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Accounting Theory Approach

THE NATURE OF ACCOUNTING THEORY

APPROACH

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The primary objective of accounting theory is to provide a basis for the prediction and explanation of accounting behavior and events.

No single comprehensive theory of accounting exists at present.

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theory defined as:-

“a set of inter-related constructs (concept), definitions andpropositions (suggestions) that present a systematic view ofphenomena by specifying relations among variables with thepurpose of explaining and predicting phenomena”.

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The General Acceptance of Accounting Principles (GAAP) guide the acctg profession to choose acctg techniques and prepare FS considered to be good acctg practice.

The GAAP are subjected to the reexamination & critical analysis with regards to the changes in environments, values and information needs.

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Changes in principles may occur as a result of providing solutions to emerging accounting problem and formulating a theoretical framework.

Provide a rationale for what accountants do or expect to be doing.

The process of theory construction should be completed by theory of verification or validation.

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Machlup (1955) defined the process:…

The statement implies that the theory should be subject to a logical or empirical testing to verify its accuracy.

If the theory is mathematically based, the verification should be predicted based on logical consistency.

If the theory is based on the physical and social phenomena, the verification based on the deduced events & observations in the real world.

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Therefore, acctg theory should result from both process of theory construction and verification.

A given theory should explain and predict the acctg phenomena.

If a given theory is unable to produce the expected results, it is replace by a better theory.

1 The Traditional Approach

2 The Regulatory Approach

3 The Positive Approach

4 The Behavioral Approach

5 The Paradigm Approach

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APPROACH IN ACCOUNTING THEORY

Traditional approaches to accounting

theory

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1. Non-theoretical, practical or pragmatic (informal)

2. Theoretical:

a. Deductive approach

b. Inductive approach

c. Ethical approach

d. Sociological approach

e. Economic approach

1. Non-theoretical approaches (P&A)

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The pragmatic approach:

consists of the construction of a theory that conforms to real-world practices and suggests practical solutions

Means “that property which fits something to serve or facilitate its intended purposes”

“usefulness to users & relevance for decision making”

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The authoritarian approach:

The formulation of AT, which is employ primarily by professional organization, consists of issuing pronouncements for the regulation of accounting practices

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Both approach assume AT (pragmatic & authoritarian) & the resulting technique must be predicted on the basis ultimate use of financial reports, if accounting is to have useful function.

A theory without practical consequence is a bad theory.

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However; The approaches have been largely unsuccessful in reaching

satisfactory conclusions in their attempt to construct an AT.

For example; balance sheet approach & profit-oriented; pragmatic & authoritarian approach absence on theoretical foundation.

2. The Deductive Approach

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Constructions of AT theory begins with basic propositions & proceeds to derive logical conclusions about the subject under considerations.

Move from general to particular

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Steps used to derive the deductive approach1. Specifying the objectives of financial statements2. Selecting the ‘postulates’ of accounting3. Deriving the ‘principles’ of accounting4. Developing the ‘techniques’ of accounting

3. The Inductive Approach

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The construction of theory begins with observations & measurements & moves toward generalized conclusions.

Lead to Positive approach

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Involved four stages, i.e. :-1. Recording all observations2. Analysing and classifying these observations to

detect recurring relationships3. Inductive derivation of generalisations and

principles of accounting from observations that depict recurring relationships

4. Testing the generalisations

Comparing deductive and inductive

approaches

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In the inductive approach, the truth or falsity of the propositions does not depend on other propositions, but must be empirically verified

In the inductive approach the truth of the propositions depends on the observation of sufficient instances of recurring relationships

Accounting propositions that result from inductive inference imply special accounting techniques only with high probability

Accounting propositions that result from deductive inference lead, on the other hand, to specific accounting techniques with certainty (confidence)

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Note; The general proposition formulated through inductive process

Principles & technique from deductive process

e.g.; Paton (deductive theorist) & Littleton (Inductive theorist)

4. The Ethical Approach

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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 misreprsentation

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For example: The committee on auditing procedures refers to concept of

‘fairness of presentation’ as:

1. conformity with GAAP

2. disclosure

3. consistency

4. comparability

5. The Sociological Approach

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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

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Evolution to new accounting sub discipline, socioeconomic accounting

The main obj encourage business to account their impact on business activities on social environment through measurement, internalization, & disclosure in their FS.

