ACCOUNTING THEORY
Accounting theory is at the heart of
accounting practice and is of
fundamental importance to a student of
accounting.
SCOPE OF ACCOUNTING
DATA COLLECTION
HISTORIC FORECAST
ACCOUNTING THEORY
DATA PROCESSING
DATA RECORDING
DATA REPORTING
EXTERNAL INTERNAL
DATA EVALUATION
WHAT IS A THEORY?
A THEORY IS A GENERALISATION,
WHICH IDENTIFIES A SPECIFIC
RELATIONSHIP BETWEEN
PARTICULAR EVENTS, THUS
PROVIDING AN EXPLANATION OF
SUCH EVENTS AND FORMING THE
BASIS FOR THE PREDICTION OF
SIMILAR EVENTS.
WHAT IS A THEORY?
• Theories are concerned with
EXPLANATION AND PREDICTION.
• Accounting theory should therefore
explain and predict accounting events,
thus providing a rationale for the
behaviour of accountants and
accounting practice.
WHAT IS A THEORY?
• In other words, accounting theory
should provide a framework in which
existing practice can be evaluated and
from which new practices can be
developed.
CONSTRUCTION OF ACCOUNTING
THEORY
• The construction of accounting theory,
should involve two interlinked
processes.
• THEORY FORMULATION.
• THEORY VERIFICATION.
THEORY FORMULATION
There are two types of reasoning which
may be adopted when formulating a
theory:
INDUCTIVE, and
DEDUCTIVE.
INDUCTIVE
Inductive reasoning commences with
the observation and recording of events.
The events can then be analysed to
detect any recurring relationships, from
which generalisations can be derived.
Using a process of inductive reasoning
in the formulation of accounting theory,
thus involves the following basic steps:
INDUCTIVE
1. The observation of accounting
practice.
2. The analysis of such practices, to
identify recurring relationships.
3. The derivation of generalisations,
or principles of accounting, from
the relationships identified.
DEDUCTIVE
Deductive reasoning commences with
a statement of basic assumptions, or
generalisations regarding events.
From these, relationships can be
logically derived. Using a process of
deductive reasoning in the formulation
of accounting theory, involves the
following:
DEDUCTIVE
1. A statement of the objectives of
accounting.
2. A statement of the basic assumptions, or
postulates of accounting.
3. The logical derivation of the principles of
accounting.
4. The logical derivation of accounting
techniques to be applied in practice.
INDUCTIVE OR DEDUCTIVE?
Many argue that inductive reasoning
presupposes deductive reasoning, as the
formulation of the basic assumptions of
accounting, is conditioned in the first
instance by experience of accounting
practice. This would seem a valid
argument, considering the which the
inductively formulated fundamental
concepts of accounting, stated initially in
SSAP 2, subsequently had on other
deductively formulated accounting
regulations.
INDUCTIVE REASONING
Theories which have been formulated
using inductive reasoning, tend to be
DESCRIPTIVE, that is they are
constructed from what is actually
observed.
DEDUCTIVE REASONING
Theories which have been formulated
using deductive reasoning, tend to be,
PRESCRIPTIVE, that is they indicate
what should be observed.
NORMATIVE THEORY
A theory which proposes what
should IDEALLY be observed, may
be described as a NORMATIVE
THEORY.
ACCOUNTING THEORY
From the discussion above it is likely
that accounting theory will be both
DESCRIPTIVE and PRESCRIPTIVE.
THEORY VERIFICATION
•
A theory which has not been verified
may be described as SPECULATIVE.
• There are two forms of verification:
 LOGICAL
 EMPIRICAL
THEORY VERIFICATION
•
•
If a theory is mathematically based, then it
may be verified by demonstrating that it is
logically consistent.
If a theory is based upon physical, or social
events, then it may be verified by the
observation of events predicted by the
theory, i.e. empirical findings or the ‘test of
experience’.
THEORY VERIFICATION
•
If during the process of verification
anomalies (departures from what was
expected according to the theory)
develop, which can not be explained
by the existing theory, then this theory
must be either modified, or rejected.
THEORY CONSTRUCTION
•
•
Hence, theory construction involves
two interlinked rather than distinct
processes:
The results of theory verification mat
well provide a valuable input to the
process of theory formulation.
