CHAPTER 1
THE ROLE OF
ACCOUNTING THEORY
Nature of Theory
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The objective of accounting theory is to
explain and predict accounting practice.
 Auditing practice is included as part of
accounting practice
Explanation: providing reasons for
observed practice.
Prediction: the theory predicts unobserved
accounting phenomena.
Why Accounting Theory is
Important

Many individuals have to make decisions
about external accounting reports.
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Corporate managers
Public accountants
Officers of lending institutions
Investors and financial analysts
Individuals in accounting standard-setting
bodies
Why Accounting Theory is
Important (Cont’d)
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All these various parties act so as to maximize
their own welfare.

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Corporate managers: if corporate manager’s welfare
is dependent on the market value of the corporation,
he/she wants to know the effect of accounting
decisions on stock/bond prices.
Determining the relation between accounting
reporting decisions and variables affecting
individual welfare is difficult

Can not be determined by mere observation
Why Accounting Theory is
Important (Cont’d)

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They requires a theory that explains the
relation between the variables
By using large number of observations and
carefully constructed empirical tests,
researchers should be able to provide
theories that are more useful to decision
makers in maximizing their welfare.
Evolution of Accounting Theory

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After the US Securities Acts of 1933 and 1934:
accounting theorists became more normative –
concerned with what should be done.
Development in finance, which inherited the
concept of economics
Empirical tests of hypotheses were facilitated by the
creation of a large computer data base of security
prices (CRSP) and combined with the availability
of computer.

Led to the development of the efficient market
hypothesis
Evolution of Accounting Theory
(Cont’d)


Article that had the biggest impact on the
accounting literature was Ball and Brown
(1968).
By mid 1970s accounting researchers had
observed systematic accounting behavior in
accounting practice, which suggested that a
theory could be developed to explain
accounting practice.
Evolution of Accounting Theory
(Cont’d)

Another basis for the emerging accounting
theory was the ongoing debate over the
desirability of government regulation of
financial disclosure
Positive and Normative
Propositions

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Positive propositions are concerned with
how the world works.
Normative propositions are concerned with
prescriptions.
Positive Accounting Theory (Scott)

PAT is concerned with predicting such
actions as the choices of accounting
policies by firm managers and how
managers will respond to proposed new
accounting standards
The Three Hypotheses of
Positive Accounting Theory (Scott)
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The bonus plan hypothesis
The debt covenant hypothesis
The political costs hypothesis
An Outline of Methodology
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Development of a Theory
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A theory consists of 2 parts: the assumptions
and the set of substantive hypotheses.
If the phenomena the research address and/or
the empirical results are interesting, others
researchers will try to improve the original
researcher’s methodology, apply it to
different phenomena, find and test alternative
explanations, and so on, and a literature will
develop

The theory will change and evolve
An Outline of Methodology (Cont’d)
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The Nonexistence of Perfect Theories and the
Role of Anomalies
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A theory can not explains and predicts all accounting
phenomena
Theories are simplifications of reality and the world
is complex and changing.
The mere fact that a theory does not predict perfectly
does not cause researchers or users to abandon that
theory.
But prediction errors are important, because
investigation of them frequently leads to
improvement in the accepted theory.
An Outline of Methodology (Cont’d)
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The Nature of Evidence
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Concern with anecdotal evidence:
In some circumstances, that evidence is the only
evidence available, and some evidence is better than
none.
 It can suggest ways to improve the theory.

An Outline of Methodology (Cont’d)
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The Criterion for a Theory’s Success
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The value of the theory to users
The costs of prediction errors.
 The cost of developing the theory’s prediction.
 Intuitive appeal of the theory’s explanation for
phenomena and by the range of phenomena it can
explain and predict as well as by the usefulness of
its prediction to users.
 Competition between alternative theories
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An Outline of Methodology (Cont’d)
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The Important Role of Competing Theories
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Competing theories arise because theories are
imperfect and we can not prove a theory
correct
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Only test a theory’s hypotheses
There is often competition among alternative
theories about the same phenomena.
If competing theories exists, we have to
investigate the variables that those competing
theories suggest are important.