Topic 1 Accounting Theory
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Learning Objectives
Appreciate what is meant by ‘accounting theory’ and the purpose it has served over time
Explain the importance of understanding ‘accounting theories’
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Key Terms
Theory Accounting theory Nature and role of accounting Descriptive, normative and positive theories Postulates, concepts and principles Conceptual framework
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Definition of Theory
What is a theory?– …the coherent set of hypothetical, conceptual and
pragmatic principles forming the general framework of reference for a field of inquiry (Hendriksen)
– theories are composed of words or other symbols…they are statements and do not have a physical form
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Why do we need theory?
To Systematically Create New Knowledge!
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Accounting Theory
– …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 (Hendriksen).
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What is the Nature of Accounting? …the process of identifying, measuring and
communicating economic information to permit informed judgements and decisions by users of information (AAA, A statement of Basic Accounting Theory)
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The Measurement-Communication System (Sterling 1967)
Accountant: Metrician- Transmitter
Receiver:Decision-Maker
Identified Objectives:
Firm EnvironmentPicture of the firm
Message Decision
a b
c
d e
f
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The Measurement-Communication System (Sterling 1967)
a). The accountant observes the transactions and events of the firm;
b). Measures them in a way which is conducive to the preparation of a message in the form of a financial report;
c). After the transactions and events have been measured, the accountant prepares a message in the form of a financial report;
d). The receiver interprets the message; e). Obtains an image of the firm; f). Which is then used as the basis for decisions.
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The Measurement-Communication System (Sterling 1967)
The system involves HUMAN BEHAVIOUR
Accounting practitioners - concerned with procedures largely determined by convention or authority
Accounting researchers - systematic study of accounting. Development of theories.
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Function of Theories
Theories which explain (e.g. accountants do not do X because of Y)
Theories which predict (e.g. cosmetic accounting policy changes will have no impact on share price)
Theories which recommend/ prescribe (e.g. current cost accounting should be used to provide more useful information)
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Accounting Theory Eras
‘General Scientific Period’ (up to 1955??)– ‘What is’ theories (descriptive)– Based on observations– Empirical analysis– e.g. Choose ‘best’ depreciation method based
on the one that has been used the most
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Accounting Theory Eras
‘Prescriptive/Normative Period’ 1956 +– ‘What should be’ (prescriptive)– Norms for best practice– Not necessarily based on observation– e.g. the development of current value
accounting systems in the late 1960s - early 1970s
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Some prescriptive theories
Decision usefulness theories– Decision makers: ask the users what they want– Decision models: researcher deduces what is
necessary for efficient decisions to be made
Measurement Issues and Concept of Income Conceptual framework projects
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Accounting Theory Eras
‘Positive Period’: 1975 +– ‘Specific scientific theory’– Dissatisfaction with normative theories– Normally based on observation– Seek to explain and predict
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Some descriptive/positive theories
capital market based research contracting theory behavioural research
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Evaluating theories
Consider logic and evidence
Using ‘all’ instead of ‘some’
Repeated ‘affirmation’ Argument by analogy
only
Use of emotional words False credentials Appeal to authority Change in the meaning of
terms during arguments
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Recap
Nature of accounting:– The Measurement Communication System
Accounting theories– prescriptive (normative)
– descriptive (positive)
NOW– The Conceptual Framework (a prescriptive model) and
the Measurement-Communication System
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The Measurement-Communication System (Sterling 1967)
Accountant: Metrician- Transmitter
Receiver:Decision-Maker
Identified Objectives:
Firm EnvironmentPicture of the firm
Message Decision
a b
c
d e
f
REGULATION WHO ARE THEY?
INFORMATION RELEVANT TO USERS’ NEEDS?
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Historically
Accounting seen as pragmatic, procedural endeavour
Rules, practices and procedures developed on an ad-hoc basis usually in response to recording and reporting issues that presented themselves for resolution
Repetition and general acceptance has provided support and legitimacy to the practitioners’ rules.
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GAAP
Think of Generally Accepted Accounting Practices:– What are some conventions?– What are some doctrines?– What are some principles?
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Objectives of Financial Statements
Postulates of Accounting
Theoretical Concepts of Accounting
Principles of Accounting
Accounting Techniques
Hierarchy of the Elements of Structure of Accounting Theory
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Postulates, Concepts and Principles
Difficulty due to lack of precise terminology
“Each book usually contains a mixture of axioms, conventions, generalisations, methods, rules, postulates, practices, procedures, principles and standards. These terms cannot all be synonymous.” Littleton
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Entity Postulate
Going ConcernPostulate
Accounting Period
Postulate
Unit of MeasurePostulate
Accounting Postulates
Accounting Postulates
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Proprietary Theory
Entity Theory
Fund Theory
Theoretical Concepts
Theoretical Concepts
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AccountingPrinciples
Cost
RevenueRecognition
Matching
ConsistencyFull
Disclosure
Conservatism
Uniformity &Comparability
Materiality
Accounting Principles
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Criticisms of development of accounting rules Concern that descriptive method of inferring
GAAP from practices gives no guidance for dealing with unusual or different situations
Piecemeal approach introduced inconsistencies ‘Creative’ accounting
SO … due to
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– problems from a lack of a general theory– permissiveness of accounting practice– inconsistency of practices– defense against political interference
a normative method of theory development was proposed (CONCEPTUAL FRAMEWORK). It is premised on user needs driving the formulation of rules and other operational procedures for use in practice.
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What is the conceptual framework?
… a coherent system of interrelated objectives and fundamentals that is
expected to lead to consistent standards and that prescribes the
nature, function and limits of financial accounting and reporting. (FASB)
… a coherent system of interrelated objectives and fundamentals that is
expected to lead to consistent standards and that prescribes the
nature, function and limits of financial accounting and reporting. (FASB)
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Summary
Meaning of theory History of accounting ‘theories’ Types of accounting theories Evaluating accounting theories Importance of theory in the development
of accounting practices