Accounting Theory
Learning Objectives
Definition of theory and accounting theory
The needs, purposes & benefits of AT
Inductive & deductive approach to construct
theory
Descriptive, decision usefulness & welfare
approaches to the construction of AT
Structure of AT
Relationship between AT & AP
1
Accounting Theory
Defined as:
A set of broad principles that provides a general
frame of reference by which accounting practice
can be evaluated and guides development of new
practices and procedures. (Hendrickson, 1982) or
A cohesive set of conceptual, hypothetical and
pragmatic propositions explaining and guiding the
accountant’s action in identifying, measuring and
communicating economic information.
2
Nature and Purpose of Theory
Theory can be defined as a set of general propositions,
used as principles of explanation of the apparent
relationship among certain observed phenomena, events
or things.
Proposition – statements concerned with the relationship
among concepts.
Concepts – generalized idea or expression in words about
events observed in the real world.
Theory is used as basis of explanation with regard to
how/why certain phenomena happens the way they do.
Explanation as well as prediction offers by theory is
important as it enhance our understanding of the
phenomena that exist in reality
Generally theory is sometimes said to deal with the
creation of scheme of ideas which provide definition of
the problem observed and the understanding of it.
3
Needs and Importance of Accounting
Theory
To provide a basis for prediction and explanation of
accounting behaviors and events and help to understand
current development in accounting practice.
Provide general frame of reference by which accounting
practice can be evaluated.
Guide the development of new practices and procedures.
4
Purposes of Accounting Theory
Helps to evaluate existing practice. E.g. are methods and
techniques used by accountants valid or correct in terms of
what it should be?. This is to eliminate unnecessary diversities
in accounting treatment for similar items.
From the evaluation of existing practices, reasons for diversity
that cannot be eliminated may be discovered and explained.
This will enhance our understanding of current practice and
facilitate in the regulating the profession by policy makers.
Theory also assist in the development of future practice where
it serves as basis in the development of accounting standards.
As business practices becomes more sophisticated , new
accounting problems may arise that require development of
new techniques and procedures.
The goal of theory is to provide coherent set of logical
principles that form the general frame of reference for
evaluating and developing new accounting practices.
5
Benefits of Accounting Theory
To guide the body responsible for establishing
accounting standards.
To provide a frame of reference for resolving
accounting questions in the absence of a specific
promulgated standard.
To determine bounds for judgment in preparing
financial statements.
To increase financial statement’s users’
understanding of and confidence in financial
statements.
Enhance comparability.
Improve the image of the profession.
6
Theory Construction
1.
Descriptive – inductive theory which
derived from factual empirical observation,
describe what reality is like.
2.
Normative – deductive theory which
describe what the empirical world should be
regardless of its reality.
7
Approaches to the
Construction/Development of Accounting
Theory.
Three basic approaches:
1. Descriptive approach
2. Decision usefulness approach
3. Welfare approach
8
Descriptive Approach
Theories developed are concerned with what accountants do,
that is the practice of accounting.
Making observation to look for similarity and recurrence and
drawing generalized conclusions from those observation or
practices. (E.g. observed how accountants record assets)
The focus of the theory is to explain what accountant do or the
functional tasks of an accountant and enable prediction to be
made and hence its treatment in the book.
In standard setting the setter are concerned with discussing the
varied practices used by accountant and reaching a consensus
on the most feasible basis to reduce diversity of practices within
which descriptive theory has developed.
Involves the process of specifying the objectives of financial
statements, selecting the postulates of accounts, deriving the
principles of accounting and developing the techniques of
accounting.
9
Decision Usefulness Approach
Emerged due to the expansion of behavioral research into
accounting – based on the thought that the purpose of accounting
reports is to influence action or behavior of users (e.g. users
make investment decision based on information in the F/S).
Two types of theories in this approach are empirical and
normative theories.
Empirical Approach – employs statistical technique (research) to
make accounting research more rigorous and to improve the
reliability of results.
Normative Method – concerned with specifying the manner in
which decision to be made serves as a precondition to
considering the information requirement. It focus on decision
models used by decision maker and provides insight on
information needs of decision makers as a basis for developing
accounting theory. (Refer to page 34)
10
Welfare Approach
An
extension of decision making approach
which consider the effects of decision
making in social welfare due to the effects of
the decision made base on the accounting
information do have effect to the external
society.
