Chapter 2 Godfrey

8/19/2019 Chapter 2 Godfrey

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CHAPTER 2 ACCOUNTING THEORY

CONSTRUCTION

Godfrey, J., Hodgson, A., Tarca, A., Hamilton, J. and

Holmes, S.


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I. THEORY FORMULATION

A. What is a theory

In the simplest form: theory is a statement of a belief

expressed in a language.

Theories are logical arguments; their concludingstatements of belief are hypotheses.

Such theories comprise a set of premises (statements)

that are logically connected to give rise to thehypothesis.

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Two different approaches to theory development:

1. Deductive reasoning:

From general premises to develop predictions,

prescriptions or explanations of specific

matters.

2. Inductive reasoning:

From specific observations to develop a general

implication of those observations.

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PANEL B: The nature of the Plant and Machinery account

DEDUCTION

P1 All assets accounts have debit balances.

P2 The Plant and Machinery account is an asset account.

_______________________________________________________

C The Plant and Machinery account has a debit balance.

INDUCTION

P1 The Plant and Machinery account is an asset account and

has a debit balance.

P2 The Motor Vehicle account is an asset account and has a

debit balance.

P3 The Land account is an asset account and has a debit

balance.

______________________________________________________

C All asset accounts have debit balances.4


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B. Parts of a theory

A theory must be expressed in a language, which canbe either verbal or mathematical.

Theory development begins in the ‘unreal’ world ofabstraction – that is, in the human mind. But for it

to be useful, theory must eventually relate to the‘real’ world, the world of experience.

Note that the impetus (driving force) for a theory islikely to derive from the real world but the start of a

theory is the intellectual reasoning in ‘the abstractworld’.

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PARTS OF A

THEORY

Syntactic Semantic Pragmatic

Three types of relationship in the theoreticalstructure that should be noted are the syntactic,semantic and pragmatic relations.


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Parts of a Theory(a) Syntactic relationship

The first relationship is the syntactic orlogical relationship, linking together thebasic concepts.

This relation has to do with the rules of thelanguage employed. For example, if thetheory is expressed in English, then this

relation refers to the rule of grammar; if thetheory is mathematical, then this relationrefers to the rules of mathematics.

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Evaluating the syntactic relation of atheory involves evaluating the validity (i.e.the logic) of the argument that constitutesthe theory. It does not involve establishing

the truth of an argument.

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For example, take the following argument:

Premise 1: All accounts relating to assets have debitbalances.

Premise 2: The accumulated depreciation account

relates to assets.

_____________________________________________

Conclusion: The accumulated depreciation account has

a debit balance.

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The conclusion, or hypothesis, that the accumulated

depreciation account has a debit balance is clearlyincorrect. However, the logic (syntactic relationship) is

valid because if the premises were both true, the

conclusion would also be true.

(Premise 1 is incorrect because contra assets have

credit balances.)

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(b) Semantic relationship

Semantics = branch of linguistics concerned withmeaning.

The second relationship is the semantic

relationship, which link the basic concepts of atheory to objects in the real world.

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For example, consider the following argument:

Premise 1: All asset accounts have debitbalances.

Premise 2:The sales returns account is not an

asset account.________________________________________Conclusion: The sales returns account has a

debit balance.

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The conclusion that is reached is true because inthe real world sales returns accounts have adebit balance. However, if we look at the logicflowing from premises 1 and 2, then thestatement is not true. Hence, in this case truthis inductively derived from the observation.

If we have semantic rules for linkingpropositions to objects or events and analyticrules for linking basic concepts, we can thenform hypotheses or theories, which have bothempirical and syntactic content.

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(c) Pragmatic relationship

The third relation is the pragmatic relation. Manytheories do not have a pragmatic aspect. This relation

pertains to the effect of words or symbols on people.

The nature of accounting is such that an overall theoryof accounting must have a pragmatic orientation. We

are interested in how accounting concepts and their

real-world corresponding events or objects affect

people’s behaviour.

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Accounting information must satisfy the informationneeds of users.

Observe that people react to the same message indifferent ways. For example, the release of anaccounting standard may motivate some managers tosupport that standard while others will lobby for its

withdrawal.

Investors or other users of accounting reports who basetheir actions on the same information might either buy

or sell on the stock market.

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THE MAIN PURPOSE OF THIS CHAPTER IS TO PROVIDE

SOME INSIGHT INTO HOW ACCOUNTING THEORIES

HAVE BEEN HISTORICALLY FORMULATED.

