Ch 2 ACCOUNTING THEORY & METHOD

Imposing order

Accountants often need to impose some sort of order on imprecise events and transactions
so that they can summarize their financial implications

The accountant will need to exercise appropriate judgment appropriate to a range of

professional role

Analyze the financial implications of transactions

Assess the impact of transactions

Establish the legal entitlement

Calculate the current value

A range of accounting theories

Range of theories provide sometimes conflicting interpretations about the nature and
significance of accounting

a historical record: accounting is concerned with providing a faithful record of the

past transactions of an entity does not see the role of accounting as being to
provide info about the value of the firm at a particular point in time

A language: Accounting Perceived as a language of business.- Business

activities are reported in accounting statements using accounting language -
Translate economic event and transactions into smthg that can be understood
by users.
intracorporate politics accounting systems reflect and support the values and
needs of specific interest groups - accounting info is constructed and used as a
resource to shape company policies esp in decision making and furthering the aims
of management

standards setting as politics: according to this theory, management lobby on

accounting standards to increase the likelihood the resultant accounting
requirements will serve their own interests , and they select accounting techniques
to maximize their own utility

mythology; asserts accounting systems provide a societal resource to be used in

sustaining concepts of rationality and are means of justifying, rationalizing, and
legitimizing decisosn that ultimately serve other individual or social ends

magic: accounting has a veneer of rationality and respectability - behind which an

accountant can perform a sleight of tricks which can be compared to a magicians
tricks

communication-decision information: accounting is action orientated - a/c

reports prepared in manner suited to the needs of users will have an impact on the
decision making needs of managers and investors

an economic good: theory considers accounting as one part of a wide information

set which may include, macroeconomic, political, taxation and other specific

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 information that effects the performance of a firm. .Theory recognizes that
accounting data is not costless to produce and that the a/c standards

a social commodity : Argues that accounting effects the welfare of different groups in
society and can be an agent for social change

ideology and exploitation: accounting is part of an ideological apparatus of capitalist

society: it sustains an reinforces societys structure and provides techniques for
exploiting and extracting wealth in support of elite int groups and the expense of
employees and society at large

a social club; accounting principles and standards only exist to promote the interests
and aims of accountants generate a professional culture and create a monopoly -
enhance their own image

Theory formulation

Theory formulation

WHAT IS A THEORY

A Theory is the logical flow of argument leading from fundamental assumptions and
connected statements to final conclusions.

Different researchers have different perspectives of the role of accounting theory.

a. Some researchers believe that the principal role of accounting theory should be to
explain and predict particular accounting-related phenomena.

b. Other researchers believe that the role of accounting theory is to prescribe

particular approaches to accounting based on a perspective of the role of accounting.
E.g. a theory that prescribes the assets should be valued on the basis of market
values rather than historical costs.

If theories are logical arguments, or systems of statements, how are they developed?

- Through deduction (reasoning from general statements to specific statements) i.e.

deductive reasoning from general premises to develop predictions, prescriptions or
explanations of specific matters; or

- Through induction (reasoning from the particular to the general) i.e. inductive
reasoning from specific observations to develop a general implication of those
observations.

Deductive Approach

o Deductive reasoning = entails a valid argument in which it is impossible to assert

the premises and to deny the conclusion without contradicting oneself

o Deductive approach to theory constriction: begins with establishing the objective

of accounting - once identified then definitions and assumptions are stated - then
the researcher must develop a logical structure for accomplishing objectives

o Methodology often goes reasoning from general statements to specific statements

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o Validity of any theory developed is highly dependent on the ability of the researcher to
correctly identify and relate the various components of the accounting process in a
logical manner

o The deductive method is basically are a closed, non empirical system

o By combination the results of observations; theories need to be able to predict or explain

features of the environment.
o The discipline of logicn is required to progress from observation based theories to the
prediction or explanation of phenomena.
o Logical deduction is based on the if....then progressive from Premises to logical
deduction.

