+

CIA 3003
ACCOUNTING
THEORY AND
PRACTICE

The Scope and Role of

Accounting Theory
+
Outline
2

Introduction:

• What is accounting theory’?

• How accounting theories relate to accounting practices?

Formulation of accounting theory: Inductive vs Deductive

Development of accounting theory

• Pre-theory period
• General Scientific Period
• Normative Period
• Specific Scientific theory

Construction of accounting theory

+ 3

Introduction:
The Nature of Accounting

Accounting is not like the ‘hard’ sciences, nor is it a simple

mechanical exercise.

Accounting is viewed as a practical discipline:

There may seem to be little use for
Accounting rules are the primary focus.
theory.

However, THEORY is necessary to:

Provide a basis for decisions we make.
+ We are studying Financial Accounting 4

Theory but…
What is a THEORY?

A coherent set of A scheme or system of A theory could be based on

hypothetical, ideas or statements held numerous observations
conceptual and as an explanation or (inductive reasoning) or
pragmatic principles account of a group of developed on the basis of
forming the general facts or phenomena logic (deductive
framework of reference (The Oxford English reasoning)
for a field of inquiry Dictionary)
(Hendriksen 1970, p.1)

Based on logical Could be

Different to a (coherent) reasoning, ‘positive’ or
‘hunch’
and not ad hoc in ‘normative’
nature
+ Why is theory needed? 5

Two different ways in which theories are useful:

• provide an explanation and predict of a particular
accounting related phenomenon
• Prescribe particular approaches to accounting.

Just because there is a theory about something, it

does not mean that the theory is correct.

An important issue when learning about or using

theory (including accounting theory) is to consider
how the appropriateness of any particular theory can
be assessed.
 6
What is Accounting Theory?

provide a general
framework of reference by
Logical which accounting practice
reasoning in the can be evaluated
form of a set of
broad principles guide the development of
that: new practices and
procedures

(Hendriksen, 1970)
+ Examples of uses of accounting theories
7

n Theories might:
n prescribe how assets should be valued
n predict why managers will choose particular accounting
methods
n explain how an individual’s cultural background affects
accounting information provided
n prescribe what accounting information should be provided to
particular classes of stakeholders
n predict that the relative power of a stakeholder group will affect
the accounting information it receives
n explain or predict how accounting disclosures might be used as
part of a strategy to legitimise the operations of an organisation
+ 8

How can accounting theories

help the accounting profession?
n Without a theoretically informed understanding, it is difficult
to:
n evaluate the suitability of current accounting practices
n develop improved accounting practices, where current practices
are unsuitable for changed business circumstances
n defend the reputation of accounting when accounting practices
are blamed for causing companies to fail
n Eg: In the case of Enron, it is not that failure of accounting
information to signal financial catastrophes, but auditors
colluded with management to mislead external stakeholders
n Can be argued to support positive accounting theory, one
party was acting to maximise wealth at the expense of others.
+ 9

Accounting Theory:
Objectives & Acceptance

Main objectives of accounting The acceptance of a theory will

theory: depend on:

Explain why & Provide the How well it

how current basis for How well it is
explains and
accounting development of predicts reality constructed
practice evolved such practice

How acceptable
Suggest are the
improvements implications of
the theory

(Godfrey et al., 2010)

 10

Accounting Theory: Formulation

2 APPROACHES

Inductive: Deductive:
Specific to General to
general specific
+ Accounting Theory Formulation
11

(Inductive/ Bottom-up Approach)

• !"#$%&' ()*$#+",-(. (% Theory

"//(&.,-.0 1#"/,-/$*
#$+$"'$2 1",,$#.* (% Tentative
Hypothesis
/(.*-*,$., )$3"+-(&#
45$.2$#*(. $, "'67 899:;6
Pattern
• From specific observations to
a general conclusion.
Observation

Example:
P1: The plant and machinery account is an asset account and has a debit
balance.
P2: The motor vehicle account is an asset account and has a debit balance.
P3: The land is an asset account and has a debit balance.
Conclusion: All asset accounts have debit balance.
+ Accounting Theory Formulation
12

(Deductive/ Top-down Approach)

• !"#$%&' %'( #)*(&+,

Theory
• -$$ %)./0*', &1 $2.&+%$ ,2 ,3*
*",*', ,3%, &4 ,3* #)*0&1*1 2'
53&+3 &, &1 6%1*( %)* ,)/*7 ,3*' Hypothesis

,3* +2'+$/1&2' 5&$$ 6* ,)/*8

• Drawing specific conclusion Observation
from detailed observations and
measurements
Confirmation

