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I!#?
T%
ftneri
canAc
counti
n8Ass
ociatio
nU
/AitC
ommi
tteeo
nConc
eptsand
Standa
rds
F; ccep
tan
ce
/
STATEMENT ON ACCOUNTING THEORYAND THEORY ACCEPTANCE
Committee on Concepts and Standardsfor Externa] Financial Reports
AMERICAN ACCOUNTING ASSOCIATION
Copyright, American Accounting Association, 1977, All rights reservedLibrary of Congress Catalog Card Number 77-747-36
Printed in the United States of America
CONTENTS
PREFACE ix
CHAPTER 1Introduction l
CHAPTER2
AlternativeTheory Approaches 5
CHAPTER3
Criticisms of Present Theory Approaches 31
CHAPTER4Difficulties in Achieving Consensus: A General View 41
CHAPTER5Implications 49
1976-77
EXECUTIVE COMMITTEE
CHARLES T. HORNGRENWILTON T. ANDERSON
R.LEEBRUMMET
DONT.DcCOSTER
THOMAS R.DYCKMAN
ROBERT L. GRINAKER
VII
ALFRED RAPPAPORT
ROSS SKINNER
DAVID SOLOMONS
FLOYD W.WINDAL
Preface
This project was initially commissioned by the Executive Committee of the AmericanAccounting Association in 1973. The charge was to write a statement that would providethe same type of survey and distillation of current thinking on accounting theory as AStatement of Basic Accounting Theory' (ASOBAT) provided in an earlier decade. Thisdocument represents our response to that assignment.
A periodic reappraisal was deemed necessary since accounting is an important andconceptually rich area and has naturally attracted a wide range of thoughtful and talented researchers. The past ten years have been unusually active in this regard. Fundamental changes have occurred since the publication of ASOBAT. The basic disciplinestraditionally utilized by accounting theory have been altered considerably, and accounting researchers have enthusiastically employed their new tools, perspectives, and analytical techniques toexplore a wide range of accounting issues from new directions.
In our view, these changes are exciting and indicative of intellectual growth. Yet, theyare also frustrating since the new knowledge gathered during the past decade amplytestifies to the view that there are no easy theoretical answers to many of the urgentproblems faced by the profession.
For this reason, ours is not a statement of accounting theory; instead we have prepared a statement about accounting theory and theory acceptance. This distinction is anaturalconsequenceof the recent advances in knowledge. Just as a synthesis of leadingthought ten years ago led to an ASOBAT-type document, an equally conscientious synthesis of today's research findings generates this current statement. While different interms of scope, mode of analysis, and conclusions, this document—like ASOBAT—is intended to be a faithful rendition of the frontiers of accounting theory at the time it is written.
The committee has worked on this document for two years. We have met as an entiregroup eight times and have had several subcommittee meetings. Numerous drafts havebeen written and rewritten, edited, and re-edited. It is our hope that the final product notonlysynthesizes the predominant theory perspectives in the contemporary literature butalso serves as an educational document for students of accounting thought.
This report benefited from the editorial suggestions of Lanny G. Chasteen and JeanEros. Much of the groundwork for this document was developed by a predecessor committee in 1973-74 under the chairmanship of Kermit Larson. In addition to most of themembers of the current group, that committee also included Enrico Petri, Gary L. Sun-dem and Jan R. Williams. Their contributions, as well as the excellent guidance providedby Kermit Larson, are gratefully acknowledged.
Lawrence Revsine, ChairmanCommittee on Concepts andStandards for External Financial Reports
* Committee to Prepare A Statement of Basic Accounting Theory. A Statement of Basic Accounting TheoryIAmerican Accounting Association. 1966>
IX
CommitteeonConcepts andStandards forExternal Financial Reports
Statement on Accounting TheoryandTheory Acceptance
Members: James R. BoatsmanJoel Demski
JohnW.KennellyKermit D.LarsonLawrence Revsine,
ChairmanGeorge J. StaubusRobert R. SterlingJerryJ.WeygandtStephen A. Zeff
Oklahoma State UniversityStanford UniversityDePaul UniversityUniversity of Texas, Austin
Northwestern UniversityUniversity ofCalifornia, BerkeleyRice UniversityUniversity of Wisconsin, MadisonTulane University
The views expressed in this report are those ofa majority ofthe committeemembers. Publication in this volume does not imply agreement orofficial endorsement on the partof theAmerican Accounting Association or its Executive Committee.
Chapter 1
Introduction
There has been a persistent, widely heldbelief among accountants that the accumulation of accounting theory literaturewould eventually lead to a compellingbasis for specifying the content of externalfinancial reports. Indeed, a primary objective implicit in the charge to this committee was to ascertain the extent to which existing accounting theories do in fact provide a basis for determining the content ofexternal financial reports and resolvingaccounting controversies.
If a compelling conceptual basis couldbe discerned, the committee would thenidentify the basic concepts that shouldunderlie the design of external reports. Alternatively, if the theoretical literature ofaccounting has not provided a sufficientbasis for guiding the design of external reports, the committee would then assess theplausible reasons for this state of affairs.
In the view of this committee, a singleuniversally accepted basic accountingtheory does not exist at this time. Instead,a multiplicity of theories has been—andcontinues to be—proposed. Therefore, thisstatement cannot provide accounting withan unequivocally acceptable conceptualsuperstructure when the underlying foundation has not yet settled. Accordingly, wehave defined our task to be somewhat different from past theory statements. Hereinwe seek to explain why the accountingcommunity has been unable to achieve theoretical closure. That is, we attempt to explore the problem that characterizes theoretical debate at this stage of accountingdevelopment: virtually endless argumentation and inability to resolve issues thatare raised. Once the nature of the problemis better and more widely understood, webelieve that unrealistic expectations regarding "authoritative theory pronouncements" will be reduced. While we most emphatically do not call for a moratorium ontheory building and conceptual modeling,we do call for a better understanding of thereasons why such efforts in the past seemto have persuaded only a small proportionof the intended audience.
We believe that theory acceptancewould not be facilitated by this committee's attempting to impose theory closure.Numerous theories already exist. Selectionof one such theory by this committee mightbe persuasive to some. However, becauseof the complex nature of the process oftheory acceptance (which is discussed inChapter 4), any imposed selection of onefrom among competing theories would notresolve existing debates and would not provide rigorously defensible theoretical closure. Accordingly, this report does not attempt to develop a statement of universally accepted accounting theory; insteadours is a statement about accountingtheory and theory acceptance. Specifically, we explore certain theoretical approaches to accounting and explain thereasons why achieving consensus is an arduous task.
Basis for Different AccountingTheories
There is currently an abundance of theories of external reporting. At a very general level, accounting writers appear toagree that the central purpose of financialaccounting is the systematic provision ofeconomic data about reporting entities.The data are provided to individuals andgroups external to the reporting entity, andit is generally acknowledged that profit-seeking as well as not-for-profit entitiesmay be involved.
However, when one attempts to applythis doctrine to resolve actual accountingissues, divergent theories arise. Such divergence results from differences in theway people specify both the "users" of accounting data and the "environment" inwhich preparers and users of accountingdata are thought to behave.
In this section we survey alternativecharacterizations of "user" and "environment." The differences in specificationsthat we observe among writers and the variety of analyses induced by these divergences lead us to conclude that:
1. no single governing theory of finan-
Stat
emen
tonA
ccou
ntin
gT
heor
yand
The
oryA
ccep
tanc
e
cial
acco
unti
ngis
rich
enou
ghto
enco
mpa
ssth
efu
llra
ng
eo
fus
er-e
nvi
ronm
ent
spec
ific
atio
nsef
fect
ivel
y;he
nce,
2.th
ere
exis
tsin
the
fina
ncia
lac
coun
tin
gli
tera
ture
nota
theo
ryof
finan
cial
acco
untin
g,bu
ta
colle
ctio
nof
the
orie
sw
hich
can
bear
raye
dov
erth
edi
ffere
nces
inus
er-e
nvir
onm
ent
spe
cif
ica
tio
ns.
Use
rs The
seto
fuse
rsof
finan
cial
acco
untin
gre
port
sso
met
imes
isde
fined
narr
owly
toin
clud
eonl
yth
epre
sent
owne
rsof
are
port
ing
enti
ty;
atot
her
tim
es,
itis
defin
edbr
oadl
yto
incl
ude
cred
itors
,em
ploy
ees,
regu
lato
ryan
dta
auth
oriti
es,
char
ita
ble
inst
itutio
ns,
and
the
"gen
eral
pub
lic." Fu
rthe
r,th
ere
isso
me
ques
tion
abou
tw
hatc
onst
itute
s"u
se"o
facc
ount
ing
data
.It
isap
pare
ntth
atin
divi
dual
sw
hodo
not
actu
ally
rece
ive
the
acco
untin
gda
tain
ques
tion
can
beaf
fect
edby
the
acti
onso
fth
ose
who
dore
ceiv
ean
dac
tupo
nth
ose
data
.(In
sider
tradi
ngis
acl
assic
exam
ple
ofth
isph
enom
enon
.)T
heno
tion
of"u
se"
ofac
coun
ting
data
can
bebr
oade
ned,
ther
efor
e,to
enco
mpa
ssth
ose
affe
cted
indi
rect
lyby
the
appe
aran
cean
dem
ploy
men
toft
heda
taby
thos
ehav
ing
dire
ctac
cess
.In
the
lim
it,t
hen,
the
enti
rem
embe
rsh
ipof
aso
ciet
ym
aybe
rega
rded
asco
nst
itutin
gth
eun
iver
sal
seto
f"us
ers"
;fu
ture
gene
rati
onsm
ight
wel
lbe
incl
uded
.1W
ith
hom
ogen
eous
user
s,or
hete
ro-
gene
ousu
sers
who
happ
ento
agre
eon
the
finan
cial
data
they
wan
t,th
ere
solu
tion
ofac
coun
ting
issu
esis
fair
lyst
raig
htfo
rw
ard.
