Lecture 1
Introduction to
Accounting Theory
1
Doris Merkl-Davies
Division: Financial Studies
Location: Room 1.08, Hen Goleg
Telephone: 01248 38 2120
Email: d.m.merkl-davies@bangor.ac.uk
Reader in Accounting
MA, PGCE (Vienna University), MBA, PhD
(Bangor University)
Office hours: Mon. 9.00-10.00; Wed. 2.00-3.00
(Hen Goleg, Room 1.08)
2
Doris Merkl-Davies
 Research interests
 Corporate narrative reporting
 Impression management
 CSR reporting
 Accounting theory
1.3
Doris Merkl-Davies
 Can’t live without
 Motto
1.4
BBS film club
 Venue: Alun A0.01, 3.00-5.00pm
 WEEK 3 (WEDNESDAY 15 OCTOBER):
Wall Street (discussant: Doris MerklDavies)
 WEEK 5 (WEDNESDAY 29
OCTOBER):
Office Space (discussant: Tony Dobbins)
 WEEK 9 (WEDNESDAY 26
NOVEMBER):
Citizen Kane (discussant: Bernardo
Batiz-Lazo)
1.5
Module format
 Lectures: Mon. 10-12 in Drama Rehearsal
Room
 Tutorials:
 Group A: Mon, 13.00-14.00 LR5
 Group B: Tue, 9.00-10.00 LR1
1.6
Recommended Textbooks
 Deegan, C. and Unerman, J. (2011). Financial
Accounting Theory. European edition. 2nd ed. McGrawHill. (D&U) [Main text I]
 Rankin, M., Stanton, P., McGowan, S., Ferauto, K.,
Tilling, M. (2012). Contemporary Issues in Accounting.
2nd ed. Wiley. (R) [Main text II]
 Godfrey, J., Hodgson, A., Holmes, S. and Tarca, A.
(2010). Accounting Theory. 7th ed. Wiley. (GHHT)
[additional reading]
 Additional journal articles will be posted on
blackboard for you to download.
1.7
Background reading for Lecture 1
 D&U Chapter 1
 Rankin et al. Chapter 1; Chapter 5, pp. 131-134
 GHHT Chapts. 1&3
1.8
Overview of Lecture 1
 Definition of accounting theory
 Types of accounting theories
 Accounting theory development over time
 Relationship between theory and research
 Evaluation of theories
1.9
Exercise 1: What is a theory?
 In groups of 6 find an example of a
famous theory
 Discuss the main features of the theory
 What does this theory do?
 What do we use it for?
 Nominate a group member to report
back to the class
1.10
What is a theory?
 An organized way of thinking about a subject
 A set of ideas that explains something
 ‘a scheme or system of ideas or statements held as an
explanation or account of a group of facts or
phenomena’ (Oxford English Dictionary)
 “theory is a statement of concepts and their
interrelationships that shows how and/or why a
phenomenon occurs” (Corley & Gioia, 2011: 12)
1.11
What is the purpose of theories?
 To make sense of the world (physical, social,
psychological phenomena) and communicate that
understanding to others
 To make sense of (financial) accounting
information
 Financial statements, corporate annual reports
 Accounting info is compiled and interpreted by people
1.12
Types of theory
Type of theory
Users
Example
Common-sense
theory
Lay people
(personal
experience)
• It is not what you
know, but who
you know
http://www.telegraph.co.
uk/news/politics/10137928
/Its-still-who-you-knownot-what-you-know-thatmatters-say-two-thirdsof-Britons.html
Working theory
Managers,
investors,
auditors
(Generalisations
made in
particular
professions)
• Crisis
communication
should prioritise
key stakeholders
http://www.bernsteincrisi
smanagement.com/article
s/10-steps-of-crisiscommunications.html
Scholarly theory
Academics
• Accounting choice Positive
is driven by
Accounting
managerial selfTheory
interest
1.13
Scholarly theory
 Has undergone systematic research
 Provide more thorough, accurate, and abstract
explanations for financial accounting than commonsense or working theories
1.14
What is the purpose of theories?
 Theories are used to
Describe what people do = Descriptive theories
2. Suggest the best way (i.e., prescribe) to deal with
specific types of human behaviour = prescriptive or
normative theories
3. Explain and predict what people do = predictive or
positive theories
1.
1.15
1. Descriptive theories
 Describe what people do
 Based on common practice
 Describe
 Common practise of bringing up children
 Common practises for dealing with underage binge
drinking in various countries
 Describe accounting practice
 Common practise of accounting for fixed assets
 Future accountants are trained by practising
accountants
1.16
Descriptive theories
 Advantage:
 Tends to be accepted by majority
 Disadvantage:
 Does not entail critical evaluation
 Does not allow for change
1.17
2. Prescriptive (= normative) theories
 Also called normative theories
 What people should do
 Suggest best way to
 Bring up children, i.e., authoritarian, laissez-faire style,
etc.
 Prescribe particular accounting practices
 Account for fixed assets, i.e., historical cost, current cost,
exit price, etc.
 Advantage
 Can improve accounting practises
 Disadvantage
 Assumes that there is one “best way”
1.18
3. Predictive (= positive) theories


