Lecture 1

Introduction to Accounting Theory

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Doris Merkl-Davies

Division: Financial StudiesLocation: Room 1.08, Hen Goleg Telephone: 01248 38 2120Email: d.m.merkl-davies@bangor.ac.uk

Reader in Accounting MA, PGCE (Vienna University), MBA, PhD (Bangor University)Office hours: Mon. 9.00-10.00; Wed. 2.00-3.00 (Hen Goleg, Room 1.08)

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Doris Merkl-Davies

Research interestsCorporate narrative reportingImpression managementCSR reportingAccounting theory

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Doris Merkl-DaviesCan’t live without

Motto

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BBS film clubVenue: Alun A0.01, 3.00-5.00pmWEEK 3 (WEDNESDAY 15

OCTOBER):Wall Street (discussant: Doris Merkl-Davies)

WEEK 5 (WEDNESDAY 29 OCTOBER):Office Space (discussant: Tony Dobbins)

WEEK 9 (WEDNESDAY 26 NOVEMBER):Citizen Kane (discussant: Bernardo Batiz-Lazo)

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Module formatLectures: Mon. 10-12 in Drama

Rehearsal RoomTutorials:

Group A: Mon, 13.00-14.00 LR5Group B: Tue, 9.00-10.00 LR1

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Recommended TextbooksDeegan, C. and Unerman, J. (2011). Financial

Accounting Theory. European edition. 2nd ed. McGraw-Hill. (D&U) [Main text I]

Rankin, M., Stanton, P., McGowan, S., Ferauto, K., Tilling, M. (2012). Contemporary Issues in Accounting. 2nd ed. Wiley. (R) [Main text II]

Godfrey, J., Hodgson, A., Holmes, S. and Tarca, A. (2010). Accounting Theory. 7th ed. Wiley. (GHHT) [additional reading]

Additional journal articles will be posted on blackboard for you to download.

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Background reading for Lecture 1D&U Chapter 1Rankin et al. Chapter 1; Chapter 5, pp. 131-

134GHHT Chapts. 1&3

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Overview of Lecture 1

Definition of accounting theoryTypes of accounting theoriesAccounting theory development over

timeRelationship between theory and

researchEvaluation of theories

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Exercise 1: What is a theory?In groups of 6 find an example of a famous theory

Discuss the main features of the theoryWhat does this theory do?What do we use it for?

Nominate a group member to report back to the class

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What is a theory?An organized way of thinking about a

subjectA set of ideas that explains something

‘a scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’ (Oxford English Dictionary)

“theory is a statement of concepts and their interrelationships that shows how and/or why a phenomenon occurs” (Corley & Gioia, 2011: 12)

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What is the purpose of theories?To make sense of the world (physical,

social, psychological phenomena) and communicate that understanding to others

To make sense of (financial) accounting informationFinancial statements, corporate annual reports

Accounting info is compiled and interpreted by people

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Types of theoryType of theory Users Example

Common-sense theory

Lay people (personal experience)

• It is not what you know, but who you know

http://www.telegraph.co.uk/news/politics/10137928/Its-still-who-you-know-not-what-you-know-that-matters-say-two-thirds-of-Britons.html

Working theory

Managers, investors, auditors(Generalisations made in particular professions)

• Crisis communication should prioritise key stakeholders

http://www.bernsteincrisismanagement.com/articles/10-steps-of-crisis-communications.html

Scholarly theory

Academics • Accounting choice is driven by managerial self-interest

Positive Accounting Theory 1.13

Scholarly theoryHas undergone systematic researchProvide more thorough, accurate, and

abstract explanations for financial accounting than common-sense or working theories

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What is the purpose of theories? Theories are used to

1. Describe what people do = Descriptive theories

2. Suggest the best way (i.e., prescribe) to deal with specific types of human behaviour = prescriptive or normative theories

3. Explain and predict what people do = predictive or positive theories

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1. Descriptive theoriesDescribe what people doBased on common practiceDescribe

Common practise of bringing up childrenCommon practises for dealing with underage

binge drinking in various countriesDescribe accounting practice

Common practise of accounting for fixed assetsFuture accountants are trained by

practising accountants

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Descriptive theoriesAdvantage:

Tends to be accepted by majorityDisadvantage:

Does not entail critical evaluationDoes not allow for change

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2. Prescriptive (= normative) theoriesAlso called normative theoriesWhat people should doSuggest best way to

Bring up children, i.e., authoritarian, laissez-faire style, etc.