The
pref
eren
ces
ofa
"rep
rese
nta
tive
"in
divi
dual
wil
lgov
ern,
beca
usea
llin
divi
dual
sar
e—by
assu
mpt
ion—
unan
imou
sin
thei
rpre
fere
nces
for
finan
cial
repo
rting
.B
utw
ith
hete
roge
neity
,th
epr
oble
mbe
com
esqu
ite
com
plex
.E
ven
whe
nth
epo
pula
tion
ofus
ers
issp
ecifi
ed,a
num
ber
ofqu
esti
onsa
bout
the
beha
vior
ofus
ers
rem
ain.
Fore
xam
ple,
tow
hat
exte
ntdo
belie
fsan
dpr
efer
ence
sva
ryac
ross
user
san
dho
w,
ifa
tall
,do
dif
fere
nces
inus
ers'
belie
fsan
dpr
efer
ence
saf
fect
the
dem
and
for
and
use
ofac
coun
tin
gre
port
s?W
hen
face
dw
ith
anac
coun
tin
gre
port,
how
dous
ersr
eact
?Ar
eth
eyin
fluen
ced
byth
e"f
orm
"as
wel
las
"con
tent
"of
the
data
pres
ente
d?A
reth
ey"r
atio
nal"
proc
esso
rsof
the
data
?Do
they
adop
t"n
aive
"in
terp
retiv
epr
oces
ses
or"s
ophi
stic
ated
"pr
oces
ses?
Whe
nfa
ced
with
mul
tiple
sour
ces
ofda
ta,h
owdo
they
com
bine
thev
ario
usda
tain
toa
com
posi
teas
sess
men
t?F
urth
erm
ore,
doan
swer
sto
thes
equ
estio
nsch
ange
whe
nw
elo
okat
user
sin
the
aggr
egat
era
ther
than
indi
vid
ua
lly? To
illu
stra
teth
eim
port
ance
ofth
ese
issu
esto
theo
ryco
nstr
ucti
on,
cons
ider
the
follo
win
g.W
hile
ques
tion
sab
out
whe
rece
rtai
nda
tash
ould
bedi
sclo
sed
wit
hin
are
port
ma
ybe
cruc
ial
ifon
evi
ewof
user
beha
vior
isas
sum
ed,
they
may
beir
rele
vant
ifan
othe
rvi
eww
erea
dopt
ed.F
orex
ampl
e,a
rati
onal
proc
esso
r,un
infl
uenc
edby
form
,wou
ldbe
tota
llyin
diffe
rent
toth
edi
sclo
sure
ofda
tain
foot
note
sra
ther
than
inth
est
atem
ent
prop
er.
Sim
ilarly
,qu
estio
nsof
whe
ther
finan
cial
repo
rts
shou
ldju
stpo
rtra
yev
ents
,or
port
ray
and
inte
rpr
etev
ents
,bec
omei
nter
esti
ngor
unin
ter
esti
ngde
pend
ing
onon
e's
view
ofus
erbe
ha
vio
r.
Ina
"gen
eral
"th
eory
,the
spec
ifica
tion
ofus
erss
houl
dbe
able
toco
pew
ith
ava
-
'How
ever
,thi
sobs
erva
tion
does
noti
mpl
yth
atfo
cusin
gup
ona
subs
et,e
ven
aqu
itena
rrow
subs
et,o
fth
isbr
oadg
roup
isun
desir
able
pers
e.On
thec
ontra
ry,
give
nth
epu
rpos
eof
thea
naly
sisan
dth
eaud
ienc
eto
which
itis
addr
esse
d,su
cha
restr
ictio
nm
aybe
eith
erth
eore
tical
lyso
undo
rpra
gmat
ical
lydi
ctat
ed.
Wec
ansa
ytha
tthe
focu
s(o
na
subj
ect)
is"t
heor
eti
cally
soun
d"if
itca
nbe
show
ntob
ebas
edup
on:f
irsta
deco
mpo
sitio
nof
the
seto
fall
user
sin
tosu
bset
s;an
dse
cond
,an
anal
ytic
alse
para
tion
ofth
esub
sett
obe
con
sider
edfro
mth
eoth
ersu
bset
s.Fo
rexa
mpl
e,ca
nwef
ocu
sup
on"n
aive
"us
ersw
ithou
tals
ogi
ving
dire
ctat
tentio
nto
thei
mpa
ct(s
)tha
tthe
yha
veup
on"s
ophi
stica
ted"
user
s,an
d/or
thos
eim
pact
swhi
chth
eact
ions
ofso
phist
icat
edus
ersh
ave
upon
them
?Th
epo
ssib
ility
ofin
tera
ctiv
eef
fect
can
serio
usly
wea
ken,
ifno
tdes
troy
the
effi
cacy
offo
cusi
ngon
asu
bset
.
Eve
nw
here
theo
retic
also
undn
ess
wou
ldbe
wea
ken
edby
focu
sing
ona
subs
et,th
efoc
usm
aybe
"pra
gm
atic
ally
just
ified
"w
here
the
loss
esin
"the
oret
ical
soun
dnes
s"ar
emor
etha
nof
fset
byth
egai
nsin
(rat
abi
lity
inth
eana
lysi
s(i
nth
eju
dgm
ento
ftho
sefo
rmu
latin
gan
dtho
sein
tend
ing
toem
ploy
thet
heor
y).
Intr
od
ucti
on
riet
yof
indi
vidu
alan
dm
ulti
-per
son
conf
igu
ratio
ns.
Such
ast
rong
requ
irem
ent
impl
ies
that
ifa
"gen
eral
"th
eory
isto
exis
tan
dsu
rviv
eit
shou
lda
cco
mm
od
ate
wha
tis
know
nor
beli
eved
abou
tth
eva
riet
yof
user
s.In
deed
,suc
ha
theo
rysh
ould
beab
leto
cope
wit
han
dsa
yso
met
hing
abou
tthe
desi
rabi
lity
ofa
vari
ety
ofin
stit
utio
nal
arra
ngem
ents
asw
ell.
Seve
ral
crit
ical
ques
tion
sar
eem
piri
cal
and
larg
ely
unex
plor
ed.A
sa
cons
eque
nce,
seve
rala
ccou
ntin
gth
eori
es—
each
inco
rpor
atin
ghi
ghly
spec
ific
view
sof
user
beha
vior
—co
exis
t.A
nd
the
view
sof
use
rbe
havi
ora
reus
uall
yin
con
sist
ent
acr
oss
the
theo
ries
tha
tem
ploy
this
appr
oach
.
En
vir
on
men
tA
sim
ila
rse
tof
ob
serv
ati
on
sm
ay
bem
ad
ew
hen
we
exa
min
eth
een
viro
nm
enti
nw
hich
user
san
dpr
epar
ers
ofac
coun
ting
data
are
thou
ghtt
obe
have
.O
nepr
omin
ent
envi
ronm
enta
lis
sue
con
cern
sth
eex
iste
nce
ofco
mp
etin
gso
urc
eso
fin
form
ati
on
ab
ou
tth
een
tity
inqu
esti
on.
Som
eth
eori
esdo
not
expl
icit
lyco
nsi
der
alt
ern
ati
veso
urc
esof
fina
ncia
lin
form
atio
n;ot
hers
acti
vely
exam
ine
acco
unti
ngin
form
atio
nas
one
ofse
vera
lso
urc
esof
fina
ncia
lin
form
ati
on
.S
imil
ar
ly,
inex
amin
ing
acco
unti
ngin
form
atio
n,so
me
theo
ries
focu
son
the
prep
arer
sof
such
info
rma
tio
nw
hil
eo
ther
str
eat
them
pass
ivel
y.In
am
ulti
ple-
sour
cese
ttin
g,co
nsid
era
tions
ofef
ficie
ncy
wou
ldim
ply
that
acco
unti
ngsy
stem
ssh
ould
beor
ient
edto
repo
rtin
gth
ose
attr
ibut
esof
the
enti
tyfo
rw
hich
they
have
aco
mpa
rati
vead
vant
age
ove
rot
her
sour
ces,
eith
eras
ap
rim
ary
sou
rce
of
"new
s"or
asan
inst
rum
ent
for
conf
irm
ing
(or
disc
onfi
rmin
g)"n
ews"
repo
rted
bym
ore
tim
ely
sour
ces.
An
oth
er
en
vir
on
men
tal
issu
eco
nce
rns
the
natu
reof
the
mul
ti-p
erso
nse
ttin
gfo
rac
tion
sby
user
s.B
oth
"ma
rket
"in
tera
cti
ons
(exc
hang
es)
and
"non
mar
ket"
inte
rac
tion
s(e
xter
nali
ties
)ap
pear
tobe
pre
sent
inre
lati
onsh
ips
amon
gpr
epar
ers
and
user
s.W
ith
resp
ectt
om
ark
etin
tera
ctio
ns,
such
ques
tion
sas
the
follo
win
gar
eas
ked:
To
wh
at
exte
nt
are
secu
riti
esm
ark
ets
"ef
fici
ent"
inre
flec
ting
avai
labl
ein
form
ati
on
?W
ha
tis
the
na
ture
ofth
em
ark
etfo
r
info
rmat
ion?
Inpa
rtic
ular
,do
we
obse
rve
ma
rket
fail
ure
tosu
cha
degr
eeth
at
inte
rve
ntio
nis
soci
ally
desi
rabl
e?2
Wit
hre
spec
tto
"ext
erna
liti
es,"
tow
hat
exte
nt
are
no
nm
ark
etin
tera
ctio
ns
am
on
gus
ers
pres
ent?
To
wha
tex
tent
are
they
pert
inen
t?E
xter
nali
ties
may
also
exis
tam
ong
prep
arer
s.In
form
atio
nco
nvey
edby
one
sour
cem
ayaf
fect
that
from
anot
her.