Inductive Approach

o reasoning from the particular to the general b/c the research generalizes about the
universe on the basis of limited observations of specific situations
o Induction is a method of reasoning by which a general law or principle is inferred or
observed in particular instances
o Making observations and drawing conclusions from them - the inductivist draws
theoretical and abstract conclusions from limited observation of specific situations
o In accounting involves making observations about financial information of business
enterprises and proceeding to construct generalizations and principles of accounting
from those observation on the basis of reoccurring relationships

The Route from observation to explanation

Facts acquired through Universal laws Predictions

Observation and theories and explanation

Observation it enable the observer to produce singular statements which,

o by a process of generalization
o lead to the production of universal statements
o which may be elevated to theories and laws after a large number of similar
observations.

REMEBER ONCE A THEORY IS FORMULATED IT IS VERY IMOIRTANT THAT ITS

VERIFIED

Formulating a theory

Epistemology the study of the acquisition of knowledge

Accounting theorists have drawn on the natural sciences

Accounting:

Social science

Measurement and technical process

Scientific or naturalistic method?

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Parts of a theory

A theory must be expressesed in a language can be verbal or mathematical

There are three types of relationships in the theoretical structure that should be noted

1 Syntactics:

Rules of the language used

Syllogism: set of premises and conclusion

SYNTCTIC Relationship

Represents the logical relations in the theory. For example, the rules of grammar
for a language or the rules of mathematics for a mathematically expressed theory.
An example in accounting is the double-entry system. A trial balance will always
balance by virtue of the construction of the rules of debits and credits and the
logic of mathematics.

o The syntactic, or logical, relationship has to do with the rules of the language
used. For example, if the theory is expressed in English, then the relationship
refers to the rules grammar; if the theory is mathematical, then this relationship
refers to the rules of mathematics.
o An analytic (or syntactic) methodology relies upon a syllogism.
o A syllogism consists of a set of premises and a conclusion, such as the following:
Premise 1: If all accounting theory students are brilliant,
Premise 2: And you are an accounting theory student,
Conclusion: Then you are brilliant.

o This is a syllogism which forms an analytic proposition.

o We do not need to know the meaning of accounting theory student or brilliant
to see that the syllogism is logical.
o It is logical because, if we accept that the premises are true, the conclusion that
you are brilliant necessarily follows.
o It is important to understand that syntactic relations refer to a flow of logic, not
to the accuracy of the arguments representation of the real world.
o As such, evaluating the syntactic relations of a theory involves evaluating the
validity (i.e. the logic) of the argument that constitutes the theory.
o It does not involve establishing truth, where truth is regarded as accuracy in
relation to observations from the real world.
o If an argument is valid, then if its premises are true its conclusion must also be
true.
o An argument can still be valid if its premises do not accurately represent real-
world phenomena or if its conclusions are not correct.
o The test of validity is simply to ask whether, if the premises were true, the
conclusion would necessarily follow.
For example, take the following argument:
Premise 1: All accounts relating to assets have debit balances.
Premise 2: The accumulated depreciation account relates to assets.
Conclusion: The accumulated depreciation account has a debit balance.
o The conclusion, or hypothesis, that the accumulated depreciation account has a
debit balance is incorrect.
o However, the logic is valid because if the premises were both true, the
conclusion would also be true. (Premise 1 is incorrect because there are accounts

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 that relate to assets, e.g. contra asset accounts such as accumulated depreciation,
which have credit balances).

2 Semantics:

Links the basic concepts of a theory to objects in the real world

Parts of a theory

The rules of correspondence on operational definitions in the theory. These rules

connect symbols, words, terms or concepts with real-world objects, events or
functions and are seen to make a theory realistic.
An example in accounting is measuring the effects of inflation on assets and
liabilities. Theorists in this area argue that by applying adjustments from historical
cost to market prices, the accounts now have semantic content and can be related
to the real world (which they see as being market prices).

o The semantic relationship links the basic concepts of a theory to objects in the
real world.
o Sometimes these relationships are referred to as rules of correspondence, or
operational definitions.
o Semantic relationships concern the relationship of a word, sign or symbol to a
real-world object or event and it is the semantic relationships that make the
theory realistic and reasonable.
For example, the accounting equation A = L + E is purely abstract. Only as we
correlate each concept to real-world objects do we make the equation realistic.
o The truth value, or semantic accuracy, of a premise is established by reference
to real world descriptive accuracy.
o It is established in relation to individual premises and the conclusion, but not the
line of logic (argument).
o For example, consider the following argument:
Premise 1: All asset accounts have debit balances.
Premise 2: The sales returns account is not an asset account.
Conclusion: The sales returns account has a debit balance.
o The conclusion that is reached is true because in the real world sales returns
accounts have a debit balance.
o However, if we look at the logic flowing from premises 1 and 2, then the argument
is not valid.
o In this case truth is inductively derived from the observation. However, the
syllogism fails any test of logic. That is, logic is flawed.