II. PRAGMATIC THEORIES A. Descriptive pragmatic approach

An inductive approach to accounting theory

development – it is based on continual observation of

the behaviour of accountants in order to copy theiraccounting procedures and principles. Accountants

were trained by being apprenticed or articled to a

practicing accountant for a number of years.

Descriptive pragmatic is probably the oldest and most

universal method of accounting theory construction.

Sterling refers to this method as the anthropological

approach.

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Criticisms:

1.The descriptive pragmatic approach does not include

an analytical judgement of the quality of anaccountant’s actions; there is no assessment ofwhether the accountants report in the way in which heor she should.

2.This approach does not provide for accountingtechniques to be challenged, hence it does not allow forchange. For example, we observe practicingaccountant’s methods and techniques and teach those

methods and techniques to students. But thosestudents will become practicing accountants whom wewill observe in the future to learn what to teach, andso on.

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3.The descriptive pragmatic approach focuses attention

on accountants’ behaviour, not on measuring the

attributes of the firm such as assets, liabilities andprofit. In taking a descriptive pragmatic approach, we

are not concerning ourselves with the semantics of

accounting phenomena.

Sterling comments:

‘……………..it is my value judgement that the theory

of accounting ought to be concerned with accounting

phenomena, not practicing accountants, in the sameway that theories of physics are concerned with

physical phenomena, not practicing physicists.”18


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B. Psychological pragmatic approach

Psychological pragmatic approaches observe users’responses to the accountants’ outputs (such as the

financial reports). A reaction by the user is taken as

evidence that the financial statements are useful and

contain relevant information.

One problem that will arise is that each individual will

react differently to the financial information.

Therefore, we have to rely on decision theories, whichis a refinement of the psychological approach.

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II. SYNTACTIC AND SEMANTICTHEORIES

Traditional historical cost accounting has beentheoretically interpreted as almost completely asyntactic theory.

This interpretation of accounting theory may bedescribed as follows:

the semantic inputs of the system are thetransactions and exchanges recorded in thevouchers, journals and ledgers of the business.

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All these steps were accomplished on the basis

of the premises and assumptions of historical

cost accounting; inflation is not to be recorded

and market values of assets and liabilities are

ignored.

Use double-entry accounting and the principlesof historical cost accounting to calculate profit

and loss and the financial position.

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The individual propositions are verified every

time the statements are audited by checking the

calculations and manipulations.

However, the accounts are rarely audited

specifically in terms of whether and how people

will use them (a pragmatic test).

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Criticism:

1. The theory has semantic content only on the basis of

its inputs.

2.There is no independent empirical operation to verify

the calculated outputs, for example ‘income’ or ‘total

assets’.

These figures are not observed; they are simple

summations of account balances and the auditing

process is, in essence, simply a recalculation.

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Sterling comments:

If one were to confirm a theory of astronomy, as

illustrated by a particular planetarium, one will

check on the accuracy of the observational inputs,

and check for errors in computation. However, atsome point, the outputs of the system would be

verified by looking at the sky to see if the stars

were in fact in the position indicated by the

planetarium.

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3. Traditional historical cost accounting has also

been criticised on the basis of its syntactic, for

example, with respect to the practice of summingseveral different money amounts assigned to

specific assets (i.e. summing of cash held today

with cash paid for land 20 years ago, which the

company still holds today).

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4.Further criticism by Chambers:

The internal inconsistency of historical cost accountingis similar to the philosophy of doublethink.

Doublethink means the power of holding two

contradicting beliefs in one’s mind simultaneously, and

accepting both of them.

For example, valuations are incorporated in balance

sheets… but the balance sheet is not a valuation

statement. Fixed assets should be carried at cost … inhistorical accounts, unless such cost is no longer

meaningful.

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5.There are many imprecision of definitions in

accounting. In terms of Popperian approach to

science, many of the propositions of conventionalaccounting are not falsifiable.

Popperian approach of verifying theory:

All hypotheses proposed must be capable of

falsification. If a hypothesis is not proposed or worded

so that it is falsifiable, then it is not informative and

does not add to scientific progress. Once proposed, ahypothesis needs to be tested rigorously and ruthlessly

by both analytical and empirical analysis.27


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In defence of the historical cost system:

Historical cost accountants however, argue that there is no

requirement that accounting outputs should have anysemantic content or be subjected to falsification rules

because the purpose of accounting is to allocate the

historic cost of resource usage against revenue, which is

the matching concept.