Sim
ilar
ly,
repo
rtin
gfo
rin
com
eta
xpu
rpos
es,f
orex
ampl
e,ca
nin
tera
ctw
ith
fina
ncia
lrep
orti
ng.A
lso,
ther
eis
anin
tera
cti
onbe
twee
nm
anag
ers'
deci
sion
sand
exte
rnal
fina
ncia
lre
port
s.A
thir
dcl
ass
of
issu
esd
eals
wit
ha
ttri
bute
sof
acco
unti
ngpr
oces
ses,
and
ofth
eco
ntro
lofs
uch
proc
esse
s.W
esh
ould
reco
gni
ze,
for
exam
ple,
that
audi
ting
isan
acce
pted
com
pone
ntof
the
exte
rnal
repo
rtin
gen
viro
nmen
tan
d,by
impl
icat
ion,
tha
tre
port
ing
conc
erns
cann
otbe
sepa
rate
dfr
omau
diti
ngco
ncer
ns.
We
mus
tal
sose
ekto
unde
rsta
ndth
em
an
yen
viro
nmen
t-us
erin
flue
nces
that
have
anim
pact
upon
audi
ting
ifw
ear
esu
bseq
uent
lyto
unde
rsta
ndth
ena
ture
ofau
diti
ng's
infl
uenc
eon
repo
rtin
g.
Su
mm
ary
Itis
easy
toob
tain
agre
emen
ton
the
broa
dro
leof
fina
ncia
lac
coun
ting
,a
sw
ell
ason
the
fact
tha
tac
coun
ting
syst
em
sa
re"c
ostl
y,"
and
henc
eth
atth
eir
desi
gnpr
ese
nts
acl
ass
ofre
sour
ceal
loca
tion
prob
lem
s.Su
chag
reem
ent,
how
ever
,ove
rloo
ksth
eex
iste
nce
of
ba
sic
dif
fere
nce
sin
the
way
vari
ous
theo
ries
view
user
san
dth
epr
epar
er-u
sere
nvir
onm
ents
.One
'ssp
ecif
ica
tio
ns
ofu
sers
an
den
viro
nm
ent
are
inte
gral
toth
em
odel
ing
ofac
coun
ting
choi
ces
and
wil
lsig
nifi
cant
lysh
ape
the
resu
ltin
gth
eori
es.
Wha
tw
ese
ekis
ath
eory
that
isge
nera
len
ough
toco
pew
ith
this
vari
ety
and
spec
ifi
cen
ough
toof
fer
assi
stan
ceto
acco
unti
ngpo
licy
mak
ers.
But
none
ofth
eav
aila
ble
theo
ries
isac
cept
able
toal
lac
coun
tant
s.
2A
ma
rket
fail
ure
issa
idto
exis
tw
hen
the
ma
rket
-de
term
ined
prod
uctio
nan
dco
nsum
ptio
nle
vels
gene
ra
tean
inef
fici
ent
allo
cati
onof
reso
urce
s.S
eeB
eave
ran
dD
emsk
i(1
974)
and
Gon
edes
,Dop
uch.
and
Pen
man
(197
5)fo
rfu
rthe
rdi
scus
sion
ofm
ark
etfa
ilur
eco
nsid
era
tio
ns.
4 Statement on Accounting Theory and Theory AcceptanceInstead, we have a collection of theories, pects of this specification problem buteach perhaps capable of coping with as- only by sacrificing attention toothers.'
Chapter 2
Alternative Theory Approaches
In this chapter we classify accountingtheories and summarize the dominant approaches that have evolved within each ofthe classifications. We have discernedthree basic theoretical approaches: (1)classical ("true income" and inductive)models; (2) decision usefulness; and (3)information economics.1 This survey is intended to provide the foundation necessaryfor our subsequent examination of thereasons that the profession has beenunable to achieve consensus on a"general" theory of external reporting.
Classical Approaches toTheory Development
"The history [of accounting thought)."writes Chambers, "is not a history of development, but a series of disconnectedepisodes" (1965, p. 33). The authors ofearly accounting theories failed to supply adevelopmental thread from one argumentto the next. Few referred to the works ofothers, and none built explicitly on thewritings of predecessors or contemporaries in the accounting literature.
At the outset, it will be useful to classifya number of major writers discussed inthis section according lo their roles withinthe literature. We begin by chronologicallylisting their principal writings:
William A. Paton, Accounting Theory —With Special Reference to the Corporate Enterprise (1922).
Henry Rand Hatfield, Accounting —ItsPrinciples and Problems (1927).
John B. Canning, The Economics of Accountancy (1929).
I We should observe (hat some authors who havehelped develop these approaches may disavow any intention of having contributed to an accounting theory.Nevertheless, each of these approaches has variouslybeen perceived as a potential source of a theory ofaccounting or as a basis for determining the conlent ofexternal financial reporting. The widespread acceptanceof these perceptions leads the committee, tentatively atleast, lo recognize each as an approach to theorizing inaccounting.
Henry W. Sweenev. Stabilired Accounting (193G).
Stephen Oilman, Accounting Conceptsof Profit (1939).
Kenneth MacNeal. Truth in Accounting(1939).
W. A. Paton and A. C. Littleton, An Introduction to Corporate AccountingStandards (1940).
Sidney S. Alexander. "Income Measurement in A Dynamic Economv"(1950).
A. C. Littleton, Structure of AccountingTheory (1953).
Edgar 0. Edwards and Philip W. Bell.The Theory and Measurement ofBusiness Income (1961).
Maurice Moonitz, The Basic PostulatesofAccounting (1961).
Robert T. Sprouse and Maurice Moonitz.A Tentative Set of Broad AccountingPrinciples for Business Enterprises(1962).
Yuji Ijiri, Theory of Accounting Measurement (1975).
Writers such as Paton, Sweeney, MacNeal, Edwards and Bell, Moonitz, andSprouse are advocates: they have arguedfor the primacy of new theories or approaches. They have been, in every sense,reformers. Canning and Alexander, bycontrast, are more analysts and expli-cators than advocates. They analyze andassess what accountants do and seek to do,they undertake to explain an economicmodel lo accountants, and they concludeby endeavoring to adapt the economicmodel to the pragmatic world of the accountant. All the writers in this first groupare normative theorists. They are primarily deductivists. Canning and Alexander differ from the rest of the group more in degree than in kind; they are motivated lessby missionary zeal than by a desire toanalyze, criticize, and suggest.
Hatfield, Gilmaii, Littleton, the Paton-Littleton partnership, and Ijiri are chieflypositivist, inductive writers, some of whom
Stat
emen
ton
Acc
ount
ing
The
orya
ndT
heor
yAcc
epta
nce
inte
rpos
eoc
casi
onal
norm
ativ
ede
duct
ive
reas
onin
gder
ived
from
unst
ated
prem
ises
.O
fthe
five
,Gil
man
and
Hat
fiel
din
duce
ata
mor
eco
ncre
tele
vel
ofge
nera
liza
tion
than
the
othe
rth
ree;
they
sum
mar
ize,
com
pare
,an
dex
pose
elem
ents
ofill
ogic
and
inco
nsis
tenc
y;th
eyse
ekto
rati
onal
ize
dive
rse
theo
ries
and
prac
tices
.L
ittle
ton,
Pato
n-L
ittle
ton,
and
Ijir
i,co
ntra
riw
ise,
unde
rtak
eto
deve
lop
cohe
rent
theo
ries
ofex
tan
tp
ract
ice.
Wha
tpr
oble
ms
doth
ese
auth
ors
expl
ore?
Tot
hein
duct
ivis
ts,w
hen
they
dono
tin
terp
ose
norm
ativ
ede
duct
ive
reas
onin
g,th
epr
oble
ms
are
perf
orce
thos
eth
atar
eim
plic
itly
bein
gad
dres
sed
inac
tual
acco
untin
gpr
actic
e.In
the
proc
ess
ofin
duc
tion,
how
ever
,th
eau
thor
sm
aydi
sagr
eeov
erge
nera
lized
prin
cipl
esan
dgo
als.
To
the
norm
ativ
ede
duct
ivis
ts,
the
answ
eris
less
evid
ent.
Inth
ebr
oade
stte
rms,
both
dedu
ctiv
ists
and
indu
ctiv
ists
are
con
cern
edw
ithde
sign
ing
fina
ncia
lre
port
sth
atco
mm
unic
ate
pert
inen
tin
form
atio
nto
ase
to
fre
ad
ers
.W
hydi
dm
any
ofth
epr
omin
ent
theo
rist
sad
voca
tecu
rren
tco
sts
or
valu
es?
To
asi
gnif
ican
tdeg
ree,
they
may
have
been
infl
uenc
edby
the
neoc
lass
ical
econ
omic
theo
ryof
the
firm
,in
whi
chhi
stor
ical
cost
sar
eig
nore
den
tirel
y.T
hey
may
have
obse
rved
the
beha
vior
ofin
vest
ors
and
othe
rec
onom
icde
cisi
onm
aker
san
dco
nclu
ded
with
ava
lidat
edhy
poth
esis
that
such
deci
sion
mak
ers
seek
curr
ent
valu
e,no
thi
storic
alco
st,in
form
atio
n.No
findi
ngs
from
any
form
alhy
poth
esis
test
ing
are
repo
rted
;pr
ior
toth
e19
60s,
itw
asno
tcu
stom
ary
for
acco
untin
gw
rite
rsto
con
duct
such
rese
arch
.U
nlik
eth
elat
ergr
oup
ofno
rmat
ive
wri
ters
who
embr
aced
ade
cisio
n-us
eful
ness
appr
oach
,th
eea
rlyno
rmat
ive
wri
ters
did
noti
nqui
rede
eply
into
the
deci
sion
alfr
amew
ork
ofus
ers.
They
posit
edth
eex
iste
nce
ofsp
ecifi
edus
ers,
and
proc
eede
dto
argu
eth
atcu
rren
tva
lues
are
asu
peri
orty
peof
info
rmat
ion
tohi
stor
ical
cost
s.A
sw
ew
illno
tebe
low
,pr
agm
atic
cons
ider
atio
nsob
liged
seve
ral
ofth
ew
rite
rsto
soft
enth
eir
reco
mm
en
dati
on
s.