3 Pragmatics:
The effect of words or symbols on people: is an inductive approach where it
based on continual observation of the behaviour of accountants in order to
copy their accounting procedures and principles.
o Relate to the effects of words or symbols on the behaviour of people.
o Not all theories have a pragmatic orientation, but the nature of accounting makes
this relation an important one.
o For example, the analysis of reactions of investors and other users of published
financial reports is an important area of research in accounting theory.
o The study of pragmatics in accounting leads us to form political and social theories
about the reactions of people to financial information

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 o The nature of accounting is such that if an overall theory of accounting exists, it
must have a pragmatic orientation.
o We are interested in how accounting concepts and their real world corresponding
events or objects affect peoples behaviour.
o Another pragmatic approach is to observe that people react to the same message
in different ways.
o As an example, investors or other users of accounting reports who base their
actions on those accounting reports might either buy or sell shares on the stock
market in response to announcements of unexpected high or low earnings.
o Criticism-
does not include an analytical judgement of the quality of an
accountants actions.
Doesnot provide for accounting techniques to be challenge and does
not allow for change. Focus in accountants behaviour not on
measuring the attributes of the firm.

Criteria of truth: TESTING A THEORY

An important function of a scientific theory is testing to determine whether it is worthy of

acceptance

Distinction between truth and the criteria of truth

Truth = What it means for a statement to be true confirmed by scientific testing

Criteria of Truth: how we determine if a statement is true

Philosophers have had difficulty defining the phrase truth this has not stopped
scientists from testing theories

What is authoritative to one person, however, may not e so for another.

People have confidence in different criteria for truth.

Three different kinds of criteria or authoritative bases that people use are:

- The dogmatic basis

- The self-evident basis
- The scientific basis

If the statement is analytical, the testing is a logical one. Mathematical statements are of
this type. Their truth is determined by proving that mathematical rules have been
followed. This testing reveals whether analysis is valid rather than true. If an argument is
valid and its premise are true, then the conclusion is also true.

If the statement is empirical, then persuasive, objective evidence exists to support it. A
decision must be made by the experts of the given field of study from which the
statement evolves concerning the persuasiveness of the evidence. If by absolute we
mean certain, then truth in science is not absolute, because it is inferred knowledge
based on a finite amount of evidence.

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From a behavioural point of view, certainty is a matter of degree and conviction. We
behave as though a statement is absolutely true, because we are personally convinced by
the evidence. But this type of behaviour can occur with the dogmatic and self-evident
bases as well.

1 Dogmatic basis - believe what we read

o Whenever we believe in statements made by others simply because they have been
made by an authority, we are using the dogmatic basis for judging truth.
o We cannot personally observe or test all things, and therefore must rely on others
to inform us.
o Underlying the dogmatic basis is the confidence people have in those who make the
statements.
o Such confidence may be due to religious or political beliefs, to training, or to the
charisma, credentials or position of the speaker or writer.
o In accounting, dogmatism is the basis by which accountants come to accept the
validity of rules and procedures.
o An authoritative body approves pronouncements or accounting standards that are
accepted by those in the profession.
o The weakness of the dogmatic basis is that introspective evidence, including
personal bias, is acceptable in determining whether a statement is true.
o The crucial factor is the individuals personal opinion about the person or group
making the statement.
o The objective evidence in support of the statement is secondary.

o Describe the following authoritative bases: dogmatic, self-evident, and scientific.

