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Introduction To Financial Accounting Theory

This document provides an introduction to financial accounting theory. It discusses that accounting theories can be developed to describe or prescribe accounting practices. Theories are based on value judgments and should be critically evaluated. Early theories were developed inductively by observing practices, while later theories were developed deductively to prescribe practices or predict behaviors. Positive theories seek to explain rather than prescribe practices. Theories must be evaluated based on logical arguments and underlying assumptions.

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79 views

Introduction To Financial Accounting Theory

This document provides an introduction to financial accounting theory. It discusses that accounting theories can be developed to describe or prescribe accounting practices. Theories are based on value judgments and should be critically evaluated. Early theories were developed inductively by observing practices, while later theories were developed deductively to prescribe practices or predict behaviors. Positive theories seek to explain rather than prescribe practices. Theories must be evaluated based on logical arguments and underlying assumptions.

Uploaded by

mskskkd
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Chapter 1

Introduction to
financial
accounting theory
Learning Objectives
In this chapter you will:
– Appreciate how knowledge of different financial accounting
theories increases our ability to understand and evaluate various
alternative financial accounting practices.
– Understand that there are many theories of financial accounting.
– Understand that the different theories of financial accounting are
often developed to perform different functions, such as to
describe accounting practice, or to prescribe particular
accounting practices.
– Understand that theories, including theories of accounting, are
developed as a result of applying various value judgements and
that acceptance of one theory, in preference to others, will in
part be tied to one’s own value judgements.
– Be aware that we should critically evaluate theories before
accepting them.
– Understand why students of accounting should study accounting
theories as part of their broader accounting education.
What is a theory?
• ‘a scheme or system of ideas or statements held as an
explanation or account of a group of facts or phenomena’
(Oxford English Dictionary)
• Accounting theory is ‘a coherent set of hypothetical,
conceptual and pragmatic principles forming the general
framework of reference for a field of inquiry’ (Hendriksen
1970, p. 1)
– based on logical (coherent) reasoning
Examples of uses of accounting theories

• Theories might:
– prescribe how assets should be valued
– predict why managers will choose particular accounting
methods
– explain how an individual’s cultural background affects
accounting information provided
– prescribe what accounting information should be provided
to particular classes of stakeholders
– predict 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
Why study accounting theories?

• Essentially, to improve understanding of accounting


practice.
• Learning the rules of financial accounting without
considering the implications of accounting information
not recommended.
• In the wake of the sub-prime banking crisis of 2007-
2009, where it has been claimed that the financial
accounts of several financial institutions did not
communicate the underlying financial assets, liabilities
and risks.
Early development of accounting theory

• Inductive approach:
• Relied upon the process of induction
– development of ideas or theories through
observation

• 1920s to 1960s theories developed from


observing what accountants did in practice
– codified as doctrines or conventions of accounting
like historical cost and conservatism
Criticisms of inductive method
• reactionary in attitude for the current practice
• assumes what is done by the majority is the
most appropriate practice
• No improvement of the current practice is
suggested
Theory development - 1960s and 1970s

• Prescriptive approach:
• Sought to prescribe particular accounting
practices
– known as normative theories
• Theories were based on arguments about what
accountants should do – deductive reasoning.
• Not driven by existing practices
• Not developed by observing what accountants
were doing
Example of prescriptive (normative) theory

• 1961 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
Normative theories

• based on what the researcher believes should


occur in particular circumstances
– not based upon observation
• example of normative theory:
– Conceptual Framework
• should not be evaluated on whether they
reflect actual accounting practice
Classifications of normative theories

• true income theories


– make assumptions about the role of accounting
then seek to provide a single ‘best measure’ of
profits
• decision usefulness theories
– ascribe a particular type of information for
particular classes of users on the basis of assumed
decision making needs
Decision usefulness theories

• decision-makers emphasis
– undertaking research that seeks to ask decision-
makers what information they want
– knowledge then used to make prescriptions
about what information should be supplied
• decision-models emphasis
– develops models based upon the researchers’
perceptions about what is necessary for efficient
decision making
Theory development - mid to late 1970s

• Predictive approach:
• Research aimed at explaining and
predicting accounting practice rather
than prescribing particular practices are.
• known as positive theories.
Positive theories
• Seek to predict and explain particular phenomena
• Process: 1-put an assumption(s), 2- make observations of
the practice and 3- explanation (accept or reject the
assumption)
• Positive Accounting Theory
– developed by Watts and Zimmerman
– seeks to predict and explain why managers or 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
Criticisms
Normative Accounting Theory Positive Accounting Theory
• based on personal opinion • Does not prescribe what
about what should happen should be done in the
• Is not provided base on the practice
practice • Makes a gap between
• Does not provide prediction academics and
• Lack of empirical evidence professionals of
Accountancy

• Assumes self interest is the


driver of persons’ behaviour
Evaluating theories – logic and evidence

• when evaluating theories consider:


– whether the argument supporting the theory is
logical
– whether you agree with the central assumptions
of the theory
– whether you accept any supporting evidence
provided
Evaluating theories
• Evaluating Logical Deduction

• Evaluating Underlying Assumption


Logical deduction

• acceptance of an argument must be based


upon the accuracy of the premises
– an 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
Evaluating underlying assumptions

• even though an argument is logical, we might


only accept the argument if we accept any
critical assumptions being made
– if we reject any central assumptions we may reject the prediction
• Example:
– if manager X get paid bonus base on accounting profit.
– Method Y is an accounting method which increases the accounting
profit
– Then the Accepted ASSUMPTION is: Manager X should use method Y
Universal Applicability of theory
• We cannot apply theory on all cases
• However, theory should be applied on the
majority of cases and this called ‘the general
trend’ of the theory

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