Chapter 1 Financial Accounting Theory

1.1 What is Financial Accounting Theory?

Henderiksen (1970) Theory is defined as:
A coherent set of hypothetical, conceptual and pragatic principles
foring the general frae!ork of reference for a field of in"uiry#
$A%& a coherent syste of interrelated o'(ecti)es and fundaentals that
can lead to consistent standards#
Introduction theories of financial accounting
Accounting is a huan acti)ity and !ill consider such thing as people*s
'eha)ior and+or people*s needs as regards financial inforation, or the
reason !hy people !ithin organi,ations ight select to supply particular
inforation to particular stakeholder group#
Theories !ill include consideration of:
-rescri'e ho!, asset should 'e )alued for e.ternal reporting purpose
(norati)e theories /urrent cost accounting), 'ased on a particular
perspecti)e of the role of accounting#
-redict that anagers paid 'onus on the 'asis of easures such as
profits !ill seek to adopt those accounting ethod that lead to an
increase in reported profit (i#e# -ositi)e Accounting theory)
-redict that the relati)e po!er of a particular stakeholder group#
%eek to e.plain ho! an indi)idual*s cultural 'ackground !ill ipact on
the types of accounting inforation to pro)ide to people outside the
organi,ation#
-redict that organi,ation seeks to 'e percei)ed 'y the counity as
legitiate and that accounting inforation can 'e used as a eans of
gaining, aintaining or regaining the legitiacy to the organi,ation
(i#e# 0egitiacy Theory)
Chapter 1 Financial Accounting Theory
1.2 A brief overvie of theories of accounting
1ifferent researchers ha)e different perspecti)es of the role of accounting
theory#
a# %oe researchers 'elie)e that the principal role of accounting theory
should 'e to 2e!plain and predict" particular accounting3related
phenoena#
'# 4ther researchers 'elie)e that the role of accounting theory is to
#prescribe" particular approaches to accounting 'ased on a
perspecti)e of the role of accounting# 5#g# a theory that prescri'es the
assets should 'e )alued on the 'asis of arket )alues rather than
historical costs#
5arly de)elopent of accounting theory relied on the process of induction,
that is, the de)elopent of ideas or theories through observation.
-eriod 1 (1960s to early 1970s)
$ro the 1960s to the 1970s, theories of accounting !ere predoinantly
de)eloped on the 'asis of o'ser)ation of !hat accountant actually did in
practice# That is, they !ere de)eloped 'y the process referred to as
2induction8# This can 'e contrasted !ith a process !herein theories are
de)eloped 'y deducti)e reasoning, !hich is 'ased ore upon the use of
logic rather than o'ser)ation#
-eriod 6 (1970s and 1970s)
9hile soe accounting researchers continued to adopt an inducti)e
approach, a different approach 'ecoes popular in the 1970s and 1970s#
This approach sought to prescribe particular accounting procedures, and as
such !as not dri)en 'y e.isting practices# :#e# theories 'eing de)eloped
'ased on de)elopent of arguents a'out what the researchers considered
accountant should do#
;ather than 'eing de)eloped on the 'asis of inducti)e reasoning, these
theories !ere 'eing de)eloped on the 'asis of deducti)e reasoning#
-eriod < (0ate 1970s)
:n the id to late 1970s, there !ere further changes in the focus of
accounting research and de)elopent and a great deal of accounting
research had the a(or ai of explaining and predicting accounting
practice, rather than prescri'ing particular approach#
Chapter 1 Financial Accounting Theory
1.$ %ositive research and nor&ative research
;esearch that seeks to predict and e.plain particular phenoena is
classified as positi)e research and the associated theories are referred to as
positi)e theory#
A positi)e theory 'egins !ith soe assuption(s) and, through logical
deduction, ena'les soe prediction(s) to 'e ade a'out the !ay things !ill
'e#
:f the prediction is sufficiently accurate !hen tested against o'ser)ations of
reality, then the story is regarded as ha)ing pro)ided an e.planation of !hy
things are as they are# 5#g# A positi)e theory of accounting ay yield a
prediction that, if certain conditions are et, then particular accounting
practice !ill 'e o'ser)ed#
-ositi)e theories can initially 'e de)eloped through soe for of deducti)e
(logical) reasoning# Their success in e.plaining or predicting particular
phenoena !ill then typically 'e assessed 'ased on o'ser)ation that is,
o'ser)ing ho! the theory*s predictions corresponded !ith the o'ser)ed
facts#
-ositi)e Accounting Theory is de)eloped 'y 9atts and =ieran, !hich
seeks to predict and e.plain !hy anagers elect to adopt particular
accounting ethods in preference to others# The theory relied in great part
of !ork undertaken in the fields of econoics, and central to the
de)elopent of -ositi)e Accounting Theory !as the acceptance of
econoics 'ased >rational econoic person assuption8#
That is the assuption that an accountant are priarily oti)ated 'y self3
interest, and that the particular accounting ethod selected !ill 'e
dependent on certain conditions#
$actors 3 $AT
1# Assuption : self3interest
6# -reises :
a# The accountant is re!arded in ters of accounting3'ased 'onus?
'# The organi,ation they !ork for is close to 'reaching negotiated
accounting 'ased de't co)enants#
Ho!e)er, -AT does not seek to tell us that !hat is 'eing done in practice is
the ost efficient or e"uita'le process#
Chapter 1 Financial Accounting Theory
1.' (or&ative research
9hile positi)e theories tend to 'e 'ased on epirical o'ser)ation, there are
other theories 'ased not on o'ser)ation 'ut rather on hat the researcher
believes should occur in particular circu&stances. Theories that
prescribe particular actions are called nor&ative theory.