No
rma
tiv
eD
edu
ctiv
eS
cho
ol
Inth
efi
rstd
ecad
esof
the
cent
ury,
mos
t
acco
untin
gw
rite
rsde
alt
with
the
par
ticu
lars
ofac
coun
ting
prac
tice
rath
erth
anw
ithco
ncep
tual
unde
rpin
ning
s.A
ccou
ntin
gth
eory
,es
peci
ally
inth
em
ajor
ityof
text
book
s,co
nsis
ted
ofsp
ecia
lple
adin
gs,
with
out
anev
iden
ttr
ail
oflo
gic,
for
orag
ains
tspe
cifi
cac
coun
ting
prac
tice
s.D
octr
ine
was
defe
nded
agai
nsth
eret
ics.
The
deve
lopm
ent
ofa
cohe
rent
acco
untin
gth
eory
may
have
been
thou
ghtb
yp
ract
itio
ner
sto
bea
task
mo
resu
ited
toth
eac
adem
icm
ind.
Infa
ct,
acad
emic
acco
un
tan
tsp
rio
rto
the
1950
swer
ea
dich
oto-
mou
slo
t.M
ost
acco
untin
gpr
ofes
sors
inA
mer
ican
univ
ersi
ties
wer
efa
rm
ore
orie
nted
tow
ards
prac
tice
than
tow
ards
acad
emic
rese
arch
.M
any
wer
efo
rmer
prac
titio
ners
orw
ere
cont
empo
rane
ousl
yen
gage
din
acco
unti
ngpr
acti
ce.
Aco
mp
arat
ivel
ysm
all
nu
mb
erof
acad
emic
sp
oss
esse
dd
oct
ora
tes.
Onl
ya
rela
tive
lyfe
wun
iver
siti
esaw
ard
edd
oct
ora
tes
inb
usi
nes
sad
min
istr
atio
no
rco
mm
erce
bef
ore
the
1950
s—
and
mos
toft
hose
appe
arto
have
requ
ired
ast
rong
dose
ofec
onom
icth
eory
.T
hus,
man
yof
the
earl
ydo
ctor
ates
awar
ded
toac
cou
nti
ng
acad
emic
s,to
Hat
fiel
dan
dP
aton
,fo
rex
ampl
e,w
ere
inec
onom
ics.
Itsh
ould
com
eas
nosu
rpri
se,
ther
efor
e,th
atec
onom
icth
eory
wou
ldin
flue
nce
toa
con
side
rabl
edeg
reet
hede
duct
ive
writ
ings
ofth
ose
com
para
tive
lyfe
wac
adem
ics
who
chal
leng
eddo
ctri
new
ithco
here
ntac
coun
tin
gth
eori
es.
Inde
ed,
seve
ral
ofth
em
ost
prom
inen
tw
rite
rs,
nota
bly
Can
ning
and
Ale
xan
der
,wer
eec
on
om
ists
.T
hede
duct
ive
theo
rist
s,w
ithth
eex
cept
ion
ofA
lexa
nder
(sec
App
endi
x),c
oncl
uded
that
inco
me
mea
sure
dus
ing
asi
ngle
valu
atio
nba
sew
ould
idea
llym
eet
the
need
sof
allu
sers
.In
that
rega
rd,t
hey
have
som
etim
esbe
ende
scri
bed
asad
voca
tes
ofa
"tru
ein
com
e"th
eory
.(A
sum
mar
yan
alys
isof
thei
rre
spec
tive
posi
tions
isgi
ven
inE
xhib
itI.
)T
hey
drew
onth
ete
achi
ngs
ofne
ocla
ssic
alec
onom
icth
eory
and
onth
eir
obse
rvat
ions
ofec
onom
icbe
havi
orto
prop
ose
that
acco
untin
g,w
hich
had
been
preo
ccup
ied
with
hist
oric
alre
cord
-kee
ping
and
con
serv
ativ
ere
ckon
ings
,sh
ould
bere
cons
truc
ted
tore
flec
tcu
rren
tco
sts
orva
lues
.T
hey
borr
owed
from
econ
omic
sth
ete
rms
"in
com
e"an
d
Alt
ern
ativ
eT
heo
ryA
pp
roac
hes
EX
HIB
ITI
nm
ttry
An
oty
taof
the
Ap
p'o
ach
eto
flh
tD
edu
ctiv
eT
fceo
ruU
Sa
me
fn/r
f»rd
t/ie
rtif
Pat
onT
opr
omot
eef
fici
ent
man
agem
ent,
H9
Ci
whi
chfu
rthe
rsth
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lder
s,al
soat
are
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lders
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g
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rtT
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US
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ward
vB
ell
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riet
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lyin
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ish
chie
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oth
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iffe
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ere
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alu
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urh
as
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co
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etassrt
s
Acc
ou
nt
for
ch
an
ges
inre
pla
cem
en
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at
'wh
ich
are
den
om
inate
das
un
reali
zed
un
til
the
assets
are
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ged
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ket
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lace
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8 Statement on Accounting Theory and Theory Acceptance
Canning, Sweeney, Alexander, Edwardsand Bell, and Moonitz were more influenced by the vision of capital as the presentvalue of future incomes. In theory, however, asset prices correspond with capitalized future incomes only under very restrictive conditions. Thus, the differencesin the specific policy recommendations ofPaton, Canning, Sweeney, MacNeal, Alexander, Edwards and Bell, Moonitz, andSprouse and Moonitz can be traced to therelaxations in conceptual rigor which theybelieve to be warranted by the presence ofuncertainty.
Several of the writers cite particularusers (ordinarily shareholders, creditors,and managers) and occasionally suggestthe information that users would finduseful; however, it is not possible to employ these casual references to explain thesurrogate choices that the writers made.Typically, the pragmatic modifications ina model are matter-of-factly asserted bythe writer. Except in the case of Alexander, who proposes different models for different users, each writer offers his policyrecommendation as a universally validproposal, as if the entire hierarchy of userswould be sufficiently well served by theresulting information. Nothing was saidabout the possible repercussions on resource allocation decisions made elsewhere in society as a consequence of decisions taken on the basis of information generated by a model.
What factors did the writers regard asinfluential in shaping their policy recommendations? Paton — and perhaps Sweeney — opted for replacement cost in preference to net realizable value in order not torecognize gross margin prior to realization. In that respect, Paton and Sweeneyare more conservative than is generallybelieved. Both attached considerable importance to the distinction between realized and unrealized outcomes. Sweeneywas under pressure from his dissertationadviser to be "practical," and his book stabilized Accounting was a product of the dissertation (see Appendix).
Canning had a dual mission: to lend advice to the profession as an economist, andto interpret accountants' handiwork toother economists. He acknowledged that it
would seldom be possible for accountantsto compute the capitalized values of nonmonetary assets. He therefore proposed amethod of indirect valuation by which anasset would be assessed at the current costto reacquire by the least costly means theremaining services inherent in the asset.This approach, Canning believed, constituted a sound application of the economist's opportunity cost analysis, and he devoted the latter part of his book to the practical problems of implementation.
Edwards and Bell imposed upon themselves the constraint that the accountingprofession not be rcvulsed by their policyrecommendation; consequently, like Patonand Sweeney, they proposed a replacementcost system in which gross margin wouldnot be recognized until sale. But unlikePaton and Sweeney, they preferred to include in income the currently accruedholding gain on nonmonetary assets.
MacNeal had been a practicing accountant; he alone among the deductive writersdid not possess a doctorate. To MacNeal,"truth" was ascertainable in current markets ; he shared the practitioner's aversionto relying on management's opinion of thevalues of assets. He recommended replacement costs — and, as a last resort, historical costs — only when acceptable marketselling prices were not accessible (see Appendix).
An interesting comparison may bedrawn among the deductive writers according to whether their orientation wastoward income-statement analysis or comparative balance-sheet analysis. Paton andSweeney, oriented toward income statements, were mindful of the accountant'sreluctance to record or report unrealizedgross margins and unrealized holdinggains. MacNeal, Edwards and Bell,Moonitz, and Sprouse and Moonitz were inclined lo view accounting as a successionof balance sheets. It is therefore not surprising that they would include unrealizedholding gains in net income and, except forEdwards and Bell's preoccupation with thereaction of the accounting profession totheir proposed system, they would havebeen unanimous in their disavowal of theconventional realization concept.
Of the deductive theorists, only Alexan-
Alternative Theory Approaches
der proposed that different models mightbe needed for different users. Yet he onlyintimates how and why different usersmight require different information; hestops well short of constructing decisionmodels.
It may be observed that the deductivewriters operated independently of oneanother, rarely comparing their work withthat of predecessors or contemporaries.The logic of their analyses is difficult tomonitor, as it reflects implicit criteria andjudgments. Of their writings, it may besaid that they neither proved their pointsnor were disproven by others. A commonthread may be discerned in their diverserecommendations: the implicit agreementthat users seek (or should seek) current-price information in making economicdecisions. In this important respect, notwithstanding the diversity of their recommendations, their cause was united.
Inductive SchoolHatfield and Gilman are inductivists in
a special sense. They were annotators ofthe literature. They compared and contrasted different practices and policyrecommendations, drew attention to similar and discordant notes among diversesources of authority, and commented uponillogic and inconsistencies in practice andin the literature. While they did not attempt to formulate coherent theories of extant practice, they did endeavor to identifygaps and (Hatfield especially) to distinguish doctrine from principle.
Littleton, upon observing the evolutionof accounting practice over a considerableperiod of time, concluded that theaccountant endeavors to help the readersof financial reports understand thebusiness enterprise by confining hismeasures to objectively verifiable transactions to which the firm is a party. By alargely implicit argument of a normativevariety, Littleton maintained thataccounting reports can best serve theneeds of those who contemplate future actions by reporting factually on the immediate consequences of actionspreviously taken by the firm. Currentprices and index numbers are eitherirrelevant to the transactional experience
of the enterprise or are not susceptible toobjective measurement; their inclusion infinancial statements would disturb thehomogeneity of the contents and mightwell reduce the integrity of the objectivelydetermined historical results.