Also called positive theories
Concerned with explaining reasons for
behaviour and predicting future behaviour

Explain characteristics of children are most likely to
engage in binge drinking, i.e., social class, gender,
parenting style

Predict what effect a change in licensing laws
will have on underage teenage drinking
 Explain and predict accounting method choice


Characteristics of companies most likely to revalue
their assets
What effect a change in accounting standards on
leases will have on the way firms finance their assets1.19
Comparison of descriptive,
prescriptive and predictive theories
Descriptive theories
Descriptive “what is”
Prescriptive (normative)
theories
Prescriptive
“what should be”
Non-value laden
Value-laden
No empirical methodology No empirical methodology
* PAT Assumes specific human characteristics
Predictive (positive)
theories
Explanatory, predictive
“why it is” “what will
happen”
Non-value laden*
Empirically based
1.20
Examples of uses of accounting
theories
 Theories might:
 prescribe how assets should be valued
 predict why managers will choose particular accounting




methods
explain how an individual’s cultural background affects
accounting information provided
prescribe what accounting information should be
provided to particular classes of stakeholders
predict that the relative power of a stakeholder group
will affect the accounting information it receives
predict that accounting information is used to present
organisations as legitimate
1.21
Accounting theories
 Accounting is a human activity
 Explain the behaviour of people within and outside of
organisations with respect to accounting information
 Theories of accounting consider:
 Why people within organisations elect to provide
particular information (preparer perspective)
 People’s behaviour with respect to accounting
information (user-perspective)
 People’s needs for accounting information (userperspective)
1.22
Accounting theories
 Accounting is a social phenomenon
 Accounting theories are theories about
human behaviour
 Borrow from disciplines dealing with human
behaviour
 Psychology, sociology
1.23
Exercise 2
 Which of the following is NOT an assumption
used in normative theory construction?
 A. Profit and value can be measured precisely
 B. Financial accounting is useful for making
economic decisions
 C. There are multiple available profit measures
 D. Markets are inefficient and can be fooled by
'creative accountants‘
 E. All of the above
1.24
Why do we need accounting theories?
 Accounting is viewed as a ‘practical’
discipline
 Learning how to apply accounting rules
 Theories are necessary to understand the
(social) world we live in
 They provide a basis for the decisions we make,
e.g. whether to include an item in the financial
statements or not (materiality and recognition
criteria)
1.25
Why do we need accounting theories?
 We can make better predictions and
decisions if we get the contradictions out of
our thinking, if we consider what is known
on the many sides of the issue
 i.e. the various theories which exist on:



The regulation of accounting, e.g. whether we need
regulation or not
The provision of financial information, e.g. Why
accountants choose particular accounting methods
The way financial information is received, e.g. How
people react to particular accounting numbers
1.26
Why study accounting theories –
to understand:
 Motivation for individuals to support or lobby
regulators for some accounting methods in
preference to others ( Regulatory theories)
 How and why the capital markets react to
particular information ( Positive accounting
theory)
 Whether there is a ‘true measure’ of income
( Asset valuation theories)
1.27
Overview of theories of accounting
 Many theories of financial accounting exist
 No universally accepted theory of
accounting
 Different perspectives about the central
objective, role and scope of financial
accounting
 No universally accepted perspective about
the role of accounting theory
 Different researchers have different
perspectives of the role of accounting theory
1.28
Accounting Theory Timeline
1.29
Early development of accounting
theory
 Descriptive theories
 Relied upon the process of induction
 Development of ideas or theories through observation
 1920s to 1960s theories developed from observing what
accountants did in practice
 Codified as doctrines or conventions of accounting
1.30
Criticisms of inductive method
 … ‘concentrates on the status-quo, is reactionary in
attitude, and cannot provide a basis upon which
current practice may be evaluated or from which
future improvements may be deduced.’ (Gray, Owen
and Maunders 1987, p. 66)
 Assumes what is done by the majority is the most
appropriate practice
 Perspective of accounting Darwinism
1.31
Example of inductive approach to
theory development
 Grady (1965) undertook research commissioned by the
AICPA
 Formed the basis of APB Statement No. 4 ‘Basic
Concepts and Accounting Principles Underlying the
Financial Statements of Business Enterprises’
 Reflected generally accepted accounting principles at
the time
1.32
Theory development - 1960s and 1970s
 Sought to prescribe particular accounting
practices
 Known as normative theories
 Not driven by existing practices
 Theories critical of historical cost accounting
 Sought to provide improved approaches to
asset valuation in a time of widespread
inflation
1.33
Example of prescriptive theory
 1961 and 1962 studies by Moonitz, and Sprouse
and Moonitz commissioned by the Accounting
Research Division of the AICPA
 Authors proposed that accounting
measurement systems be changed from
historical cost to a system based on current
values
 Not supported by AICPA as too radically
different from current practice
1.34
Theory development - mid to
late 1970s
 Research aimed at explaining and predicting
accounting practice rather than prescribing
particular practices
 Known as positive theories
1.35
Positive theories
 Seek to predict and explain particular
phenomena
 Begins with assumption(s), and through logical
deduction enables prediction(s) to be made
 If predictions are sufficiently accurate when
tested against observations of reality, they are
regarded as having provided explanation of
why things are as they are
1.36
Positive theories - continued
 Positive Accounting Theory
 Developed by Watts and Zimmerman
 Seeks to predict and explain why accountants elect to
adopt particular accounting methods in preference to
others
 Based upon ‘rational economic person’ assumption