$or e.aple, /ha'ers /ontinuously conteporary accounting descri'es
ho! financial accounting should 'e undertaken# :t is prescripti)e and
central to this theory is a )ie! that ost useful inforation a'out an
organi,ation*s assets for the purpose of econoic decision is inforation
a'out their current cash e"ui)alent#
@orati)e theories of accounting are not necessarily 'ased on o'ser)ation
and therefore cannot (or should not) 'e e)aluated on !hether they reflect
actual accounting practice#
The conceptual frae!ork of accounting is an e.aple of a norati)e
theory of accounting# ;elying on )arious assuptions a'out the types or
attri'utes of inforation useful for decision aking, The /$A pro)ides
guidance on ho! assets, lia'ilities, e.penses, incoe and e"uity should 'e
defined, !hen they should 'e recogni,ed, and ultiately ho! they should
'e easured#
Chapter 1 Financial Accounting Theory
1.) *valuating theories of accounting
The -ositi)e Accounting theorist and the norati)e theorist !ould 'e
considered to 'e !orking fro different >paradigs8 !hich pro)ided greatly
different perspecti)es a'out the role of accounting research#
Argu&ent beteen %AT and (or&ative Theorist+
-roponents of -AT ha)e at different ties, tried to underine norati)e
research 'ecause it !as not 'ased on o'ser)ation (o'ser)ation3'ased
research !as deeed to 'e >scientific* and scientific research !as
considered to 'e akin to >good research*, 'ut rather !as 'ased on personal
opinion a'out !hat should happen#
,ationale
-AT theorist often argue that in undertaking research they do not !ant to
ipose their o!n )ie!s on others as this is unscientific, 'ut rather they
prefer to pro)ide inforation a'out the e.pected iplications of particular
actions and thereafter let people decide for thesel)es !hat they should
do#
Ho!e)er, as a nu'er of accounting acadeics ha)e "uite rightly pointed
out, selecting a theory to adopt for research such as pu'lic theory or -AT is
'ased on a )alue (udgent? !hat to research is 'ased on )alue (udgent,
'elie)ing that all indi)idual action is dri)en 'y self3interest as the -AT do is
a )alue (udgent, and so on#
%ositive theories are value laden
Tinker et al#(19A6) argue that all research is )alue laden and not socially
neutral#
/opetition aong theories to eet users* deand constraints the e.tent
to !hich researcher )alues influence research design# -ositi)e theories are
>if##then* propositions that are 'oth predicti)e and e.planatory# ;esearchers
choose the topics to in)estigate, the ethod to use, and the assuptions to
ake# ;esearcher*s preferences and e.pected payoffs affect the choice of
topics, ethods and assuptions, :n this sense, all research, including
positi)e research is >)alue laden*#
Chapter 1 Financial Accounting Theory
1.- Can e prove a Theory?
:n relation to the issue of !hether !e can >pro)e* a theory or not, it is
useful to refer to insights pro)ided 'y a group of theorist kno!s as
>falsification(ists)* the a(or leader of !hich is considered to 'e Barp
-opper#
%opper. and the falsification/ists0, considers that kno!ledge de)elops
through trial and errors# To de)elop hypotheses fro a theory of a
researcher, the falsification(ist)s 'elie)e that these hypotheses ust 'e of a
for that allo!s the to 'e re(ected if the e)idence is not supporti)e of the
hypotheses#
According to %opper and other falsificationists. kno!ledge de)elops as a
result of continual refineent of a theory# 9hen particular hypotheses are
deeed to 'e false through lack of epirical support, the pre3e.isting
theories !ill 'e refined (or a'andoned)#
Chambers provides a useful overview of falsificationisem. He states:
The falsification freely admits that observation is guided by and
presupposes theory. He is also happy to abandon any claims implying that
theories can be established as true or probably true in the light of
observational evidence.
:t is al!ays safer to say that our e)idence >supports* a theory 'ut that it is
also possi'le that !e ight e'race an alternati)e theoretical perspecti)e
at a future tie should 'etter e.planation for a particular phenoenon
'ecoe a)aila'le#
Chapter 1 Financial Accounting Theory
1.1 *valuating theories consideration of logic and evidence
2ogical deduction
Acceptance of a theory and its associated hypotheses ust 'e tied to
!hether !e accept the logic of the arguent, the underlying assuptions
and any supporting e)idence pro)ided#
An arguent is logical to the e.tent that if the preises on !hich it is
'ased are true, then the conclusion !ill 'e true# That is, the arguent
(e)en if logical) !ill only pro)ide a true account of the real !orld if the
preises on !hich it is 'ased are true#
The positi)e theories of accounting has a nu'er of central assuptions,
including an assuption that all people are opportunistic and !ill adopt
particular strategies to the e.tent that such strategies lead to an increase in
the personal !ealth of those parties aking the decision#
That is self3interest is a core 'elief a'out !hat oti)ates indi)idual action#
Central %re&ises
$or /onceptual $rae!ork of Accounting odel, it is 'ased on a central
preise that the o'(ecti)e of financial accounting is to pro)ide inforation
that allo!s users of general purpose financial reports to ake and e)aluate
decision a'out the allocation of scarce resources# :f !e !ere not accepted
this central preises then !e could re(ect the guidance pro)ided 'y the
frae!ork e)en if it could 'e considered to 'e logically structured#
3u&an factor
9hile !e ust al!ays consider the logic of an arguent and the )arious
assuptions that ha)e 'een ade, !hat !e also ust ree'er is that
theories, as particularly those in the social science 'y nature are
a'stractions of reality# 9e cannot really e.pect particular theories a'out
huan factor to apply all the tie#