Littleton induced accounting principlesfrom observing accounting practice, andargued in a normative deductive vein thatthe goals implicit in this generalized practice should be retained. He seemed to beconcerned that an accounting that dealswith actual transactions could become debauched by integrating in the financialreports subjective judgments about the impact of economic forces on the enterprise.While Littleton is remembered primarilyas a historian and an inductive theorist, hispersistent defense of the generalized principles induced from actual practice partake of normative deductive logic developed from unstated premises. In that respect, he has been characterized as proposing an "accounting Darwinism." According to this view, accounting is continuallyin evolution, and the elements that havewithstood the succession of challengershave, at least thus far, earned a place incurrent practice.
When a predominantly deductive writerof decidedly strong views (Paton) and apredominantly inductive writer possessingequally strong views (Littleton) join in thewriting of a monograph, a compromisemethodology should not be unexpected.The resulting monograph (1940), probablythe most influential work in American accounting literature, was a rationalizationof then extant accounting practice, explicated at a level of theoretical abstraction that had known few precedents.The elegance of the writers' generalizations even deceived a leading practicingaccountant who, in a review of the monograph for a journal, asserted that it bore noperceptible relation to current practice. Indeed, the work never could have attainedthe degree of popularity it has since enjoyed had it not been a largely faithful induction of actual accounting practice, evendespite an occasional oughtness spliced into the exposition. In addition, vivid metaphors employed in the inductive exercise(e.g., "matching," "attaching," "costs are
10 Statement on Accounting Theory and Theory Acceptance
assembled... as if they had a power of cohesion") conferred a greater respectability on practices that could be so colorfullyand attractively characterized. (A moredetailed analysis of this monograph isgiven in the Appendix to this chapter.)
In comparison with Littleton, Ijiri(1975) shows a clearer separation of deductive and inductive reasoning. Ijiri undertakes to generalize the goals implicit incurrent accounting practice, and thendefends historical cost against thecriticisms of current-cost and currentvalue advocates by a reverse-inductiveanalysis. The defense is embedded in theparticular manner of his induction. Ijiriconcludes that accounting practice maybest be interpreted in terms of accountability, which he defines as economicperformance measurement that is notsusceptible to manipulation by interestedparties. Unequivocal and unambiguousmeasures are viewed as the sine qua non ofaccountability. The continuous recordingof current values is rejected because theyare predicated on hypothetical actions ofthe entity and, as such, are not verifiable.Ijiri explains forthrightly his strategy forpreferring inductive to deductive reasoning:
This type of inductive reasoning toderive goals implicit in the behaviorof an existing system is not intendedtobepro-establishment orto promotethe maintenance of the status quo.The purpose of such an exercise is tohighlight where changes are mostneeded and where they arc feasible.Changes suggested as a result of sucha study have a much better chance ofbeing actually implemented. Goalassumptions in normative models orgoals advocated in policy discussionsare often stated purely on the basis ofone's conviction and preference,rather than on the basis of inductivestudy of the existing system. Thismay perhaps be the most crucialreason why so many normativemodels or policy proposals are notimplemented in the real world, (p. 28)
Other Possible ApproachesIt is sometimes suggested that "postu
lates and principles" should be viewed as afundamentally distinct approach to theorydevelopment. Yet it may represent nothingmore than a different packaging of the deductive methodology and could accommodate either the "true income" or "decisionmodel" approach. "Postulates and principles" could also be adopted as the framework for developing a hierarchy of generalizations in an inductive study.
SummaryTwo approaches to theory development
may be discerned apart from the more recent emergence of decision-usefulness formulations, which are discussed in the following sections of this chapter. These arethe "true income" (an example of the normative deductive school >and the inductivemethodologies. The former attempts to formulate implicit accounting models ofglobal application, while the latter attempts to rationalize, and sometimes evento justify (by the interposition of normativedeductive reasoning), major elements ofextant accounting practice.
The Decision-Usefulness
ApproachAnother approach by which accounting
theory has been generated is based on explicit recognition of the usefulness objective. The decision-usefulness approach is abroad one from which two major branchesarise. In the first, decision models arestressed. Information relevant to a decision model or criterion is isolated and various accounting alternatives are comparedto the data presumably necessary for implementing these decision models. In thesecond branch of the decision-usefulnessapproach, decision makers are the focus ofattention. Their reactions to alternative accounting data are studied as a means forinductively deriving preferred reportingalternatives.
Decision ModelsMost of the earliest research on deci
sion-usefulness implicitly adopted the decision model emphasis although the assumeddecision model was often not specified indetail. This approach first began to appearin the literature in the 1950s. By 1973 it had
Alternative Theory Approaches
achieved both professional recognition andbroad exposure through publication of thereport of the American Institute of Certified Public Accountants (AICPA) StudyGroup on the Objectives of Financial Statements (1973). In that document, alsoknown as the Trueblood Report, it wasstated that "the basic objective of financialstatements is to provide information usefulfor making economic decisions" (p. 13).
Prior to the 1950s,a number of carefullyprepared works on accounting theory didrefer to users of accounting outputs, butthe theoretical structures in those workswere not demonstrably based on the alleged information "needs" of users. Several instances of passing references to usersand the uses of financial information willserve to illustrate that practice. The 1936"Tentative Statement" of the AmericanAccounting Association (AAA) included,but did not build upon, this paragraph:
The most important applicationsof accounting principles lie in thefield of corporate accounting, particularly in the preparation ofpublished reports of profits and financial position. On the interpretation ofsuch reports depend so many vitaldecisions of business and governmentthat they have come to be of greateconomic and social significance, (p.187)
The 1941 AAA statement reiterated thispoint, again without subsequent development (p. 133).
The Sanders, Hatfield, and Mooremonograph (1938) was more explicit inrecognizing the groups who have information "needs" in relation to an entity.The authors' list of functions of accountingincluded:
... preparing from time to timestatements showing all the more important aspects of the capital and income of the business and of the legalequities in them, satisfying therebythe need for information of all theparties in interest, especially of:
(a) the management of the business,
<b> outside groups, such as investors and creditors.
11
(c) government, in such matters astaxation and regulation, (p. 4)
Paton and Littleton (1940) gave user needseven more prominent attention, includingthem in their statement of the purpose ofaccounting:
The purpose of accounting is tofurnish financial data concerning abusiness enterprise, compiled andpresented to meet the needs of management, investors, and the public,(p.l)May (1943, pp. 19-21) went still further
when he listed ten "uses of financial accounts," such as "to determine the legalityof dividends" and "as a basis for price orrate regulation." May followed thatenumeration with a chapter on "The Usesof Accounts and Their Influence on Accounting," although he did not modeldecision processes or use decision modelsand their information requirements as abasis for accounting theory.
Vatter (1947, pp. 7-9) also gave a gooddeal of attention to the uses of accounting— in management, in the various taxingand social control activities of governments, and in the general area of credit extension and investment — but he rejectedthe idea of basing a general theory on anyparticular point of view. Instead, he developed the operations-oriented "fund theory," which ignores all user groups in an effort to be impersonal and unbiased. Thistheory later provided part of the basis forthe "data bank" and "events theory" approaches to accounting.
During the 1950s there was a stronguser-oriented movement in the manageria"accounting literature. That movemenimay have served as the stimulus for theinitial acceptance of the decision-usefulness objective in external reporting at thatime. Early works include a doctoral disscrtation (Staubus, 1954) and Chambersarticle, "Blueprint for a Theory of Accounting," published in 1955, whichstressed that "the basic function of accounting .. . [is] the provision of information to be used in making rational decisions" (p. 25). The July 1955 issue of TheAccounting Review included the Committee on Concepts and Standards' Supplementary Statement No. 8:
12 Statement on Accounting Theory and Theory Acceptance
Since the ultimate test of thequality of any communication is itseffectiveness in conveying pertinentinformation, the initial step in thedevelopment of standards of disclosure for published financial statements is the establishment of the purposes to be served. The potentialusers of corporate reports includegovernmental agencies, short- andlong-term creditors, labor organizations, stockholders, and potential investors. Since in all likelihood theneeds of these groups cannot beserved equally well by a single set ofstatements, the interest of some oneaudience should be identified as primary. Traditionally, this has been thestockholder group....
In considering disclosure standards,therefore, the Committee has beenconcerned primarily with the use offinancial statements (l) in making investment decisions and (2) in theexercise of investor control overmanagement, (p. 401)
The Committee's acceptance of the userorientation was not merely superficial; itshaped the entire Statement. However, thenext major statement of the Committee onConcepts and Standards, issued in 1957,ignored the user approach except in thelast section, "Standards of Disclosure,"which was based on Supplementary Statement No. 8. As a result, AAA literature didnot contribute heavily to the acceptance ofthe decision-usefulness approach to accounting theory until A Statement of BasicAccounting Theory was published in 1966.
Chambers' "Blueprint" article mightwell have served as the starting point for adecision-usefulness theory of financial accounting:
... a formal information-providingsystem should conform with twogeneral propositions.
The first is a condition of all logical discourse. The system should belogically consistent; no rule or pro
cess can be permitted which is contrary to any other rule or process
The second proposition arisesfrom the use of accounting statements as a basis for making decisionsof practical consequence. The information yielded by any such system should be relevant to the kinds ofdecision the making of which it is expected to facilitate, (pp. 21-22)
When considering "the introduction of additional rules,... in every case the test isrequired to be: 'What is necessary forrational decision-making' " (p. 24). Whilethat view provided an excellent foundationfor the development of a detailed decisionmodel approach, in his subsequent worksChambers apparently rejected the idea ofbasing an accounting theory on the decision models of specific user groups. Instead, he emphasized the general usefulness of "current cash equivalents" muchin the manner in which MacNeal acceptedcurrent market values and Canning accepted the present value measure of capital. Chambers explained that "the effect ofthe arguments of this book is to shift the focus of attention from the parties of interest(creditors, investors, managers) to the entity under consideration..." (1966, p. 375)."To provide the corroborable and corroborated financial statements which willserve as foundations for everyman's evaluations and actions is the business of thekind of accounting here envisaged" (1966,p.376).