Which category do you think accounting standards fall into?
o Accounting standards falls into the dogmatic basis. Accountants believe, adhere to,
and accept the validity of accounting rules and procedures as it was informed to them
via the experts (being the standard setters in Australia - AASB)

2 Self-evident basis - Reasonableness

o The justification of self-evidence as a way to determine truth is the

reasonableness, sensibility or obviousness of a statement based on our general
knowledge, experience and observation.
o For example, accounting involves the use of market prices, is self-evidently true.
It hardly seems necessary to conduct an empirical study to determine this.
o The criterion of self-evidence has revealed its untrustworthiness in the sciences.
o Some propositions formerly regarded as self-evidently true have been shown to be
false.
o A reason for not relying on the self evident basis to assess the truth of a
statement or theory is that self-evidence is usually determined by observation
we observe something and we believe it to be true.
o However, our powers of observation are not always good.
o Sometimes we see what we expect to see; at other times we might incorrectly
attribute what we see to a wrong cause.

3 Scientific basis - Syntactics and induction

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o Scientific endeavour is the trial-and-error testing of speculative hypotheses which
can never be proven absolutely true, but can be rejected when shown to be false.
o Under the falsification view, all hypotheses proposed must be capable of
falsification.
o If a hypothesis is not proposed or worded so that it is falsifiable, then it is not
informative and does not add to scientific progress.
o As such, a theory that gains acceptance (although it can never be asserted to be
true) is one that has not been proven false by tests that are designed to reject the
theory if it is not true.
o A good theory is not one that is false, nor is it necessarily one that is true; it is one
for which there is a conceivable means of testing its falsity, and the theory
withstands the test.
o The non-falsifications of bold hypotheses or the falsification of cautious hypotheses
mark significant advances in science.
o Theories are never said to be absolutely true but they are the best available at the
time.

3.1 Syntactic rules and induction

To be meaningful in science, theory must be formulated in a way that makes it
testable either by Syntactic rules or induction.

o In syntactic rules, examination of the logic of the argument making up

the theory is the basis of the test. The validity of argument can be
established without reference to sensory experience. Known by reasoning
without verify from observation of real-world events.

o In induction, statements whose truth or falseness can be known only by

reference to empirical evidence. It is according to the correspondence with
observations of real-world phenomena.
o Inductivist believes that all sciences start with empirically observable facts
and science progresses by continual observations and experimentation.
o Logical positivism- all meaningful statements must be capable of verification.
Anything cannot be verified empirically is regarded as meaningless and
theoretical statements should be capable of being reduced to
statements of immediate observation.

3.2 Popper and falsification

o In falsification view, all hypotheses proposed must be capable of falsification.
o All inductinve evidence is limited, as we do not observe the universe at all
times and in all places. We are not justified therefore in making a general rule from
this observation of particulars.
o A theory that gains acceptance is one that has not been proven false by tests
that are designed to reject the theory if it is not true.
o The clearer and more precise the hypothesis, the better. Vague hypotheses
are difficult to falsify and unacceptable.
o Poppers point is this: no matter how many observations are made which
confirm a theory there is always the possibility that a future observation could
refute it. Induction cannot yield certainty.
o The deduction logic is -: However many confirming instances there are for a theory,
it only takes one counter observation to falsify it: only one black swan is needed to
repudiate the theory that all swans are white.

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 o Science progresses when a theory is shown to be wrong and a new theory is
introduced which better explains the phenomena. For Popper the scientist should
attempt to disprove his/her theory rather than attempt to continually prove it. Popper
does think that science can help us progressively approach the truth but we can
never be certain that we have the final explanation

3.3 Research programs

Lakatosian research program

Scientific theory consists of structure of a positive and negative heuristic

o negative heuristic = hard core of the research stipulates the basic

assumptions - not questioned not subject to falsification constitutes the
dogmatic or self evident part of the research program
o positive = surround the core and forms a protective belt of auxiliary (support)
hypotheses methodology of a research program consists of modifying or
expanding this protective belt scientists who work on hypothesis testing in
the positive heuristic belt are said to be participating in the research program

o Any hypotheses challenges the core is ignored or rejected unless it has

significant explanatory power beyond the existing hypotheses
o A progressive research program has a group of scientists actively working on
research in a positive heuristic, whereas a degenerating program has no active
research.
o Lakatos, however, finds it difficult to say that one program is superior to another.
o The problem is that progress can be very slow, and what appears to be a
degenerating program now may well lead to progress many years later.
o The underlying theory is never proven false; it simply may lie inactive, awaiting
revival at some future date.
.