Prescribe particular accounting practicesAccount for fixed assets, i.e., historical cost,

current cost, exit price, etc.Advantage

Can improve accounting practisesDisadvantage

Assumes that there is one “best way”

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3. Predictive (= positive) theories

Also called positive theories Concerned with explaining reasons for

behaviour and predicting future behaviour Explain characteristics of children are most likely to

engage in binge drinking, i.e., social class, gender, parenting style

Predict what effect a change in licensing laws will have on underage teenage drinking

Explain and predict accounting method choice Characteristics of companies most likely to revalue

their assets What effect a change in accounting standards on

leases will have on the way firms finance their assets

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Comparison of descriptive, prescriptive and predictive theories

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Descriptive theories Prescriptive (normative) theories

Predictive (positive) theories

Descriptive “what is” Prescriptive “what should be”

Explanatory, predictive “why it is” “what will happen”

Non-value laden Value-laden Non-value laden* No empirical methodology No empirical methodology Empirically based * PAT Assumes specific human characteristics

Examples of uses of accounting theoriesTheories might:

prescribe how assets should be valuedpredict why managers will choose particular

accounting methodsexplain how an individual’s cultural background

affects accounting information providedprescribe what accounting information should

be provided to particular classes of stakeholderspredict 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

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Accounting theoriesAccounting is a human activity

Explain the behaviour of people within and outside of organisations with respect to accounting information

Theories of accounting consider:Why people within organisations elect to provide

particular information (preparer perspective)People’s behaviour with respect to accounting

information (user-perspective)People’s needs for accounting information (user-

perspective)

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Accounting theoriesAccounting is a social phenomenonAccounting theories are theories

about human behaviourBorrow from disciplines dealing with

human behaviourPsychology, sociology

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Exercise 2Which of the following is NOT an assumption

used in normative theory construction?A. Profit and value can be measured

preciselyB. Financial accounting is useful for making

economic decisionsC. There are multiple available profit

measuresD. Markets are inefficient and can be fooled

by 'creative accountants‘E. All of the above

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Why do we need accounting theories?Accounting is viewed as a ‘practical’

disciplineLearning how to apply accounting rules

Theories are necessary to understand the (social) world we live inThey provide a basis for the decisions

we make, e.g. whether to include an item in the financial statements or not (materiality and recognition criteria)

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Why do we need accounting theories?We can make better predictions and

decisions if we get the contradictions out of our thinking, if we consider what is known on the many sides of the issuei.e. the various theories which exist on:

The regulation of accounting, e.g. whether we need regulation or not

The provision of financial information, e.g. Why accountants choose particular accounting methods

The way financial information is received, e.g. How people react to particular accounting numbers

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Why study accounting theories – to understand:

Motivation for individuals to support or lobby regulators for some accounting methods in preference to others ( Regulatory theories)

How and why the capital markets react to particular information ( Positive accounting theory)

Whether there is a ‘true measure’ of income ( Asset valuation theories)

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Overview of theories of accounting

Many theories of financial accounting existNo universally accepted theory of

accountingDifferent perspectives about the central

objective, role and scope of financial accountingNo universally accepted perspective about

the role of accounting theoryDifferent researchers have different

perspectives of the role of accounting theory

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Accounting Theory Timeline

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Early development of accounting theoryDescriptive theoriesRelied upon the process of induction

Development of ideas or theories through observation

1920s to 1960s theories developed from observing what accountants did in practiceCodified as doctrines or conventions of

accounting

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Criticisms of inductive method… ‘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 and Maunders 1987, p. 66)

Assumes what is done by the majority is the most appropriate practice

Perspective of accounting Darwinism

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Example of inductive approach to theory developmentGrady (1965) undertook research

commissioned by the AICPAFormed the basis of APB Statement No. 4

‘Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises’Reflected generally accepted accounting

principles at the time

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Theory development - 1960s and 1970sSought to prescribe particular

accounting practicesKnown as normative theories

Not driven by existing practicesTheories critical of historical cost

accountingSought to provide improved

approaches to asset valuation in a time of widespread inflation

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Example of prescriptive theory1961 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