Work on the decision-usefulnessapproach eventually led to more specificreliance on decision models. Staubus(1961) emphasized that "accountantsshould explicitly and continuously recognize an objective or objectives of accounting," and "that a major objective of accounting is to provide quantitative economic information that will be useful inmaking investment decisions" (p. viii). Hethen constructed an interrelated set ofbasic concepts and described a cash-flow-oriented measurement system keyed to thedominant theme of finance theory of thetime — the discounting view of securities
Alternative Theory Approaches
value. This led to the position that the attribute of assets and liabilities that is mostrelevant to security investment decisionsis discounted future cash flows.
The current status of the decision-usefulness, decision model approach to accounting theory may be summarized asfollows:
1. The primary objective of accountingis to provide financial informationabout the economic affairs of an entity to interested parties for use inmaking decisions. This objectivestatement is a premise which mostpeople seem to find acceptable, subject to slight variations. But it maynot be suitable unless one interprets"decisions" broadly. For "decisions"to encompass what might be calledthe control objective, the term mustinclude making choices regarding theinvestigation of variances, choices byemployees of the honest or dishonestcourse, and choices as to treatment ofoffending employees. If such an interpretation is not acceptable, a secondobjective — the control objective —must be given equal billing.
2. To be useful in making decisions,financial information must possessseveral normative qualities. The primary one is the relevance to the particular decision at hand of the attributeselected for measurement. The secondary one is the reliability of themeasurement of the (relevant) attribute. Objectivity, verifiability, freedom from bias, and accuracy areterms for overlapping parts of thereliability quality. Other qualities,such as comparability, undcrstanda-bility, timeliness, and economy, arealso emphasized. A set of such desirable qualities is used as criteria forevaluating alternative accountingmethods.
3. The relevance criterion is used toselect the attribute(s) of an object orevent to be emphasized in financialreporting. Information about an attribute of an object or event is relevant
13
to a decision if knowledge of that attribute can help the decision makerdetermine alternative courses of action or to evaluate an outcome of analternative course of action. Selectionof the attribute most relevant to a decision requires familiarity with thedecision processes of the user of financial data. "Modeling" decisionprocesses is often helpful to accounting theorists.
4. The decision-usefulness approachprovides for the development of theory on the basis of knowledge of decision processes of investors, taxingauthorities, union negotiators, regulatory agencies, and other externalusers of accounting data, as well asmanagers. To date, however, only thedecisions of investors (in the broadsense) have served as the basis forfairly complete theories of externalreporting.
5. The investment decision models utilized by decision-usefulness theoristshave been either simple present valuemodels or two-parameter expectedreturn and risk models. Risk lias notbeen formally incorporated in accounting theories to any great extent;expected future cash flows to investors have. Building on these commondecision-usefulness aspects, variouswriters have followed alternativepaths.
6. Investors' desires to predict cashflows from the firm have led manydecision-usefulness theorists to acash flow orientation (Staubus, 1961;AAA, 1969; Revsine, 1973; StudyGroup on the Objectives of FinancialStatements, 1973).
Cash returns to investors dependupon the firm's capacity lo pay,which, in turn, depends upon itspresent cash balance and its cashflow potentials. Present cash andpositive cash flow potentials areassets; negative cash flow potentialsare liabilities. When reliable evidenceof future cash flows is available it
14 Statement on Accounting Theory and Theory Acceptance
should be used in the measurement ofan asset or a liability. Otherwise, asurrogate measurement methodmust be used. Accordingly, severalstudies have explored the theoreticalconditions under which various financial measurement alternatives wouldtend to provide surrogates for futurecash flows (Revsine, 1970a, 1973;Staubus, 1967,1971).
When the measurements of all assets and liabilities reflect or havesome relation to cash flow potential,the difference—owners' equity—hassome relation to the cash flow potential of the owners' interests. Revenues, expenses, and income, aschanges in net assets, are estimatesof the change in the net cash flow potential of the firm from operating activities.
7. One variant of the cash flow approach(Revsine, 1973) concentrates on "distributable operating flows" as amajor basis for dividends. Distributable operating flows make up "thatportion of net operating flows whichcan be distributed to owners withoutreducing future physical operatinglevels" (p. 47).
Maintenance of physical operatinglevels requires replacement of services consumed, thereby requiringcash equal to the replacement cost ofsuch services. When expenses aremeasured on the basis of replacementcost, the resulting income is ameasure of distributable operatingflows. This emphasis on maintenanceof productive capacity was also incorporated into the Securities andExchange Commission's replacement cost disclosure requirement(SEC, 1976).
8. According to an alternative view(Chambers, 1966; Sterling, 1972b),the impossibility of measuring afuture event rules out the cash floworientation; furthermore, the irrelevance of replacement cost of an assetnow owned to future events involvingthat asset rules out replacement cost.
Only present exit values are bothrelevant and objective. Even in casesof assets not likely to be sold in theirpresent condition, exit values arerelevant to (a) an appraisal of thefirm's liquidity, (b) a judgment of itscapacity to engage in indirect exchanges (Chambers, p. 101), and (c)an assessment of the risk a shareholder bears when he foregoes alarger sum of money (the price of ashare) in order to hold an interest in acollection of assets (Sterling, p. 206).
Proponents of the decision-usefulness,decision model approach to accountingtheory acknowledge certain implementation issues. Of particular importance arethe issues associated with identification ofthe decision processes of users. First, thereis the question of whether to rely on normative models or descriptive models.Sterling (1967) poses the choice as a fundamental dilemma:
If we are convinced that the receivers(decision makers] are using thewrong decision model, we have adilemma. (1) We can transmit the information specified by their [decisionmakers'] wrong model which willyield right decisions only by chance.(2) We can transmit the informationspecified by the right model whichwill be irrelevant to their [decisionmakers'] model, and hence right decisions will result only by chance, (p.106)
Differences of opinion about how to avoidthe dilemma have arisen. Some haveargued that we ought to focus on users andignore the difficult, perhaps impossible,problem of determining when a decisionmodel is right or wrong. This is what wehave classified as the decision-usefulness,decision-maker approach (see Abdel-khalik, 1971) and is discussed below.Others have argued that the nature of theprocess requires that accountants becomeinvolved in the evaluation, refinement, andconstruction of decision models and thenthat they educate the receivers in the use ofthose models (seeSterling, 1970a, pp. 59ff).This is the decision-usefulness, decisionmodel approach that is discussed in this
Alternative Theory Approaches
section. Debate over decision-model versusdecision-maker approaches to theory construction continues.
Another problem is how to deal with different user groups with different information wants (Revsine, 1973, pp. 5-8). Forexample, is there a conflict between theconcern of short-term creditors with short-term ability to pay and the shareholders'concern with long-run payoffs? Does thispossible difference imply the need for different measures of the same asset or liability, or only for recognition of the difference in reporting on short-term and long-term items in the balance sheet and relatedflow statements? Not only might differentuser groups want different data, but different individuals within one user group maydiffer in their decision processes in waysthat call for different financial data. Issuesof this type are still open.
Criteria Useful in Making AccountingChoices. Normative standards, or criterianecessary for information to be useful,serve a major supporting role in the decision-usefulness, decision model approachto accounting theory. Long before the decision-usefulness objective was explicitlyadopted by accounting theorists, severalqualities of financial information wererecognized. For example, Sanders, Hatfield, and Moore (1938) emphasized conservatism and consistency of accountingmethods. The AAA statement (1941) gavepassing attention to objectivity, inter-period and intercompany comparability,and consistency. Moonitz (1961) includedobjectivity, consistency, and disclosure inhis group-C postulates (imperatives). Butnone of those authors accepted the ideathat criteria of useful information shouldbe a cornerstone of their theories, becausethey did not emphasize the usefulness of information.
The first authors to advocate decision-usefulness also gave more attention to thequalities that were believed to make information useful, but they did not make theconnection a very direct one. Thus, although Chambers (1955) was the firstwriter to emphasize the relevance of information, he did not develop the concept tothe point of delineating the relevance of
IS
specific information to selected decisions.The AAA Supplementary Statement No. 8(1955) underscored interperiod and intercompany comparability, recognized theimportance of timeliness of reporting, andcame close to the relevance criterion whenit suggested that "the information to beconveyed should be selected on the basis ofits significance to the investor ...." (p.401). Staubus (1961) included a section on"Criteria for the Selection of MeasurementTechniques" in which he discussed relevance, accessibility of evidence, cost, bias,and reliability, and ranked six measurement methods according to the criterion ofrelevance (p. 51).
The role of criteria of useful information in accounting theory achieved prominence in the mid-1960s with the work of theAAA Committee to Prepare a Statement ofBasic Accounting Theory (1966). A Statement of Basic Accounting Theory(ASOBAT) began with a discussion of accounting objectives that specified information for making decisions, for directing andcontrolling an organization's resources, forthe custodianship of resources, and for facilitating social functions and controls. Itthen turned to standards or criteria to beused in evaluating potential accounting information, the all-embracing criterion being usefulness. Other criteria were formulated by asking, "What characteristicsshould accounting information have in order to be useful?" Relevance, verifiability,freedom from bias, and quantifiabilitywere suggested as standards. Consistencyand uniformity were included among thesecond-tier "guidelines for communicatingaccounting information." Sterling (1967)provided further explication of these standards in a review of ASOBAT. Snavely(1967) modified the ASOBAT structure byadding understandability, "worth morethan cost," timeliness, and significance(materiality), and by relating verifiabilityand freedom from bias under the headingof reliability. During the same period, Ijiriand Jaedicke (1966) contributed a discussion of the measurement of reliability,objectivity, and bias, while McDonald(1967) elaborated on those and other"feasibility criteria" in a treatment of dispersion, displacement, timeliness, cost.