Individuals motivated by self-interest tied to wealth
maximisation
1.37
Relationship between theory and
research
 Theories are used to understand accounting
practice better
 Accounting researchers use theories
 Theories are used in empirical research (i.e.,
research based on data, such as financial
statements, annual reports, share prices) to
explain phenomena and make predictions
 Theories help us to critically evaluate a
phenomenon (i.e., accounting method choice)
1.38
Relationship between theory and
research
 "... all research emanates from the
researcher’ s implicit or explicit theory of the
phenomenon under investigation" (Rocco &
Plakhotnik, 2009: 121).
1.39
Testing a Theory in Research
Theory plane
2. Develop
theoretical
framework
3. State
research
question/
hypothesis
1. Identify
research problem
8. Assess
limitations
and constraints
4. Construct
research design
5. Observe
7. Evaluate
6. Analyse
Observation plane
40
Testing a Theory in Research
1. Identify research problem
Bias in corporate narrative documents

2. Develop theoretical framework
Agency theory assumptions


Information asymmetry between managers and
investors; managers are self-interested (want to
maximise their compensation); managers
manipulate presentation of information in corporate
narrative documents (e.g., annual report)
1.41
Testing a Theory in Research
3. State research question/hypothesis
 Managers in firms with negative financial performance
are more likely to introduce reporting bias (in the
form of pro-forma earnings number into corporate
narrative documents than managers of firms with
positive financial performance
4. Construct research design
 Sample of firms; split into two groups based on
positive/negative percentage change in earnings;
chairmen’s statements (pro-forma earnings vs. GAAP
earnings)
1.42
Testing a Theory in Research
5. Observe/Analyse
 Conduct statistical association tests
6. Evaluate
 Do findings confirm/disconfirm hypothesis; compare
with findings of prior research
7. Assess limitations/constraints
 E.g., small sample size
1.43
Criteria for evaluating theories
Area of evaluation
What to look for
Accuracy
Has research supported that they theory works the way
it says it does?
Practicality
Have real-world applications been found for the
theory?
Succinctness
Has the theory been formulated with the appropriate
number (fewest possible) of concepts or steps?
Consistency
Does the theory demonstrate coherence within its own
premises and with other theories?
Acuity
To what extent does the theory make clear and
otherwise complex experience?
1.44
Evaluation of theories
 Theories of accounting are only abstractions
of reality
 The choice of one theory in preference to
another is based on value judgements
 Cannot expect to provide perfect explanations
or predictions of human behaviour or assess
what types on information users actually
need
1.45
Evaluating theories of accounting
 When evaluating theories need to
consider:
1. Assumptions: whether you agree with the
2.
3.
4.
5.
central assumptions/premises of the theory
Logic: whether the argument supporting the
theory is logical
Research methods: Whether the research
methods are appropriate
Evidence: whether you accept any supporting
evidence provided
Rhetoric: the use of rhetoric used for
persuasion
46
The role of assumptions
 Even though an argument is logical we
might only accept the argument if we accept
any critical assumptions being made
 If we reject any central assumptions we may
reject the prediction
1.47
Logical deduction
 Acceptance of an argument must be based upon the
accuracy of the premises
 An argument is logical to the extent that if the premises
on which it is based are true, then the conclusion will be
true
 To determine the logic of an argument we do not need
to refer to ‘real world’ observations
1.48
Research methods
 Generalizing theories from the testing of samples
 Methods borrowed from sciences  phenomena
will behave the same in all situations
 Not possible when dealing with human behaviour
 Sample selection (firm size, industry, country of
origin, listed/unlisted, etc.)
 Keep in mind not only how the argument is
developed, but also how it is tested!!!
1.49
Evidence
 Is there enough evidence to support the
theory?
 Is there conflicting evidence?
1.50
Rhetoric
 Thouless (1974) identifies 38 ‘dishonest
tricks’ some writers use to support their
argument including:
 emotionally toned words
 statements where ‘all’ is implied but ‘some’ is true
 diversion to another question or to a side issue
 use of speculative argument
 prestige by false credentials
 appeal to mere authority
1.51
Any questions?
1.52