ACCOUNTING THEORY Accounting theory is at the heart of accounting practice and is of fundamental importance to a student of accounting

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 COLLECTIONHISTORIC FORECAST

ACCOUNTING THEORY

DATA RECORDING DATA EVALUATION

DATA REPORTINGEXTERNAL INTERNAL

DATA PROCESSING

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, andDEDUCTIVE.

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 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 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:


• 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:


“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.”


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.


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

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:


Value judgements

Abstractions Recommendations

Reports

Other information sources

AccountingTheories

AccountingPolicies

AccountingPractices

Non-usersAnd Users


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.


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.


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.


Details of these chapters are provided in the accompanying notes to this lecture.

The statement of principles does not represent an agreed conceptual framework.


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.”


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.”


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:


“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 evolutionary viewpoint would appear to support the concept of experimentation.

Elliot and Elliot (2003/4) comment as follows:


“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 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 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. At any given point in time, a science is dominated by a particular school of thought.

2. As this school of thought goes through a period of knowledge accumulation, anomalies may develop which it can not explain.

3. A crisis stage is reached when the search begins for a new school of thought, which will explain the anomalies discovered.

4. The crisis stage ends with the replacement of the old school of thought, with a new dominant one.


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.


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

CONCLUSIONThe 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.

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ACCOUNTING THEORY Accounting theory is at the heart of accounting practice and is of fundamental importance to a student of accounting