16 Statement on Accounting Theory and Theory Acceptance
and correlation (of the accounting numbers with an attribute to be predicted). Healso mentioned the all-inclusive criterion ofnet social benefit. Subsequent works making heavy use of the multiple-criteria approachwere Accounting Principles BoardStatement No. 4 (1970, Chapter 5), Staubus(1970), Sterling (1971), Kenley and Staubus(1972), Revsine (1973), and the Report ofthe Study Group on the Objectives of Financial Statements (1973).
It is crucial to observe the relationshipbetween the decision-usefulness objectiveand the evolution of independent normative standards (suchas comparability andobjectivity) into a coherent set of criteriaof useful information. First, the acceptance of the usefulness objective raised andemphasized the question, "What attributesof financial data make them useful to decision makers?" Without acceptance of thedecision-usefulness objective, it seemsunlikely that the multiple-criteria approach would have been developed to theextent that it has. Second, the normativeconcept that is generally recognizedas primary — relevance to the decisions of usersof financial statements — grew out of, andis dependent upon, the decision-usefulnessobjective.
Some criteria which have been advocated in contemporary literature for use inevaluating proposed accounting methods(information systems) and comparingcompeting proposals are presented in thefollowing paragraphs.
Relevance. "Relevance" has beendefined in a variety of ways, some of themrather vague and not helpful. Forexample,a general usage definition of "relevant,"such as "bearing upon the matter athand," may not be operational. Otherpossible definitions would make the termalmost synonymous with usefulness, thusruling it out as a criterion of usefulness.The current trend is to give relevance aspecific meaning related to the potentialroleof information about an attribute (e.g.,historical cost or net realizable value) ofan object or event in the decision process.For example, "An attribute of an object orevent is relevant to a decision if knowledgeof it would help the decision-maker evaluate an outcome of one or more of the alter
native courses of action under consideration" (Staubus, 1976). Or, "If a property isspecified by a decision model, then ameasure of that property is relevant (tothat decision model)" (Sterling, 1972b, p.199). Relevance is viewed as a necessarybut not a sufficient condition for usefulness.
Reliability. Users of financial information prefer that it have a high degree of reliability. Reliability is that quality whichpermits users of data to depend upon itwith confidence as representative of whatit purports to represent. But reliable information is not necessarily useful. It could,for example, be reliable but unrelated tothe use at hand. Several relatively generalterms are often used as synonyms for, or tocover parts of, the concept of reliability.Thus, verifiability, objectivity, lack ofbias, neutrality, and accuracy all are related to reliability. Like relevance, reliability (above some minimal level) is anecessary but not a sufficient condition forusefulness of data.
Other Criteria. Several writers haveemphasized the value of a criterion that focuses attention on the receiving phase ofthe communication process. Undcrstanda-bility and readability are sometimes suggested.
Timeliness, including both frequency(interval) and lag (delay), is widely accepted as a criterion of useful information.
Optima) quantity and cost are closelyrelated criteria. The literature of information economics stresses optimal partitioning and optimal aggregation. The possibility that certain information may not justifythe cost of producing and utilizing it is generally recognized. Issues regarding cognitive processing levels (Revsine, 1970b;Driver and Mock, 1975) and their impact ondecisions have also been recognized.
Many accountants believe that comparability is an important criterion forchoosing among accounting methods.Others point out that the several types ofcomparability that are desirable may beincluded in relevance, reliability, or othercriteria.
A number of accounting writers believethat the usefulness of accounting data inpredicting phenomena of interest to deci-
Alternative Theory Approaches
sion makers is a criterion that should beused in evaluating alternative accountingproposals. Thus, Beaver, Kennelly, andVoss (1968) recommended the use of "predictive ability" as a criterion. Althoughthese authors do not necessarily suggestthat the accountant do the forecasting,other theorists have attempted to distinguish measurements from forecasts andhave argued that the measurement function should be performed by the accountantand the forecasting function performed bythe decision maker (Sterling, 1970a, 1972b;Revsine, 1973, pp. 40ff, 1975).That is, whileit is clearly recognized that forecasts arerelevant (indeed indispensable) to decisions, there have been some who haveargued that the very nature of the marketmakes it necessary for the risk-bearing decision maker, as opposed to the accountant, to prepare the forecasts.
A review of the criteria discussed abovewill disclose that some criteria (e.g., relevance) are applicable primarily to the selection of attributes to be measured.Others (e.g., timeliness) play a significantrole only in the choice of methods of dataprocessing and communication. Stillothers may be important in almost anytype of accounting issue. Finally, thosewho advocate the decision-usefulness, decision model approach have proposed as anultimate criterion that the benefits yieldedby accounting activities should exceedtheir costs.
Decision MakersIn the previous section we focused on
decision models; we now shift to decisionmakers and review certain empirical research bearing upon various issues of financial reporting. Such research can beclassified according to the level at whichthe behavior of decision makers is observed: the individual level or the aggregate market level. First, we focus on empirical research on individual behavior;the second section discusses aggregatemarket behavior.
Individual User Behavior. Empirical research involving observation of individualbehavior as it relates to accounting information has ordinarily been associated with
17
the term "behavioral accounting research" (BAR). The objective of BAR is tounderstand, explain, and predict aspects ofhuman behavior relevant to accountingproblems; that is, "to establish generalizations about human behavior that are supported by empirical evidence .... Behavioral science thus represents the systematic observation of man's behavior for thepurpose of experimentally confirming specific hypotheses by reference to observablechanges in behavior" (AAA, 1971b, p. 248).
Behavioral accounting research is relatively new. Devine's critical remarks in1960 expose the failure of accountants toexamine user behavior empirically beforethat time:
Let us now turn to... the psychological reactions of those who consumeaccounting output or are caught in itsthreads of control. On balance, itseems fair to conclude that accountants seem to have wadedthrough their relationships to the intricate psychological network ofhuman activity with a heavy-handedcrudity that is beyond belief. Somedegree of crudity may be excused in anew discipline, but failure to recognize that much of what passes as accounting theory is hopelessly entwined with unsupported behavior assumptions is unforgivable, (p. 394)
Subsequent to Devine's remonstration, agrowing literature in behavioral accounting has emerged. For example, Hofstedt(1976) provides evidence of the increasingshare of the literature over the last tenyears that has dealt with accounting andhuman behavior.
In this discussion, we are interested inempirical research on individuals as it relates to the selection of alternative accounting techniques in an external environment.
BAR studies ordinarily lack anyagreed-upon basis by which their resultsmay be assessed. Instead, BAR has beenprimarily concerned with studying thetechniques of data collection and analysis;there has been little attempt to developgeneral theoretical formulations of problems or of hypotheses to be tested. Thestudies represent diverse attempts to un-
18 Statement on Accounting Theory and Theory Acceptance
derstand, explain, and predict human behavior in an accounting setting without anagreed-upon universal theoretical perspective. As a consequence, BAR lacks a theoretical base to facilitate the selection of appropriate accounting procedures for individuals in economic decision making.
For these reasons it is difficult to classify BAR as it relates to external reporting.Nonetheless, some writers have attemptedto develop systems of classification (Birn-berg and Nath, 1967; Hofstedt, 1972; andRhode, 1972). The most recent andprobably the most exhaustive attempt wasby Dyckman, Gibbins, and Swieringa(DCS, 1975). We have chosen one part oftheir classification to illustrate the generalnature of studies conducted in BAR relating to the external reporting environment.2It should be emphasized that ourdiscussion uses only the first section of theDGS paper and provides only a brief overview; readers should consult the originalsource for a more detailed discussion of thestudies involved.
BAR studies may be divided into fourgeneral classes according to financialstatement disclosure and the usefulness offinancial statement data: (1) the adequacyof financial statement disclosure, (2) theusefulness of financial statement data, (3)attitudes about corporate reporting practices, and (4) materiality judgments.
In testing for the adequacy of financialstatement disclosure, researchers haveused many different strategies. For example, one strategy develops a description ofa user's approach to financial statementanalysis in order to evaluate the reasoningunderlying that approach; it then assessesthe implications of that approach and reasoning for various disclosure issues (e.g.,Horngren, 1955,1956,1957). Another strategy focuses on certain interest groups andsurveys their perceptions and attitudesabout disclosure (e.g., Bradish, 1965;Ecton, 1969). A third strategy has been todetermine the extent to which specificitems of important information are dis-
2 More specifically, the following five paragraphsare essentially a condensation of pp. 4-17 of the DGSpaper. This area of research Is important. However,our discussion is brief because of the recency of theDGS paper and its excellent synthesis of the area.
dosed in corporate annual reports, using anormative index of disclosure as a basis forassessment (e.g., Cerf, 1961; Singhvi andDesai, 1971; andBuzby, 1974).
A second set of studies has focused onthe usefulness offinancial statement infor-motion to investors in making resource allocation decisions. In one method, users offinancial statements were asked to indicate the relative importance as information items of various factors in investmentanalysis (e.g., Baker and Haslem, 1973;Chandra, 1974). Another approach hasbeen to try to determine whether financialstatement data are used in decision making and whether their use is affected byother variables. This is done by creating arepresentation of a decision maker underquasi-laboratory conditions,and by studying the behavior of the subjects who makethe decisions (e.g., Falk and Ophir, 1973a,1973b; Libby, 1975a, 1975b). A final approach has been to attempt to measure theeffectiveness of the communication ofthose data (e.g., Soper and Dolphin, 1964;Smith and Smith, 1971; Haried, 1972,1973).
A third set of studies has attempted tomeasure the attitudes and preferences ofvarious groups toward current and proposed corporate reporting practices. Oneapproach has focused on preferences foralternative methods of accounting for specific transactions or events, such as a preference for a given form of business combination such as poolings of interest (Nelsonand Strawser, 1970; Brenner and Shuey,1972). Other attempts to measure attitudeshave focused, more generally, on attitudesabout how much information should beavailable, how much information is available, and how important given items are(Copeland, Francia, and Strawser, 1973;Godwin, 1975).