Probably play a major role in future formulation of AT.

6. The Economic Approach

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Emphasizes controlling the behavior ofmacroeconomic indicators that result from theadoption of various accounting techniques

The choice of different accounting techniquesdepends on their impact on the national economicgood

Accounting policies and techniques should reflect‘economic reality’, and the choice of accountingtechniques should depend on ‘economicconsequences’

e.g. LIFO method during continuing inflationperiod

The Eclectic (combination) Approach to the Formulation of

Accounting Theory

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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.

Continue to second approach……..

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The Regulatory Approach

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Acctg standards dominate accountant’s work.

Standards are being constantly changed, deleted and/or added.

They provide practical & handy rules for the conduct of the accountant’s work.

They generally accepted as firm rules, backed by sanction for nonconformity.

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Accounting standards usually consist of three parts:1. a description of the problem to be tackled

2. a reasoned discussion on ways of solving the problem, then,

3. in line with the decision or theory, the prescribed solution

Why Examine Theories of Regulation

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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 to Explain Regulation

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Public interest theory

Capture theory

Economic interest group theory (private interest theory)

To be continue……………………

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1.Public Interest Theory

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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

Criticisms of Public Interest Theory

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Critics question assumptions that economic markets operate inefficiently if unregulated

question the assumption that regulation is virtually costless

others question assumption of government neutrality

argue that government will only legislate and groups will only lobby for regulation if it will increase their own wealth

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The regulated seeks to take charge (capture) the regulator

seek to ensure rules subsequently released are advantageous to the parties subject to regulation

although regulating initially in the public interest, difficult for regulator to remain independent

2. Capture of Accounting Standard-

Setting

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Walker (1987) analysed capture of Australian standard-setting through the ASRB. Argued that: the accounting profession lobbied before the board

established to ensure no independent research capability, no academic as chair, to receive admin officer not a research director

priorities only set after consultation with AARF ASRB fast-tracked AARF submissions but not others majority of board membership were members of the

accounting profession

Criticisms of Capture Theory

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No reason to suggest that regulated industry the only interest group able to influence the regulator

No reason why regulated industries only able to capture existing agencies rather than procure the creation of an agency

No reason why regulated couldn’t prevent creation of the regulatory agency

3. Economic Interest Group Theory

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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

Economic Interest Group Theory –

cont….

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The regulator is not a neutral arbiter but is seen as an interest group itself

regulator motivated to ensure re-election or maintenance of its position of power

regulation serves the private interests of politically effective groups

those groups with insufficient power will not be able to effectively lobby for regulation to protect its own interests

Examples - Application to Accounting Standard-

setting

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Industry groups may lobby to accept or reject a particular accounting standard

eg. insurance oil & gas industry

large politically sensitive firms found to lobby in favour of general price level accounting in US (led to reduced profits)

accounting firms lobbying to protect their own interests

Accounting Regulation as an output

of a Political Process

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The view that financial accounting should be objective, neutral and apolitical can be challenged

will inevitably be political as it affects wealth distribution within society

standard-setters encourage affected parties to make submissions on drafts of proposed standards

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If standard-setters give consideration to views in submissions, accounting standards and therefore financial reports are the result of various social and environmental considerations

tied to the values, norms and expectations of the society in which standards are developed

questionable whether financial accounting can claim to be neutral and objective

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Compliance with accounting standards usually seen to indicate financial statements are ‘true and fair’ ??? can accounts based upon standards determined from various

economic and social consequences be deemed to be ‘true’?

Users may not be aware that financial reports are the outcome of various political pressures

should regulators consider preparers’ views given that standards are designed to limit what preparers do?

