Week 1 theory development and verification

kinh te tai chinh

THEORY DEVELOPMENT

AND VERIFICATION

Week 1 – ACC304

CHAPTER 1

INTRODUCTION

GODFREY HODGSON HOLMES TARCA

Overview of Accounting Theory

What is a theory?

Hendriksen’s definition:

…the coherent set of hypothetical, conceptual and

pragmatic principles forming the general framework of

reference for a field of inquiry.

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What is an accounting theory?

Hendriksen’s definition:

…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.

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Overview of Accounting Theory

Overview of Accounting Theory

Whether a theory is accepted depends on how:

 well it explains and predicts reality

 well it is constructed both theoretically and empirically

 acceptable its implications are

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Overview of Accounting Theory

 Accounting theory is a modern concept compared

to mathematics or physics

 Even Pacioli’s treatise on double-entry accounting 1495) focused on documenting practice and did not explain the underlying theoretical basis for it

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Overview of Accounting Theory

The development of accounting

theory has been mostly unstructured

Chambers:

Accounting has frequently been described as a body of

practices which have been developed in response to

practical needs rather than by deliberate and systematic

thinking.

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Overview of Accounting Theory

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Was developed to resolve problems as they arose – reactive

Ad hoc approach

Led to inconsistencies in practice

 e.g different depreciation methods

Accounting standard setting

 Conceptual framework projects have not resolved inconsistency in practice

Pre-theory (1400s – 1800)

Goldberg:

No theory of accounting was devised from the time of

Pacioli down to the opening of the nineteenth century.

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Pragmatic accounting (1800– 1955)

The ‘general scientific period’

 based on empirical observation of practice

 provided an explanation of accounting practice

 focused on the existing ‘viewpoint’ of accounting

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Normative accounting (1956-1970)

Sought to establish ‘norms’ for the best accounting

practice

Focused onwhat should be (the ideal) v what is

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Normative accounting (1956-1970)

Degenerated into battles between competing viewpoints on measuring and reporting accounting information

Two groups dominated:

 conceptual framework proponents

 critics of historical cost

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Normative accounting (1956-1970)

Factors prompting the demise of the normative

period include:

 the unlikelihood of one particular normative theory

being generally accepted

 the application of financial economic principles

 the availability of empirical data and new testing

methods

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Normative accounting (1956-1970)

The major criticisms of normative theories were:

 they do not necessarily involve empirical hypothesis testing

 they are based on value judgements

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Positive accounting(1950 to the present

day)

A shift to a new form of empiricism called ‘positive

theory’

Had its origins in the ‘general scientific period’

It seeks to explain the accounting practices being

observed

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Positive accounting (1950 to the present day)

Its objective is to explain and predict accounting practice

e.g the bonus plan hypothesis

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Positive accounting (1950 to the

present day)

It helps predict the reactions of ‘players’, such as

shareholders, to the actions of managers and to

reported accounting information

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Positive accounting (1950 to the present day)

Major deficiencies are:

 ‘wealth maximisation’ has become the answer to explain all accounting practices and reported information

 it relies excessively on agency theory and dubious assumptions about the efficiency of markets

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Positive accounting(1950 to the present

day)

Behavioural research:

 concerned with the sociological implications of

accounting numbers and the associated actions of ‘key

players’

 emerged in the 1950s

 despite growing acceptance since the 1980s, positive

accounting theory still dominates

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Recent developments

Academic and professional developments in accounting theory have tended to take different approaches

Academic research focuses on capital markets, agency theory and behavioural aspects

The profession has sought a more normative approach – what accounting practices should be adopted

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Recent developments

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Recent developments

Conceptual framework – resurrected in 1980s

 states the nature and purpose of financial reporting

 Establishes criteria for deciding between alternative accounting practices

 SACs 1–4

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Recent developments

Conceptual framework – Recent Developments

 Joint project between IASB & FASB

 International harmonisation of accounting practices

through a single consistent set of international financial

reporting standards (IFRS)

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Recent developments

The conceptual framework underpinning the IFRS favours a move toward

 accounting practices that provide information for enhancing decision making by investors and others

 recognising all gains and losses in the accounting periods in which they occur

 measurement using exit values

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Content outline

Part 1: Accounting theory (chapters 1 – 3)