ACCOUNTING THEORY VERIFICATION
•
•
Traditional approaches to accounting
theory verification have tended to treat
accounting practice, that is, what
accountants do, as synonymous.
This approach fails to recognise the
fundamental distinction between the
natural and social sciences.
SOCIAL SCIENCES
•
•
•
•
Social sciences are concerned with the
study of man, a thinking animal.
Unlike matter, man can alter his behaviour.
It is possible for a physicist to state that to
every action there is an equal and opposite
reaction.
It is NOT possible for the social scientist to
make such exact statements with respect to
the behaviour of man, as man can change
his behaviour.
ACCOUNTING AS A SOCIAL SCIENCE
•
•
Accounting is concerned with human
behaviour and as such may be classified as
a social science.
One of the implications for accounting as a
social science, is that accounting practice,
or the behaviour of accountants, does not
necessarily verify a given accounting theory,
as practice can be changed to
accommodate theory.
HISTORICAL DEVELOPMENT OF
ACCOUNTING THEORY
•
•
The demands placed upon accounting
have changed from the humble origin
of stewardship (score-keeping) to the
task of providing information which is
potentially useful to decision-makers.
This development has presented
accountants with numerous problems
in financial reporting.
ACCOUNTING PROBLEMS
•
•
•
•
What information should be disclosed?
How do you define useful information?
For whom should financial reports be
prepared?
How to report under conditions of
inflation?
ACCOUNTING PROBLEMS
•
•
To resolve such problems,
accountants have traditionally adopted
a descriptive approach.
By considering past and current
accounting practice, principles were
derived in a “piecemeal” fashion to
guide accounting practice.
ACCOUNTING PROBLEMS
“…..those concerned with
accounting are more adapt at
explaining what they do rather than
what accounting is, or what are the
foundations and uses of their art”
R.J. Bull
ACCOUNTING PROBLEMS
•
As demands on accounting increased,
the inconsistencies in this approach
emerged with a number of dramatic
corporate scandals:
 GEC/AEI (1968)
 ROLLS-ROYCE (1971)
ACCOUNTING PROBLEMS
Prof E. Stamp severely criticised the
failure of the accounting profession to
provide a lead in developing a set of
consistent principles for the
preparation and presentation of
financial reports.
ACCOUNTING PROBLEMS
Largely as a result of the GEC/AEI
saga, in 1969 the Accounting
Standards Committee (ASC) was
established, to narrow the areas of
difference and variety in accounting
practice.
ACCOUNTING PROBLEMS
The ASC was responsible for the issue
of Statements of Standard Accounting
Practice (S.S.A.P.s) which can be
considered rules on accounting
practice, to be observed by members
of the Professional Accounting Bodies.
ACCOUNTING PROBLEMS
The establishment of the ASC was a very
important step:
“…..what is really important, is the fact
that things will never be the same in
British accountancy. The English
Institute has stood up and declared itself
foursquare for progress and
improvement and it deserves the
greatest possible credit for having done
so.”
Prof E. Stamp
SETTING ACCOUNTING STANDARDS
In setting accounting standards, the
ASC initially continued to adopt a
descriptive approach, but there was a
gradual awareness that a prescriptive
approach should also be used in
establishing the theoretical
foundations of accounting.
SETTING ACCOUNTING STANDARDS
“A system of rules is necessary for the
consistent practice of any art and it is
useful to attempt to sort out the rules
which appear to be followed. Only if the
rules are adequately described, is it
possible to discover inconsistencies in
the system. But adequate description
does not assist in determining which of
two inconsistent rules should be
adopted and which should be
abandoned.”
Prof Chambers
THE CORPORATE REPORT
In July 1975 a discussion paper
entitled the Corporate Report was
issued. The objectives of the report
were stated as follows:
“Its aims will be to identify the
persons or groups for whom
published financial reports should
be prepared and the information
appropriate to their needs.”
THE CORPORATE REPORT
The report specifically identified seven
groups of users; the equity investor
group; the loan creditor group; the
employee group; the analyst advisor
group; the business contact group; the
government; and the public.
THE CORPORATE REPORT
The report concluded that the traditional
financial statements, that is the profit and
loss account and balance sheet, did not
satisfy the information needs of all the
interest groups.
