then used to make prescriptions
about what information should be supplied
• decision-models emphasis
– develops models based upon the researchers’
perceptions about what is necessary for efficient
decision making
Theory development - mid to late 1970s
• Predictive approach:
• Research aimed at explaining and
predicting accounting practice rather
than prescribing particular practices are.
• known as positive theories.
Positive theories
• Seek to predict and explain particular phenomena
• Process: 1-put an assumption(s), 2- make observations of
the practice and 3- explanation (accept or reject the
assumption)
• Positive Accounting Theory
– developed by Watts and Zimmerman
– seeks to predict and explain why managers or accountants elect
to adopt particular accounting methods in preference to others
– based upon ‘rational economic person’ assumption
• individuals motivated by self-interest tied to wealth maximisation
Criticisms
Normative Accounting Theory Positive Accounting Theory
• based on personal opinion • Does not prescribe what
about what should happen should be done in the
• Is not provided base on the practice
practice • Makes a gap between
• Does not provide prediction academics and
• Lack of empirical evidence professionals of
Accountancy
• Assumes self interest is the
driver of persons’ behaviour
Evaluating theories – logic and evidence
• when evaluating theories consider:
– whether the argument supporting the theory is
logical
– whether you agree with the central assumptions
of the theory
– whether you accept any supporting evidence
provided
Evaluating theories
• Evaluating Logical Deduction
• Evaluating Underlying Assumption
Logical deduction
• acceptance of an argument must be based
upon the accuracy of the premises
– an argument is logical to the extent that if the
premises on which it is based are true, then the
conclusion will be true
• to determine the logic of an argument we do
not need to refer to ‘real world’ observations
Evaluating underlying assumptions
• even though an argument is logical, we might
only accept the argument if we accept any
critical assumptions being made
– if we reject any central assumptions we may reject the prediction
• Example:
– if manager X get paid bonus base on accounting profit.
– Method Y is an accounting method which increases the accounting
profit
– Then the Accepted ASSUMPTION is: Manager X should use method Y
Universal Applicability of theory
• We cannot apply theory on all cases
• However, theory should be applied on the
majority of cases and this called ‘the general
trend’ of the theory