Part 2: Theory contributing to practice (chapters 4 –

10)

Part 3: Accounting and research (chapters 11 – 14)

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Summary

Accounting theory

Major periods of accounting theory development

Normative accounting

Positive accounting

Conceptual framework

IFRS

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Key terms and concepts

Theory

Accounting theory

Normative theory

Positive theory

Behavioural theory

Conceptual framework

IFRS

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CHAPTER 2

ACCOUNTING THEORY CONSTRUCTION

GODFREY HODGSON HOLMES TARCA

Pragmatic theories

Descriptive pragmatic approach:

based on observed behaviour of accountants

theory developed from how accountants act in

certain situations

tested by observing whether accountants do act

in the way the theory suggests

is an inductive approach

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Pragmatic theories

Criticisms of descriptive pragmatic approach:

 does not consider the quality of an accountant’s action

 does not provide for accounting practices to be challenged

 focuses on accountants’ behaviour not on measuring the attributes of the firm (assets, liabilities, profit)

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Pragmatic theories

Psychological pragmatic approach:

theory depends on observations of the reactions

of users to the accountants’ outputs

a reaction is taken as evidence that the outputs

are useful and contain relevant information

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Pragmatic theories

Criticisms of the psychological pragmatic approach:

 some users may react in an illogical manner

 some users might have a preconditioned response

 some users may not react when they should

Theories are therefore tested using large samples

of people

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Examples of pragmatic theories

(i) an historical record-keeping activity (pragmatic or

syntactic theory)

(ii) political theories (pragmatic theories)

(iii) communication — decision making (pragmatic,

syntactic and semantic theories)

(iv) accounting as an economic good (pragmatic)

(v) accounting as magic or mythology (pragmatic)

(vi) accounting as a social commodity to exploit or aid

policies or as a social club for accountants (pragmatic)

 historical record-keeping activity Example: firms use accounting principles to keep a record of their transactions so that they can advise how resources have been used

 a language Example: financial statements are used by management

to communicate to shareholders how well they have performed in running the business

 political theories Example: management use accounting reports to allocate resources among different divisions within the firm, or different levels of employees

 magic or mythology

Example: Enron management used accounting techniques to

hide the losses it suffered from transactions with its special

purpose entities.

 communication — decision making

Example: a local bank decided to give loans to a small

business after analysing the business’ financial position.

 an economic good

Example: there are costs involved in producing financial

a social commodity Example: government uses accounting numbers (such

as profits or research expenditure) to decide whether to give grants to particular firms

ideology and exploitation Example: firms cut down jobs in their unprofitable divisions

Syntactic theories

Semantic inputs are the transactions and exchanges

recorded in vouchers, journals and ledgers

The inputs are then manipulated on the basis of the

premises and assumptions of historical cost accounting

But there are no pragmatic test (how people them),

or what they mean (semantic test)

Eg: the theory of double-entry and historical costs

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Syntactic theories

Criticised because there is no independent empirical verification of the calculated outputs (profits, total assets)

The outputs may be criticised for poor syntax inaccurate e.g different types of monetary measures are added together

 Adding up value of a machine owned 20 years ago and value of a machine purchased yesterday

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Disadvantages of Syntactic theories

The truth value of any proposition is ascertained by

logic or reasoning alone

 If the underlying accepted premises of the logic have

no reference to the real world or are false, then the

conclusions have either no pragmatic usefulness or the

conclusion is incorrect.

Syntactics alone are only concerned with the

derivation of statements from other given

statements

Disadvantages of Syntactic theories

all manipulations are correct as long as the rules of mathematical bookkeeping are applied

there are many acceptable sets of ‘equations’

no semantic verification — not descriptive of real world objects or events

The outputs may be syntactically accurate but nevertheless be valueless due to a lack of semantic accuracy (a lack of correspondence with real-world events, transactions or values)

Syntactic theories

Historic cost accounting may produce ‘accurate’

outputs but which nevertheless have little or no

utility

That is, they are not useful for economic decision

making except to verify accounting entries

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Semantic theories

connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic

measurement theories:

 Eg measuring the effects of inflation on assets and liabilities and adjusting the accounts to reflect these adjustments  accounts then have semantic content

Argument: the purpose of undertaking accounting

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

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Financial statements should mean what they say

Normative theories

True income:

 a single measure for assets

 a unique and correct profit figure

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Normative theories

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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Normative theories

The decision process

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Accounting system of company X

Accounting system of company X

Prediction model of user

Prediction model of user

Decision model of user

Decision model of user

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

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Positive theories

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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Which one is positive or normative?