This sparked off further discussion and the
accounting profession, began to seriously
question:
THE CORPORATE REPORT
•
•
•
•
•
•
For exactly whom are financial statements
prepared?
For what purposes are financial statements
wanted?
What kind of accounting reports are suitable
for these purposes?
Exactly how far do present reports meet
users needs?
How could accounting practices be
improved to meet users needs?
THUS BEGAN THE SEARCH FOR A
CONCEPTUAL FRAMEWORK.
THE NATURE OF A CONCEPTUAL
FRAMEWORK
• There are many definitions of a
conceptual framework, or a common
framework of accounting theory, but
perhaps one of the most
comprehensive is that proposed by
E.S. Hendriksen:
THE NATURE OF A CONCEPTUAL
FRAMEWORK
“Accounting theory may be defined as logical
reasoning in the form of a set of broad principles
that (1) provide a general frame of reference by
which accounting practice can be evaluated and (2)
guide development of new practices and
procedures. Accounting theory may also be used
to explain existing practices to obtain a better
understanding of them. But the most important
goal of accounting theory should be to provide a
coherent set of logical principles that form the
general frame of reference for the evaluation and
development of sound accounting practices.”
THE NATURE OF A CONCEPTUAL
FRAMEWORK
In general terms, we can say a conceptual
framework is a basic structure for
organising one’s thoughts ‘about what one
is trying to do and how to go about it’. An
agreed conceptual framework would thus
provide consistent answers to the questions
crystallised by the Corporate Report and a
consistent approach to deciding ‘what is
better accounting’ and the setting of
accounting standards.
THE NATURE OF A CONCEPTUAL
FRAMEWORK
HOWEVER, ALTHOUGH THERE IS
GENERAL AGREEMENT AMONGST
ACCOUNTANTS THAT FINANCIAL
REPORTS SHOULD PROVIDE
USEFUL INFORMATION, THERE IS
LITTLE AGREEMENT ABOUT
ANYTHING ELSE!
LACK OF AGREEMENT
•
•
•
UNCERTAINTY
VARIETY OF NEEDS
CONFLICTS OF INTEREST
UNCERTAINTY
•
Even when considering information for
a particular use, or purpose, it is
difficult to:
 Discover precisely what accounting
information is used, and how it is
used.
 Show exactly how some proposed
accounting practice would provide
more useful information.
UNCERTAINTY
•
Deciding what actually is useful
information and how to go about
producing it, is fraught with difficulties
and given a complex and uncertain
economic environment, it is unlikely
that agreement can be easily reached.
VARIETY OF NEEDS
From the discussion in the Corporate
Report, it is clear that there are a number of
different users of financial reports, each with
there own specific information
requirements. Although the economics of a
‘general purpose’ set of accounts is
obvious, the problem of deciding how far
the information requirements of each group
should be satisfied by the general purpose
accounts still remains, and is an area where
agreement, again is unlikely to be easily
reached.
CONFLICTS OF INTEREST
Finally, the different individuals and groups involved
with financial reporting, such as the users
mentioned in the Corporate Report, those who
prepare accounts and auditors, very often have
conflicting social and economic interests. Thus
decisions regarding accounting practices which
affect all of them, have to be taken after
considering the consequences for each party. The
attempt to strike a FAIR balance, obviously involves
the use of subjective judgement and is therefore
likely to meet with disagreement.
SCHOOLS OF THOUGHT
Rather than having an agreed
common framework of accounting
theory, there exists several schools of
thought on the nature of accounting
and hence several accounting
theories:
SCHOOLS OF THOUGHT
The ANTHROPOLIGICAL, or
PRAGMATIC school of thought,
considers accounting practice to be
the main concern of accounting.
SCHOOLS OF THOUGHT
The MARKET BEHAVIOUR school of
thought, considers the reaction of
capital markets, to be the main
concern of accounting.
SCHOOLS OF THOUGHT
The ECONOMIC EVENTS school of
thought, considers the prediction of
economic events as the main concern
of accounting.
SCHOOLS OF THOUGHT
The DECISION PROCESS school of
thought, considers the decision
theories and processes of individuals
as the main concern of accounting.
SCHOOLS OF THOUGHT
The IDEAL INCOME school of
thought, considers the measurement
of performance as the main concern of
accounting.