Influence of the Accounting Profession on

Standards

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Standards that do not have support from accountants and/or the business community could result in:

1. lobbying by particular interest groups2. non-compliance3. refusal of companies to contribute to or participate in the standard-setting

process4. threat of governmental regulatory intervention

It is in the AARF’s best interests to issue standards that are accepted by the business community and the accounting profession

Private-sector Regulation of Accounting

Standards

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Advantages

The AASB is responsive to various constituents

The AASB attracts as members people who possess the necessary technical knowledge to develop and implement alternative measurement and disclosure systems

The AASB is successful in generating a reasonable amount of response from its constituency base and in responding to this input

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Disadvantages

The AASB lacks statutory authority and faces the challenge of being overridden by government

The AASB has been accused of lacking independence from dominating interests, such as the accounting profession

The AASB has often been accused of responding too slowly to major issues that are of crucial importance to some of its constituents

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Arguments in favour:

The ASIC acts as ‘creative irritant’ and as a catalyst for change, since the private sector and market forces do not provide the leadership necessary to effect such change

The structure of securities regulation established by the 1991 Corporations Law serves to protect investors against perceived abuses

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The ASIC is motivated by the desire to create a level of public disclosure deemed necessary and adequate for decision making

Unlike the AASB, the ASIC is secured greater legitimacy through its statutory authority

Private-sector objectives may sometimes contradict the public interest.

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Arguments against: There is a high corporate cost for compliance with

government regulation of information Bureaucrats have a tendency to maximise the total budget of

their bureau There is the danger that standard setting may become

increasingly politicised Government regulation backed by police power may hinder

the conduct of research and experimentation of accounting policy and is not essential to achieving standardisation of measurement

Accounting Standards Overload

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Too many standards Too detailed standards No rigid standards, making selective application difficult General-purpose standards fail to provide for differences in preparers’,

users’ and CPA’s needs General-purpose standards fail to provide for differences between:

public and non-public entities annual and interim financial statements large and small enterprises credited and non-audited financial statements

Excessive disclosures and/or complex measurements

Effects of Accounting Standards

Overload

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Accountants may lose sight of their real jobs because of the excessive data required to comply with standards

Audit failures may result because the accountant may forget to perform basic audit procedures

The proliferation of complex accounting regulations may lead to non-compliance

Solutions to the Standards Overload

Problem

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The AICAP Special Committee on Accounting Standards evaluated the following possible approaches:• no change• a change from the present concept of a set of unitary GAAP

for all businesses, to two sets of GAAP• change GAAP to simplify application to all business

enterprises• establish differential disclosure and measurement alternatives

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• a change in CPAs’ standards for reporting on financial statements

• an alternative to the GAAP as an optional basis for presenting financial statements

The Positive Approach

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The subject matter of positive approach is: existing accounting practices management’s attitudes towards those practices

Proponents of the positive approach argue that the techniques can be derived from and justified on the basis of their tested use, or that management plays a central role in determining the techniques to be implemented

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• Basic subject matter:– information is an economic commodity– acquisition of information amounts to a problem of economic

choice

• Accounting information is evaluated in terms of its ability to improve the quality of the optimal choice in a basic-choice problem that must be resolved by an individual

• The information system with the highest expected utility is preferred

Positive theory of accounting

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The positive theory of accounting is based on the propositions that managers, shareholders and regulators/politicians are rational and attempt to maximize their utility

Their choice of accounting policy rests on comparing the relative costs and benefits of alternative accounting procedures so as to maximize their utility

We move to third approach……..PAT

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The central ideal of the positive

approach

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1. To enhance the reliability of prediction, based on the observed smoothed series of accounting numbers along a trend considered best or normal by management

2. To reduce the uncertainty resulting from the fluctuations of income numbers in general and the reduction of systematic risk in particular by reducing the covariance of the firm’s returns with market returns

The central problem in positive

theories

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• The central problem is to determine how accounting procedures affect cash flows, and therefore management’s utility

• Theoretical assumptions guiding resolution of the problem are:– the agency theory evolves to a view of the firm as a ‘nexus of

contracts’

– given this ‘nexus of contracts’ perspective, the role of accounting information is to monitor and enforce these contracts to reduce the agency costs of certain conflicts of interest

The agency problem (dominant theory in positive

approach)

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The basic agency problem is enriched by different options concerning:

1. the initial distribution of information and beliefs2. the description of the number of periods3. the description of the firm’s production function in terms

of: amount of capital supplied by the principal agent’s level of effort an exogenously determined, uncertain-state realisation

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4. the description of the feasible set of actions from which the agent chooses

5. the description of the labour and capital markets6. the description of the feasible set of information

systems7. the description of the legal system that specifies the

type of behavior that can be legally enforced, and what is admissible evidence

8. the description of the feasible set of payment systems

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9. the description of the solution to the basic agency model

10. the role of self-interest

11. the solution concept and the nature of optimality

Income smoothing

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Propositions on income smoothing1. The criterion a corporate management uses to select

among accounting principles is the maximisation of its utility or welfare

2. The utility (effectiveness) of management increases with: job security the level and rate of growth in management’s

income the level and rate of growth in the corporation’s size

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3. The achievement of the management goals stated in proposition to depends in part on the stockholders’ satisfaction with the corporation’s performance

4. Stockholders’ satisfaction increases with the average rate of growth in the corporation’s income

Gordon’s Theorem

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Given that Gordon’s four propositions are true, management would within the limits of its power:

1. Smooth (persuasive) reported income

2. smooth the rate of growth in income

Motivations for smoothing

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According to Heyworth, motivations for smoothing include improvements of relations with creditors, investors and workers, as well as dampening of business cycles through psychological processes

Beidelman’s two motivating reasons:1. a stable earnings stream is capable of supporting a higher

level of dividends, having a favourable effect on the value of the firm’s shares

2. smoothing counters the cyclical nature of reported earnings and reduces the correlation of a firm’s expected returns with returns on the market portfolio

Constraints leading to smoothing

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Three constraints are presumed to lead managers to smooth:

1. the competitive market mechanisms, which reduce options available to management

2. the management compensation scheme, which is linked directly to the firm’s performance

3. the threat of management displacement

Dimensions of smoothing

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Barnea and others distinguished between three dimensions:

1. smoothing through events’ occurrence and/or recognition

2. smoothing through allocation over time

3. smoothing through classification

The accounting choice

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The accounting choice rests on variables that represent management’s incentives to choose accounting methods under bonus plans, debt contracts and the political process

There are three hypotheses:1. The bonus plan hypothesis maintains that managers of

firms with bonus plans are more likely to use accounting methods that increase current-period reported income

The accounting choice (cont’d)

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2. The debt/equity hypothesis maintains that the higher the firm’s debt/equity, the more likely managers are to use accounting methods that increase income

3. The political cost hypothesis maintains that large firms rather than small firms are more likely to use accounting choices that reduce reported profits

We have finished

1. Non theoretical approach

2. Regulatory Approach

3. Positive Accounting Theory

4. ………………………………

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The Behavioural Approach

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Most traditional approaches accounting theory construction have failed to consider user behavior in particular and behavioral assumptions in general

The behavioral approach to accounting theory formulation emphasizes the relevance to decision-making of the information being communicated, and of the individual and group behavior caused by the information being communicated

The behavioral approach to accounting theory formulation is concerned with human behavior as it relates to accounting information and problems

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A new multidisciplinary area in the field of accounting has been conveniently labeled ‘behavioral accounting’

The basic objective of behavioral accounting is to explain and predict behavior in all possible accounting contexts

Behavioural effects of accounting

information

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A more recent and exhaustive attempt by Dyckman, Gibbins and Swieringa illustrates the nature of studies of the behavioral effects of accounting information

We may divide these studies into five general classes:1. adequacy of disclosure2. usefulness of financial statement data3. attitudes about corporate reporting practices4. materiality judgements5. linguistic effects of alternative accounting procedures

(1) Adequacy of disclosure

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Three approaches were used to examine the adequacy of disclosure:

1. the first examined the patterns of use of data from the viewpoint of resolving controversial issues concerning the inclusion of certain information

2. the second examined the perceptions and attitudes of different interest groups

3. the third examined the extent to which different information items were disclosed in annual reports and the determinants of any significant differences in the adequacy of financial disclosure among companies

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The research on disclosure adequacy and use showed: general acceptance of the adequacy among financial statements

recognition that the differences in disclosure adequacy among financial statements are due to such variables as company size, profitability, and size and listing status of the auditing firm