 (a) Historical cost accounting should be

replaced by a market value system

 (b) Historical cost accounting provides

information used by creditors

 (c) Historical cost accounting is used by many

managers to allocate costs in determining divisional

performance

Different perspectives

Scientific approach:

 has an inherent assumption that the world to be researched is an objective reality

 is carried out by incremental hypotheses

 has an implied assumption that a good theory holds under circumstances that are constant across firms, industries and time

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Procedures of Scientific approach:

Start with prior knowledge or theory constructions

Observe real world behaviour

Does not concur: a research problem to be explained

Develop a theory to explain the behaviour and develop

testable hypotheses

Follow structured procedures for data collection and

analysis

Validate the hypotheses

Make conclusions about theory

Different perspectives

Criticism of the scientific method:

 large-scale statistical research tends to lump everything together

 it is conducted in environments that are often remote from the world of or the concerns of accountants

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Different perspectives

Naturalistic approach:

 implies that there are no preconceived assumptions or

theories

 focuses on firm-specific real-world problems

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Different perspectives

Alternative ways of looking at the world:

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CATEGORY ASSUMPTION

1 Reality as a concrete structure

2 Reality as a concrete process

3 Reality as a contextual field of information

4 Reality as a symbolic discourse

5 Reality as a social construction

CATEGORY ASSUMPTION

1 Reality as a concrete structure

2 Reality as a concrete process

3 Reality as a contextual field of information

4 Reality as a symbolic discourse

5 Reality as a social construction

Different perspectives

For categories 1 – 3 it is more appropriate to use

the scientific approach

For categories 4-6 the naturalistic approach is more

appropriate

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Different perspectives

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Scientific approach applied to accounting

Misconceptions of purpose

Make scientists out of accounting practitioners

Researchers = practitioners

The desire for ‘absolute truth’

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Scientific approach applied to accounting

The scientific method does not claim to provide

‘truth’

It attempts to provide persuasive evidence which may describe, explain or predict

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Issues for auditing theory construction

Auditing is a verification process that is applied to

the accounting inputs and processes

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Issues for auditing theory construction

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Auditors provide an opinion on

 whether the financial statements accord with the applicable reporting framework

 whether the statements give a true and fair view

Issues for auditing theoryconstruction

The normative era of accounting coincided with a

normative approach to auditing theory

The positive era of accounting has led to a positive

approach to auditing theory

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Summary

 Many different approaches to theory formulation

in accounting

 Evolution of accounting theory

 positive v normative

 scientific v naturalistic

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Exercises

What type of theories can resolve the following issues?

(a) the behaviour of investors to the release of

accounting data

(b) the reaction of all stock prices to the release of

accounting data and why

(c) the reaction of employees in one particular firm to

the release of accounting data

(d) all accounting reports should be adjusted by

inflation before they are released

(e) what type of accounting do firms in one particular

industry use for inventory before they release their

accounting reports

Key terms and concepts

 Descriptive pragmatic approach

 Psychological pragmatic approach

 Syntactic and semantic theories

 Historical cost accounting

 Normative theories

 Positive theories

 Scientific approach to theory

 Naturalistic approach to theory

 Auditing theory

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Positive theory: historical cost

 Premises are determined by observing the practice of accountants.

 Criticisms: no logical analysis of accountants’ actions, does not allow

change, does not focus on measurement, circularity of logic in the

rules, outputs not verified, doublethink, conventions not subject to

falsification.

 Also pragmatic positive as it is observable and descriptive of the

behaviour of accountants over a number of centuries.

 Provides a system of allocating costs over different reporting

periods (accrual accounting) A point of logical contention, however,

is whether the allocation of costs is truly systematic (in a deductive

sense), because a number of the ways in which the costs are