Hence, assets, liabilities and owner’s equity are residuals

from this process; they are not meant to measure or say

anything about value or the financial state of affairs.

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III. Normative Theories

The 1950s and 60s were described as the ‘goldenage’ of the normative theories. During this period

accounting researchers became more concerned

with policy recommendations and with what

should be done, rather than with analysing andexplaining current or accepted practice.

The focus in this period was either deriving the

‘true income’ or on discussing the type ofaccounting information, which would be useful in

making economic decisions.29


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A. True income

True incometheorists concentrated on deriving a

single measure for assets and a unique (and correct)

income figure.

However, there was no agreement on what constituted

correct or true measure of value and income.

Much of the literature during this period consisted of

academic debate on the merits and demerits of each

system. 30


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B. Decision-usefulness

This approach assumes that the basic objective of

accounting is to help the ‘users’ of accounting

reports in their decision-making process byproviding relevant and useful information.

For example, to help investors (current and

potential) decide whether to buy, hold or sell

shares. One test of usefulness already discussed

is the psychological pragmatic reaction to data.31


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In most cases, these theories were based on

classical economic concepts of profit and wealth

or rational decision-making.

They usually make adjustments to account for

inflation or the market value of assets. Theyare, in essence, measurement theories of

accounting.

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They are normative in nature because they make the

following assumptions:

1.accounting should be a measurement system;

2income and value can be measured precisely;

3.financial accounting is useful for making economic

decisions;

4.markets are inefficient or can be fooled by ‘creative

accountants’;

5.conventional accounting is inefficient (in information

sense);

6.there is one unique income measure.

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These assumptions were rarely subjected to

any empirical testing. Proponents usuallydescribed their derived accounting system

as ‘ideal’, recommend it replace historical

cost, and prescribed its use by all.

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IV. Positive Theories

During the 1970s, accounting theory saw a move

back to empirical or positive methodology.

Positivism or empiricism means testing or

relating accounting hypotheses or theories backto the ‘experiences’ or ‘facts’ of the real world.

At first, positive theories focused on empirical

testing of some of the assumptions made by the

normative accounting theorists.

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For example, in testing the usefulness of

different accounting techniques:

The researcher would survey the opinions of

financial analysts, bank officers or accountants

on the usefulness of different inflationaccounting methods in their decision-making

tasks (such as predicting bankruptcy, or deciding

whether to buy or sell shares.

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Today, positive theory is primarily concerned

with ‘explaining’ the reasons for current

practice and in ‘predicting’ the role ofaccounting and associated information in the

economic decisions of individuals, firms and

other parties that contribute to the operation of

the marketplace and the economy.

This research tests theories that assume that

accounting information is an economic and

political commodity, and that people act intheir own self-interest.

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Positive accounting theory (PAT) covers

questions such as:

Do firms substitute alternative ways of financing

assets when the rules governing the accounting

for leases change?

Which firms are more likely to use straight-line

depreciation rather than diminishing-balance

depreciation, and why?

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The theory used to answer these questions

generally revolves around

managers’ incentives to maximise bonuses basedon their companies’ profits,

their incentives to avoid breaching accounting-

based debt covenants and thereby reducing the

cost of debt,

or their incentives to use accounting techniques

to divert attention from their high profits if those

profits would attract public or government

scrutiny, and perhaps lead to higher taxes.

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Th idiff bt ti d iti th i


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Normative

Theories

Positive Theories

Prescriptive Descriptive, explanatory or predictive

Prescribe how

people such as

accountants

should behave toachieve an

outcome that is

judged to be right,

moral, just or a

‘good’ outcome.

Do not prescribe how people (e.g. accountants) should

behave to achieve an outcome that is judged to be

‘good’.

Rather, they avoid making value-laden prescriptions.

Instead, they describe how people do behave

(regardless of whether it is ‘right’;

they explain why people behave in a certain manner,

e.g. to maximise share values or their personal wealth

(regardless of whether that is ‘right’);

or they predict what people have done or will do

(again, regardless of whether that is ‘right’ or ‘best

behaviour’).

The main difference between normative and positive theories:


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Many positive theory researchers are largely

dismissive of normative viewpoints.

Similarly, many normative theorists do not accept the

value of positive accounting research.

In fact, the theories can coexist, and can complement

each other.

PAT can help provide an understanding of the role of

accounting which, in turn, can form the basis for

developing normative theories to improve the

practice of accounting.

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THANK YOU

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Chapter 2 Godfrey