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Theory development - mid to late 1970s

Research aimed at explaining and predicting accounting practice rather than prescribing particular practices

Known as positive theories

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Positive theoriesSeek to predict and explain particular

phenomenaBegins with assumption(s), and through

logical deduction enables prediction(s) to be made

If predictions are sufficiently accurate when tested against observations of reality, they are regarded as having provided explanation of why things are as they are

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Positive theories - continuedPositive Accounting Theory

Developed by Watts and ZimmermanSeeks to predict and explain why 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

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Relationship between theory and researchTheories are used to understand accounting

practice betterAccounting researchers use theoriesTheories are used in empirical research (i.e.,

research based on data, such as financial statements, annual reports, share prices) to explain phenomena and make predictions

Theories help us to critically evaluate a phenomenon (i.e., accounting method choice)

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Relationship between theory and research"... all research emanates from the

researcher’ s implicit or explicit theory of the phenomenon under investigation" (Rocco & Plakhotnik, 2009: 121).

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Testing a Theory in Research

1. Identifyresearch problem

2. Develop theoretical framework

3. State research question/

hypothesis

4. Constructresearch design

5. Observe

6. Analyse7. Evaluate8. Assess

limitations and constraints

Theory plane

Observation plane

Testing a Theory in Research1. Identify research problem

Bias in corporate narrative documents

2. Develop theoretical framework Agency theory assumptions

Information asymmetry between managers and investors; managers are self-interested (want to maximise their compensation); managers manipulate presentation of information in corporate narrative documents (e.g., annual report)

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Testing a Theory in Research3. State research question/hypothesis

Managers in firms with negative financial performance are more likely to introduce reporting bias (in the form of pro-forma earnings number into corporate narrative documents than managers of firms with positive financial performance

4. Construct research design Sample of firms; split into two groups based on

positive/negative percentage change in earnings; chairmen’s statements (pro-forma earnings vs. GAAP earnings)

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Testing a Theory in Research5. Observe/Analyse

Conduct statistical association tests

6. Evaluate Do findings confirm/disconfirm hypothesis;

compare with findings of prior research

7. Assess limitations/constraints E.g., small sample size

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Criteria for evaluating theories

Area of evaluation What to look for

Accuracy Has research supported that they theory works the way it says it does?

Practicality Have real-world applications been found for the theory?

Succinctness Has the theory been formulated with the appropriate number (fewest possible) of concepts or steps?

Consistency Does the theory demonstrate coherence within its own premises and with other theories?

Acuity To what extent does the theory make clear and otherwise complex experience?

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Evaluation of theoriesTheories of accounting are only

abstractions of realityThe choice of one theory in

preference to another is based on value judgements

Cannot expect to provide perfect explanations or predictions of human behaviour or assess what types on information users actually need

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Evaluating theories of accounting When evaluating theories need to

consider:1. Assumptions: whether you agree with the

central assumptions/premises of the theory

2. Logic: whether the argument supporting the theory is logical

3. Research methods: Whether the research methods are appropriate

4. Evidence: whether you accept any supporting evidence provided

5. Rhetoric: the use of rhetoric used for persuasion

The role of assumptionsEven though an argument is logical

we might only accept the argument if we accept any critical assumptions being madeIf we reject any central assumptions we

may reject the prediction

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Logical deductionAcceptance of an argument must be based

upon the accuracy of the premisesAn 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

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Research methodsGeneralizing theories from the testing of

samplesMethods borrowed from sciences

phenomena will behave the same in all situations

Not possible when dealing with human behaviour

Sample selection (firm size, industry, country of origin, listed/unlisted, etc.)

Keep in mind not only how the argument is developed, but also how it is tested!!!

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EvidenceIs there enough evidence to support

the theory?Is there conflicting evidence?

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RhetoricThouless (1974) identifies 38 ‘dishonest

tricks’ some writers use to support their argument including:emotionally toned wordsstatements where ‘all’ is implied but ‘some’ is

truediversion to another question or to a side issueuse of speculative argumentprestige by false credentialsappeal to mere authority

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Any questions?

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