SCHOOLS OF THOUGHT
The INFORMATION ECONOMICS
school of thought, considers the
evaluation of information as the main
concern of accounting.
SCHOOLS OF THOUGHT
The USER BEHAVIOUR school of
thought, considers the information
recipients behaviour as the main
concern of accounting.
SCHOOLS OF THOUGHT
A school of thought provides a
fundamental image of the subject
matter. It forms the universal set, or
framework for analysis and research,
by defining what exactly should be
studied.
THEORIES
A theory is a subset within a school of
thought, providing a specific
perspective on the subject matter
defined by it.
There may be several different
theories within a given school of
thought.
THE IDEAL INCOME SCHOOL OF
THOUGHT
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Within this school of thought five
different theories may be identified:
Current Purchasing Power Accounting
Current Exit Price Accounting
Current Entry Price Accounting
Current Cost Accounting
Present Value Accounting
IMPLICATIONS
The fact that a number of schools of
thought exist, and within these schools
of thought exists a number of theories,
means that what is considered ‘good
(or better) accounting’ is fundamentally
a subjective matter.
IMPLICATIONS
“The problem in developing accounting
theory is that subjectivity and value
judgements may enter into the final
stage of selection of theory to be
developed to standard. Individuals,
groups of individuals, and the
professional bodies, will frequently
prefer one method to be used in
preference to another”.
HARVEY AND KEER
ECLECTIC DEVELOPMENT
Accounting practice is currently
developing in an ECLECTIC manner,
drawing upon all of the accounting
theories.
Glautier and Underdown depict the
situation as follows:
ECLECTIC DEVELOPMENT
Accounting
Theories
Value judgements
Abstractions
Non-users
And Users
Other information sources
Accounting
Policies
Recommendations
Reports
Accounting
Practices
ECLECTIC DEVELOPMENT
This mode of development may
continue to produce inconsistencies,
as value judgements are still required.
STATEMENT OF PRINCIPLES
In 1990 the Accounting Standards
Board (ASB) replaced the Accounting
Standards Committee, once again
largely due to corporate scandals.
The ASB set up a project to produce a
statement of principles. In December
1999, the ASB published its Statement
of Principles.
STATEMENT OF PRINCIPLES
It is NOT an accounting standard, but
sets out the concepts that underlie the
preparation of financial statements for
external users (i.e. financial
accounting).
The purpose of the statement was to
assist the ASB in the development and
review of accounting standards.
STATEMENT OF PRINCIPLES
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The statement has the following chapter headings:
The objective of financial statements.
The reporting entity.
The qualitative characteristics of financial
information.
The elements of financial statements.
Recognition in financial statements.
Measurement in financial statements.
Presentation of financial information.
Accounting for interests in other entities.
STATEMENT OF PRINCIPLES
Details of these chapters are provided
in the accompanying notes to this
lecture.
The statement of principles does
not represent an agreed conceptual
framework.
STATEMENT OF PRINCIPLES
Sir David Tweedie, Chairman of the
ASB has commented:
“The Board has developed its
Statement of Principles in parallel
with its development of accounting
standards….It is in effect the
Board’s compass for when we
navigate uncharted waters in the
years ahead.”
STATEMENT OF PRINCIPLES
In effect, the statement of principles represents,
and develops the initial thoughts of Prof Chambers:
“A system of rules is necessary for the
consistent practice of any art and it is useful to
attempt to sort out the rules which appear to be
followed. Only if the rules are adequately
described, is it possible to discover
inconsistencies in the system. But adequate
description does not assist in determining
which of two inconsistent rules should be
adopted and which should be abandoned.”
STATEMENT OF PRINCIPLES
Elliot and Elliot (2003/4) state:
“The need for a conceptual framework is being
addressed around the world. The UK is not
alone in its search. In the USA, Australia,
Canada and the IASC (International Accounting
Standards Committee), the approach has been
the same as that now followed by the ASB, i.e.
commencing with a consideration of the
objectives of financial statements, qualitative
characteristics of financial information,
definitions of the elements, and when these are
to be recognised in the financial statements.
There is general agreement on these areas.”
THE FUTURE: EVOLUTION OR REVOLUTION
It is argued that accounting theory will progress
either in an evolutionary, or revolutionary manner.
