GODFREYHODGSON

HOLMESTARCA

CHAPTER 1 INTRODUCTION

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.

2

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.

3

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

4

Overview of Accounting Theory

• Accounting theory is a modern concept compared to mathematics or physics

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

5

Overview of Accounting Theory

The development of accountingtheory 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.

6

Overview of Accounting Theory

7

• 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.

8

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

9

Normative accounting (1956-1970)

• Sought to establish ‘norms’ for the best accounting practice

• Focused on what should be (the ideal) v. what is

10

Normative accounting (1956-1970)

• Degenerated into battles between competing viewpoints

• Two groups dominated:– conceptual framework proponents– critics of historical cost

11

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

12

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

13

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

14

Positive accounting (1950 to the present day)

• Its objective is to explain and predict accounting practice

e.g. the bonus plan hypothesis

15

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

16

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

17

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

18

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

19

Recent developments

20

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

21

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)

22

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

23

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)

24

Summary

• Accounting theory• Major periods of accounting theory

development• Normative accounting• Positive accounting• Conceptual framework• IFRS

25

Key terms and concepts

• Theory• Accounting theory• Normative theory• Positive theory• Behavioural theory• Conceptual framework• IFRS

26