It resulted in a social welfare dimension to
accounting theory – Social Responsibility
Accounting.
11
Accounting Theory and Policy Making
The
two groups that determine accounting
policy are the government and the
accounting profession.
The government employs legislative
process to ensure minimum level
information disclosed in company’s report.
Accounting profession as a regulatory body
deals with problems of accounting standards
implied in financial reports.
Refer to page 35 – Figure 3.2
12
Relationship Between Theory and Practice
Influence of policy makers in setting up rules in the form of
accounting standards.
Practice may be changed to accommodate theory.
The form of accounting information reported depends on
practices adopted, i.e. practices imposed by policy maker in
response to the needs of users.
Theory provides an abstraction of needs and serves as a basis to
provide value judgment in accounting policy making.
If deficiencies occur in either accounting theory or policy
making or accounting practices, it will impair usefulness of
accounting information.
Usefulness of accounting information may be improved via
research findings in policies devised by policy makers.
13
Structure of Accounting Theory
The structure of accounting theory serve as frame of
reference that is use to judge the extend to which a
particular accounting technique of accounting is adequate.
Based on a set of elements and relationship that govern the
development of accounting technique.
The five elements in the structure of an accounting theory
are:
Objectives of Financial Statement
Accounting postulates ( assumptions)
Accounting concepts
Accounting principles
Accounting techniques
Refer to page 36 – Figure 3.3
14
Objectives of Financial Statements
To
present fairly and conformity with GAAP,
the position, results of operation and changes in
financial position for investors to make relevant
investment and credit decisions.
The objectives contain three areas:
– User of information; specifically the investors
group, to whom the information is directed.
– Purpose to which accounting information is
generated, that is for making investment and credit
decisions.
– Nature of content of information specified, that is on
performance, position and changes in position of an
15
enterprise.
Accounting Postulates
Entity Postulate – entities are separate and distinct
from owners entities. Accountants report transactions
of enterprise itself, not of owners of enterprise. It
applies to sole proprietorship, partnership and
corporation.
Going Concern Postulate – business entity is
assumed not to be liquidated in the foreseeable future.
Unit-of-measure Postulate – information expressed in
terms of monetary unit.. This postulate is also a stable
monetary postulate where the purchasing power of
money is assumed to be stable over time.
Accounting Period Postulate – the financial reports
depicting changes in the wealth of firm should be
disclosed periodically.
16
Theoretical Concept
Theory - proprietor, the owner,
is the focus of attention.
Proprietorship
ASSETS – LIABILITIES = PROPRIETORSHIP’ EQUITY
Assets
belong to the proprietor and liabilities are
his obligation, the resulting outcome is the net
worth of owner or the proprietor.
17
Entity Theory –
– entity to be separate and distinct from those who provide
capital to the entity.
– It is the entity and not the owner to be the centre of
accounting interest.
– All accounting procedures are conducted from the viewpoint
of the entity.
– Does not focus on net worth of owner, but the business that
owns the assets and liable to all obligations.
ASSETS = EQUITIES + LIAB
– Equities represent rights or claim on assets of the entity.
– As provider of funds, shareholders have no claim to any
particular assets or income of the company, except those
dividends declared by the company.
18
Fund Theory – do not focus on owner or the
entity but the groups of assets and related
obligations and restriction that governs the use of
the assets.
ASSETS = RESTRICTION ON ASSETS
Fund is directed for specified purpose via services
derived from the use of the assets.
Focuses on the administration and appropriate use
of assets.
Fund theory is applicable for government and nonprofit organization.
19
Accounting Principles
Cost
Principle
Revenue Principles
Matching Principle
Objectivity Principle
Consistency Principle
Full Disclosure Principle
Conservatism Principle
Materiality Principle
20
Accounting Techniques
Accounting
techniques are specific rules
derived from the accounting principles that
account for specific transactions and events
faced by the accounting entity.
21
Tutorials
Harvey and Keer, Financial Accounting Theory
and Standards: Chapter 3:The Role of Accounting
Theory.
Harvey and Keer, Financial Accounting Theory
and Standards: Chapter 1:The Construction of
Financial Accounting Theory.
Glautier, M.W.E and Underdown, B., Accounting
Theory and Practice, Chapt. 4.
Ahmed Belkaoui, The Nature of an Accounting
Theory, pp. 56-57.
22