Kuhnian paradigms or disciplinary matrices

Scientific theories and progress in science have a revolutionary character.
Revolution = Very radical changes. If the theory does not fulfil the practices, it will be
thrown away and new theory develops.

Kuhns description of the way science progresses fall into 5 stages:-

i. Pre-science- period where there are no generally accepted ideas. Focus on
single paradigm which is widely accepted by general scientific community.

This disorganised period of diverse and unstructured activity eventually

organises and focuses on a single paradigm (model), or school of thought, which
is widely adopted by the general scientific community.

ii. Normal science- attempts to articulate a paradigm with the aim of improving
the match between it and nature.

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 o The paradigm, which incorporates background knowledge, research procedures
and so on, is then taught as the basis of scientific knowledge (fact) and
dominates the work of scientists.
o Scientists work within the accepted paradigm, involving themselves in
...attempts to articulate a paradigm with the aim of improving the match
between it and nature.
o This process is called normal science and is comparable to the process of
operating under Lakatosian research programs.
o Normal scientists must presuppose that a paradigm provides the basis for
solving all puzzles posed within it.
o Thus, under this interpretation, much of the work of scientists is involved in
puzzle-solving activity, both theoretical and experimental, within the
accepted paradigm.
o Any problems which cannot be solved are the contradictory to the accepted
paradigm are called anomalies.

iii. Crisis-revolution- repeated failures to resolve anomalies lead to insecurity

and loss of confidence in the paradigm. New paradigm emerges.
o However, if the number of anomalies grows, confidence in the paradigm is
undermined.
o The mere existence of anomalies does not constitute a crisis. Kuhn recognises that
all paradigms will have unexplained problems.
o An anomaly is regarded as serious only when it is seen to strike at the core of the
paradigm and persistently resists attempts by the members of the normal
scientific community to remove it.
o Repeated failures to resolve these serious anomalies eventually lead to pronounced
insecurity and a loss of confidence in the paradigm.
o Scientists then begin to argue and develop new hypotheses, with different schools
of thought arising.
o This eventually results in debate between alternative schools of thought and
research.

iv. New normal science- scientists align themselves with new paradigm and it
gain support of the majority of the scientific community.
o Finally, out of this crisis-revolution a new paradigm emerges.
o Scientists then align themselves with the new paradigm and it eventually gains
the support of the majority of the scientific community.
o With this new paradigm, a new normal science begins, the replacement of the
old paradigm by the new paradigm being described as a revolution.

v. New crisis.

How Have Kuhn and Lakatos research programs affected accoutnign development

o The Kuhn and Lakatosian research programs are applicable to accounting theory
development.
o The Lakatos approach permits research programs to be inactive rather than
dismissing alternative theories when reshaping the positive heuristic. An example

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 of this as it relates to accounting theory is the normative theories regarding
measurement that aborted in the 1960s and 1970s. In recent times, attention on
measurement has been revived with fair value accounting being advocated. The
use of various paradigms (models) (for example capital market based, contracting
and behavioural) is also an example of refining the heuristic using different
research methods that contribute in different ways to theory development.
o The Kuhn research paradigm involves replacing one theory with another when the
anomalies associated with the dominant theory at the time become too systematic
and hard to dismiss.
o This can be applied to accounting theory development once again, in the context
of historical cost accounting being the accepted paradigm. The failure of historical
cost to reflect economic reality and enhance decision making, as documented via
recent corporate collapses, will reignite the debate as to whether this paradigm is
appropriate.

3.3a Feyerabends approach

o Core of Feyer bends approach is that reality and society are far too complex
for there to only be one method or paradigram to dominate science
o Any approach is valid as long as follow the procedures.
o Good scientists are those who prepared to develop and accept inconsistent
ideas.
o There is no single scientific way of getting ideas where they can arise from
many intellectual pursuits (search). Any approach is valid

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