(2) The usefulness of financial statement data

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Two approaches were used to examine the usefulness of financial statement data:

1. the first examined the relative importance of the investment analysis of different information items to both users and preparers of financial information

2. the second examined the relevance of financial statements to decision-making, based on laboratory communication of financial statement data in terms of readability and meaning to users in general

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The overall conclusions of these studies were that: some consensus (agreement) exists between users and

preparers regarding the relative importance of the information items disclosed in financial statements

users do not rely solely on financial statements when making their decisions

(3) Attitudes about corporate reporting

practices

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Two approaches were used to examine attitudes about corporate reporting practices:

1. the first examined preferences for alternative accounting techniques

2. the second examined attitudes about general reporting issues, such as how much information should be available, how much information is available, and the importance of certain items

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These research items showed the extent to which some accounting techniques proposed by the authoritative bodies are accepted, and also brought to light some attitude (stance) differences among professional groups concerning reporting issues

(4) Materiality judgments

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Two approaches were used to examine materiality judgments1. the first examined the main factors determining the

collection, classification and summarisation of accounting data

2. the second focused on what items people consider to be material, and sought to determine the degree of difference in accounting data that is required before the difference is perceived as material

These studies indicated that several factors appear to affect materiality judgements, and that these judgements differ among individuals

(5) Linguistic effects of accounting data

and techniques

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Linguistics and accounting have many similarities

Belkaoui argues that accounting is a language and that according to the Sapir-Whorf hypothesis its lexical (relating to words) characteristics and grammatical rules will affect both the linguistic and the non-linguistic behavior of users

Linguistic effects of accounting data and techniques

(cont’d)

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Four propositions derived from the linguistic relativity paradigm to conceptually integrate the research findings of the impact of accounting information on the user’s behavior, are as follows:

1. users who make certain lexical (relating to word) distinctions in accounting are enabled to talk and/or solve problems that cannot be solved by users who do not

2. users who make certain lexical distinctions in accounting are enabled to perform tasks more rapidly or more completely than those who do not

Linguistic effects of accounting data and techniques (cont’d)

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3. users who possess the accounting (grammatical) rules are more predisposed (liable) to different managerial styles or emphases than those who do not.

4. accounting techniques may tend to facilitate or render more difficult various managerial behaviors on the part of users.

Reasons for cross-cultural research

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Cross-cultural research is needed in accounting for the following five reasons:1. it would establish the boundary conditions for

accounting models and theories

2. it would enable evaluation of the impact of cultural and ecological factors on behaviour in accounting

Reasons for cross-cultural research (cont’d)

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3. although variables are often generally confounded (confuse), the confounding is not complete, as a few ‘culturist’ may present deviant (abnormal) cases

4. cultures act as ‘natural grain-experiments’ by being high or low on variables of particular interest

5. cultures determine aspects of psychological functioning

Last…….combined any 1 to 4……

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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 subsumes, defines, & interrelates the exemplars, theories, methods, & instruments that exists within it.

The value of the predication of a theory to users influences its uses, it does not solely determined the success

Because cost of errors & the implementing vary, several theories about the phenomena can exist simultaneously for predictive purposes.

However, only one will generally accepted by theorist.

In accepting one theory over another, theorist will be influenced by the intuitive appeal of the theory’s explanation for the phenomena & the range of phenomena it can explain & predict as well as by the usefulness of the predictions to users.

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

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)

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

2. The true-income / deductive paradigm

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

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.

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

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 accountingII. Cultural relativism in accountingIII. Behavioral effect of accounting informationIV. Linguistic relativism in accounting

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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Conclusion

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As a conclusion; No single governing theory of acctg is rich enough to

encompass the full range of user-environment specificationseffectively;

Their existence in accounting literature not a theory ofaccounting but collections of theories which can be arrayover the differences in user environment specification.

To test the theory, according to Propper;

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1. Internal consistency

2. Logical form (empirical or scientific theory)

3. Survive of various test

4. Demands from practice

No necessarily adopt the same steps; theorists ???

END OF CHAPTER ONE

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