Example:
Premise 1: Asset accounts have debit balance.
Premise 2: The plant & machinery account is an asset account.
Conclusion: The plant & machinery account has a debit balance
 Development of Accounting Theory 13

1400-1800 1970-present
1800-1960
Pre-theory 1960-1970 Specific
period General Scientific
Scientific Normative
No theory of Period theory
accounting was Period
devised

Positive
Pragmatic accounting
accounting
+ Early Development of Accounting Theory 14

(1920-1960)
n Relied upon induction approach.
n Development of ideas or theories through observation of ‘real
world’ phenomena/ observations.
n Based on empirical analysis (relying on real-world observations
not simply on logic).
n Theories developed from observing what accountants did in
practice (observe what actually happened).
n Common practices were codified as doctrines or conventions of
accounting.

n Example:
n It was observed that where judgements were necessary,
accountants usually underestimated revenues and
overstated expenses – resulted in hypothesis that where
judgement is needed, a conservative procedure is adopted.
n Tested by observing whether accountants do act in the way
that theory suggests.
+ 15

Example of Inductive Approach

to Theory Development
n Grady (1965) undertook research commissioned by the
American Institute of Certified Public Accountants (AICPA).
n Formed the basis of APB Statement No. 4 ‘Basic Concepts and
Accounting Principles Underlying the Financial Statements of
Business Enterprises’.
n Reflected generally accepted accounting principles (GAAP) at the
time.
n It did not seek to evaluate logic/merit of accounting practises being
used.
n Not controversial and had a high probability of bring accepted.
+ 16

Criticisms of Inductive Approach

n ‘… concentrates on the status quo, is reactionary in

attitude and cannot provide a basis upon which current
practice may be evaluated or from which future
improvements may be deduced’ (Gray, Owen &
Maunders 1987, p.66)

n Assumes what is done by the majority is the most

appropriate practice.
+ 17

Development of Accounting Theory

(1960-1970)

n There was a shift in research focus, became known as the

‘normative period’ of accounting research.
n The normative research sought to prescribe what should
happen.
n Known as normative theories (normative theories provide prescription).
n Accounting theorist attempt to establish ‘norms’ for ‘best accounting
practice’.
n The research was not driven by existing practices, and hence not
typically inductive in nature (that is, not based on observation).
n Rather, were deductive in nature (based on logical argument)
sought to develop new methods of accounting.
+ 18

Example of Normative Theory

Studies by Moonitz (1961) and Sprouse and Moonitz

(1962) commissioned by the Accounting Research
Division of the AICPA:
n Authors proposed that accounting measurement systems
be changed from historical cost to a system based on
current values
n Sought to provide improved approaches to asset valuation
in a time of widespread inflation
n Not supported by AICPA as too radically different from
current practice
+ They are based on personal
opinion about what should
happen.

Criticism of
Normative Lack of empirical observation.

Theories

Positive theorists argue that they

would prefer to provide information
about expected implications of
actions and let others decide
themselves what they should do.
+ 20

Development of Accounting Theory (mid to

late 1970s): Positive Theories

2 major development:

n Move from normative to positive accounting.

n Research began to aim at explaining and predicting accounting
practice rather than prescribing particular practices.
n Started to become popular, known as positive theories.

n Decision-usefulness orientation:
n Focuses shifted from the principles of accounting to the outcome
of the accounting process.
n Objective of Decision-Usefulness Theory of accounting: To
provide information that is useful in making investment decisions.
+ 21

Positive Theories

n Seek to predict and explain particular phenomena.

n Begin with assumption(s), and through logical deduction

enable prediction(s) to be made:
n an assumption might be that all individuals are self-interested
and are motivated by wealth maximisation.

n If predictions are sufficiently accurate when tested against

observations of reality, they are regarded as having
provided an explanation of why things are as they are.
+ 22

Developing Positive Theories

n Researchers might firstly identify a number of key

assumptions:
n for example, that individuals are driven by self-interest, that
capital markets are efficient, and so forth.

n Through logical argument, make predictions and/or provide

explanations of actual phenomena based upon assumptions
(deduction).

n Test the predictions/explanations through actual ‘real world’

observations.

n Modify the theory, if necessary, based upon the real world

observations.
+ 23

Example of a Positive Theory

n Positive Accounting Theory (by Watts and Zimmerman):

n Seeks to predict and explain why accountants elect to adopt
particular accounting methods in preference to others.
n Based on ‘rational economic person’ assumption:
n Individual is motivated by self-interest tied to wealth
maximisation.
n Challenges the view that accountants will be ‘objective’.
+ 24