The proponents of the evolutionary viewpoint are of
the opinion that, given the existing different
accounting theories, there will be a fruitful
discussion, from which a conceptual framework of
accounting will evolve.
In The Future Shape of Financial Reports, 1989,
by Arnold et al, the following argument is
proposed:
THE FUTURE: EVOLUTION OR REVOLUTION
“Changes in financial reporting is bound to be
evolutionary rather than revolutionary. Most of
the important improvements in financial
reporting in the last fifty years have had their
origins in experimentation by practitioners
(sometimes with ideas first developed in
academic circles) rather than prescription by
legislation or accounting standards; indeed
legislation and accounting standards usually
lag developments in practice by some
years….Financial reporting practice is
continually evolving and over the years many
companies have been willing to experiment.”
THE FUTURE: EVOLUTION OR REVOLUTION
The evolutionary viewpoint would
appear to support the concept of
experimentation.
Elliot and Elliot (2003/4) comment as
follows:
THE FUTURE: EVOLUTION OR REVOLUTION
“The practitioners have now stated their claim
to create accounting theory or a conceptual
framework through the ASB. The advantage of
this is that the conceptual framework will be
based on consensus. This is illustrated by
Chapter 5 of the Statement of Principles relating
to measurement, which has not attempted to
make price level adjustment mandatory. Some
would call this attempt timid, but it is a healthy
way forward. It recognises that on many issues
genuine disagreements exist on what portrays
reality. What we need to encourage is
experimentation.”
THE FUTURE: EVOLUTION OR REVOLUTION
The evolutionary viewpoint does fail to
recognise that the different accounting
theories, are drawn from separate schools
of accounting thought. As noted earlier, it is
unlikely that several schools of accounting
thought can be combined into a single
unified accounting theory, with each school
of thought, representing as it does, a
different fundamental image of the nature of
accounting.
THE FUTURE: EVOLUTION OR REVOLUTION
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The statement of principles does recognise
that there are other factors to be taken into
account when setting standards:
Legal requirements.
Cost/ benefit considerations.
Industry-specific issues.
The desirability of evolutionary change.
Implementation issues.
REVOLUTION?
The proponents of the revolutionary
viewpoint are of the opinion that,
accounting as a social science, will
progress through the rise and fall of
particular schools of thought. This
viewpoint is drawn from Kuhn’s model
of Scientific Revolution, which can be
briefly stated as follows:
KUHN’S MODEL OF SCIENTIFIC
REVOLUTION
1.
2.
3.
4.
At any given point in time, a science is dominated
by a particular school of thought.
As this school of thought goes through a period of
knowledge accumulation, anomalies may develop
which it can not explain.
A crisis stage is reached when the search begins
for a new school of thought, which will explain the
anomalies discovered.
The crisis stage ends with the replacement of the
old school of thought, with a new dominant one.
KUHN’S MODEL OF SCIENTIFIC
REVOLUTION
Within Kuhn’s Framework, it could be
argued that accounting has been in
the crisis stage, with the anomalies
discovered in the pragmatic school of
thought, producing the search for a
conceptual framework. This search
has resulted in the identification of
several schools of accounting thought,
which are competing for dominance.
KUHN’S MODEL OF SCIENTIFIC
REVOLUTION
This viewpoint MAY be more
convincing than the evolutionary one,
but if accounting does progress in a
revolutionary manner, even given a
dominant school of thought, there may
still exist several theories of
accounting within this school.
CONCLUSION
“It therefore seems idle to hope for an agreed
conceptual framework or general accounting
theory of a type that will give explicit guidance
on what is appropriate in preparing financial
statements, or on what will improve accounting
practice……..Accounting theory cannot give
complete precise answers to accounting
problems……The value of the current attempts
to explore the ‘conceptual framework’ lies, in
my opinion, mainly in the discipline the process
imposes of identifying the important areas
where judgement is needed on questions of
accounting policy, and of stimulating enquiry
with regard to users needs and how to satisfy
them.
Prof R. Macve
CONCLUSION
The statement of principles
represents a positive step in the
development of accounting theory,
however, it would appear that the
search for an agreed conceptual
framework has much in common
with the search for the holy grail,
but has been a necessary step in
the development of accounting
practice.