Management Compensation Hypothesis:

Bonus Plan Hypothesis

n If managers’ remuneration is tied up with firm performance,

there is a higher possibility for the managers to manipulate
accounting methods/ figures to show the firm performance
is better than it should be.

n How? Inflating revenues or deflating expenses or liabilities.

n Use different depreciation method allowing lower profits at the
start and higher profits towards the end.
n Ignore any research and development costs, because it will
lower current year profits, thus affecting their income.
+ 25

Criticism of Positive Theories

n Positive accounting theories have been criticised for not

providing prescription.

n Wealth maximisation has become the answer to explain all

accounting practices and reported information.

n Relies excessively on agency theory and assumptions

about the efficiency of markets.
+ Development of Accounting Theory (1970-Present)
26

Behavioural Research Current Development

n Result from the narrow n Corporate collapses e.g. Enron
approach of positive theorists. & WorldCom has triggered
question on whether a
n Concerned the broader comprehensive theory of the
sociological implications of impact of accounting on
accounting numbers and the behaviour had been developed.
associated actions of ‘key
players’. n Increase in legislative reporting
requirements.
n e.g. The application of Theory
n Convergence of accounting
of Planned Behaviour (TPB); standards.
Technology Acceptance
Model (TAM) in accounting n Use of technology.
research.
+ 27

Evaluating Theories of Accounting

n There are many accounting theories available.
n Why or how would we select one theory in preference to another?

n Choose a theory that support the research objectives as well

as research and theoretical perspective.
n Researchers that adopt a given ‘paradigm/ perspective’ often
challenge the views of people researching from a different
paradigm.

n A ‘paradigm’ can be described as an approach to knowledge

advancement that adopts particular theoretical assumptions,
research goals and research methods (Kuhn 1962). They are
positivistic, interpretive and critical paradigm.

n Theories can coexist and complement each other.

n Positive theories can help to understand the role of accounting and
in turn can form the basis for developing normative theories to
improve the practice of accounting.
+ 28

Accounting Theory Construction

APPROACH EXPLANATION
Pragmatic • Observe the behavior of accountants/ those who use the
information provided by the accountants.

Syntactic • Logical argument, based on a set of premises.

Semantic • Concern with the way theories correspond to real-world

events.
Normative • Based on syntactic and semantic.

Positive • Test hypotheses against actual events

Naturalistic • Individual cases and do not try to generalise.

+ 29

Summary of Theories of Accounting

n Many theories of financial accounting exist.

n No universally accepted perspective about the role of

accounting theory.
n different researchers have different perspectives of the
role of accounting theory (for example, to explain and
predict practice versus prescribing particular practice).
n a researcher’s own values will influence which theory he
or she elects to embrace.
 Summary 30

Accounting theory
Formulate:
Definition:
• Deductive:
Logical reasoning in the form of
General to
a set of broad principles to
specific
provide a general framework of
• Inductive:
reference by which accounting
Specific to
practice can be evaluated &
general
guide the development of new
practices and procedures.
Objective:
Explain current accounting
practice evolved, suggest Theory Construction:
improvements & provide the 1.Pragmatic – behavior of
basis for development of such accountants & users of accounting
practice. information
2.Syntactic – rely on logical
argument based on a set of
premise.
Development of Accounting
Theory 3.Semantic – how theories
1.Pre-theory period (1400-1800) correspond to real-world events.
2.General Scientific Period (1800 4.Normative – rely both on semantic
– 1955) & syntactic approach.
5.Positive – test hypothesis against
3.Normative Period (1956 –
1970) actual events.
4.Specific scientific 6.Naturalistic – consider individual
theory/Positive Era (1970 – cases & try not to generalize.
present)
+ 31

DISCUSSION QUESTIONS
Based on the reading materials and other Internet-based resources, discuss the
following issues:

Issue 1:

nWhat do you understand from the term ‘accounting theory’?

nHow accounting theories relate to accounting practices?
nGive examples.

Issue 2:

nDifferentiate
between normative and positive approach to the development of
accounting theory.
nElaborate on the decision usefulness theory of accounting.

Issue 3:

nDiscuss on the positivistic nature of mainstream accounting research.

nExplain the role of interpretative and critical research.
+ 32

THE END

- THANK YOU -

Note: The discussion materials were prepared and compiled from various sources, including
textbooks, lecturers’ and students’ notes and Internet resources. Credits should go to all contributors
for the sake of knowledge. Sharing is caring. Let’s spread good deeds.