Another set of studies has focused onmateriality Judgments that affect financialreporting. Research on materiality judgments has generally attempted to determine what factors influence the collection,classification, and final summarization ofaccounting information (e.g., Woolsey,1973; Dyer, 1973; Boatsman and Robertson, 1974; Pattillo, 1975; Pattillo andSiebel, 1973, 1974; Rose et al., 1970;Dickhaut and Eggleton, 1975). The major
Alternative Theory Approaches
thrust of the research attempts to determine how much of a difference in accounting data is required beforeusers perceive a difference.
It should be noted that these citationsare not intended to be all-inclusive, nor isthere any attempt to explain thesestudiesand subsequent recommendations in anydepth. However, this brief overview shouldprovide a perspective on the ways inwhichsomeBARspecialists haveconducted theirempirical research inthebehavioral area.
Aggregate Marfeet-Level Research. Theinterest in decision usefulness extends notonly to individual user responses to accounting variables, but to aggregate userresponse as well. To be sure, aggregatemarket behavior is a manifestation of individual action. However, according to proponents ofmarketlevel research, therearefactors that are difficult to simulate in individual level research (such as competinginformation sources, incentives, and userinteractions) that are important in thestudyofgroups; those factors thusprohibita simplistic extension from the individualto the aggregate (e.g., see Gonedes, 1972;and Gonedes and Dopuch, 1974). Indeed,they may be so significant that theoriesabout individual behavior and theoriesabout market behavior become, in fact,theories about distinctly different things.^Therefore, some researchers believe thataggregating individual users' responsesmay not provide an apt description ofmarket-wide user behavior.
Much early research regarding relations between accounting variables andmarket behavior has been based on thetheory of capital market efficiency. Thetheory predicts that, on average, the abnormal return (return in excess of the equilibrium-expected return) to be earnedfrom employing asetofextantinformationis zero (see Fama, 1970). This implies thatan alteration in the information set will result in a prompt transition to a new equilibrium.
3 A discussion of selection of paradigms or research programs is provided inChapter 4. For arecentreview and analysis of aggregate market-level research, see Kaplan (1975).
19
The theoryis notspecificwith respecttothe information set, and technical problems arise when it is admitted that theprice actually reflects theunderlying information (Grossman and Stiglitz, 1976).However, studies of accounting data haveshown that upon release of those data,there is (at best) only a short-lived opportunity for abnormal returns. The promptadjustment to a new equilibrium in conjunction withthedissemination ofaccounting data is consistent with the notion thatthose data are useful or possess pragmaticinformation content.4 Following that logic,researchers have assessed the pragmaticinformation content of various accountingdata by studying the timing of the incidence of abnormal returns. To do so, onemust identifytherelevantdates(i.e.,whenthe data were externally available,andthelength of the adjustment period to be observed) and a model by which to specifyabnormal returns. One such model is thediagonal model attributed to Sharpe(1963). The diagonalmodelimplies that theexpected return ona particular security isa stable, linear function of the return on aportfolio of all securities in the market.*Operationally, the intercept and slope parameters are estimated by regressing anindividual security return against the return on a market portfolio. Those parameters are then utilized to generate a prediction of the return on an individual securityduring a particular period. Any disparitybetween the actual return and the predicted return is considered to be abnormal.
4"Pragmatic information" refersto the reactionof individualsor groupsto a signor message. It is contrasted to "semantic information."whichrefers to therelation betweena sign or messageand the objectorevent that it signifies. For example, the message.•There is a fire in the building."will be said to havepragmatic information content if thereceivers ofthatmessage react to it, if, say, someone calls the fire department —thereaction of receivers determines themeasure of pragmatic information. Bycontrast, thesemantic informationof that same message is tested byobserving the building toseewhether ornotthere is infacta fire.SeeSterling (1970b. pp.44S-46. 453) for further discussion.
5 Evidence on the applicability of this importantmodel is provided by King (1966). Fama, Fisher, Jensen, andRoll (1969), andGonedes<1973).
20 Statement onAccounting Theoryand TheoryAcceptance
Since the mechanics of least squares regression produce, on average, a zero abnormal return, observation of large numbers of firms with abnormal returns coincidental with dissemination of accountingdata is taken as an indicant of pragmaticinformation content.
A number of studies have been conducted along those lines. Ball and Brown(1968), Beaver (1968), and Gonedes (1974)consistently observed abnormal returns inconjunction with the announcement of theannual earnings number. May (1971) observed similar reactions to the quarterlyannouncement of firm earnings. In addition, anticipatory market reactions havebeen observed, suggesting the presence ofcompeting information sources. Finally,the Gonedes study noted that the joint information implicit in several annual accounting numbers differed little from theinformation implicit in the earnings number by itself.
In other words, these studies are consistent with the notion that financial reports are useful. Stronger statements,though, must deal with questions about internal validity. The mere presence of anabnormal return coincidental withthe publication of accounting earnings provides asomewhat tenuous basis from which to infer that the observed price movement wascaused by the earnings signal. The principal basis upon which information contentin attributed to accounting earningsis therather impressive consistency with whichabnormal returns concurrent with the publication of accounting earnings have beenobserved.
The early studies of the pragmatic information content of accounting earningssignals were extended to changes in accounting policy. Researchers investigatedwhether "artificial" accounting changesthemselves affected security price behavior. The notion that security pricescould be alteredby merebookkeeping phenomena devoid of economic import (orsemantic information) dominated theliterature prior to the early 1970s. However, studies of security price reactions toaccounting policy changes by Kaplan andRoll (1972), Baskin (1972), Archibald(1972), and Ball (1972) generally indicated
that alterations in reportedearnings whichwere more or less devoid of present orfuture cash flow consequences could notproduce significant long-lasting effects onstock prices. In addition, Sunder (1973)hasprovided evidence that changes in inventory valuation methods which reduceearnings but enhance future cash flowstend to be associated with increases instock prices.6
The widespread belief that the meanand variance of an investment portfoliocomprise the interesting parameters of investor choice led to use of the diagonalmodel in examining the extent to which accounting risk measures are associatedwith a security's contribution to portfoliovariance.7 A measure of that contributionis captured in the slope parameter (beta)of the diagonal model. Studies by Beaver,Kettler, and Scholes (1970), Gonedes(1973), Lev and Kunitzky (1974), and BU-dersee (1975) indicated that accounting-based risk measures were contemporaneously correlated with beta. Thus, accounting risk measures appear to reflect whatever economic phenomena produce thevariance in a portfolio return.
Further, Beaver, Kettler, and Scholesexamined the usefulness of several accounting risk measures in predictingfuture values of beta; they concluded thataccounting-based forecasts of beta weresuperior to naive forecasts based solely onpresent values of beta. Thus, accountingrisk signals appear to have private valuetoan investor who seeks to predict the holding period risk of the portfolio. Perhapsmore importantly, Beaver, Kettler, andScholes suggested that security price research could be applied to the evaluation ofcertain accounting measurement issues.Specifically they posited that a simplifiedordering of competing methods of accounting for common economic phenomenamight be obtainable by observing the asso-
6 Curiously, however, Sander's data did not indicate significant decreases in stock pricesin conjunction with inventory changes which increase earningsbut reduce cash flow.
7 Either quadraticutility functions over returns ornormal return distributions are sufficient to demonstrate an exclusive interest in mean and variance. SeeHaleyand Schall (1973, pp. 101-05).
Alternative Theory Approaches
ciations between earnings variability andbeta, where earnings were defined usingcompeting measurement methods.
Beaver and Dukes (1972) subsequentlyexamined the associations between security prices and three competing definitionsof accounting earnings: cash flow earnings, earnings with deferral of.incometaxes, and flow-through earnings. Their association metric was a variant of the Abnormal Performance Index (API) used byBall and Brown (1968). The API measuresthe abnormal return that could have beenearned from holding a portfolio for a specific number of periods culminating in theperiod of an earnings announcement. Securities comprising the portfolio are selected with hindsight provided by someearnings expectation model. More specifically, securities that subsequently havehigher earnings than were originally forecasted are placed in one portfolio and securities with lower-than-forecasted earnings are placed in another. A positive APIassociated with the unexpectedly higher-than-forecasted earnings is alleged to beindicative of positive association betweenunexpected earnings and unexpected orabnormal price movements. Likewise, anegative API associated with a portfolio ofsecurities with lower-than-forecasted accounting earnings is alleged to indicatepositive association between unexpectedearnings and prices.8Notice, however, thatthe entire line of research is conditionalupon the particular model used to developan expectation of accounting earnings.Beaver and Dukes utilized a variety ofearnings expectations models to assess theassociations between security prices (viathe API metric) and their three competingdefinitions of earnings.9 They concludedthat deferral earnings generally possessedthe highest association.
8 It is important to note that the API is only ameasure of information in a foreknowledge sense. Fora discussion of the nature of foreknowledge, see Hirsn-leifer(1971l.
9The importance of expectations models to thistype of research is obvious. Several studies of the timeseries properties of accounting earnings have been undertaken. See Brown and Ball (1967), Beaver (1970).Ball and Watts (1972), Ball, Lev, and Watts (1976).Gonedes (1973).and Magee (1974).
21
Since their findings were inconsistentwith their expectations, Beaver and Dukesundertook a second study (1973) in whichthey treated various amounts of differencebetween tax expense and tax payable notas deferred charges or credits, but as aform of depreciation. They concluded thatearnings numbers computed upon deduction of depreciation amounts exceeding reported depreciation tended to display thehighest association with security prices.
To date, no other studies utilizing theAPI as a metric for ordering accounting alternatives have been forthcoming. As wediscuss in the next chapter, questions havebeen raised whether the API indeed can beused to assess the association betweenprice movements and accounting earnings.Further, Beaver and Dukes only suggestedthat their analysis provided informationregarding the associations between expectations sequences and a price sequence;nevertheless, other questions have arisenregarding the wisdom of interpreting suchanalyses as assessments of the relative desirability of accounting alternatives. Thosequestions are also discussed in Chapter 3.
Information Economics
The applications of economics to accounting problems discussed in the previous sections utilized economic theory forthe purpose of specifying what kinds of information were needed to make economicdecisions. In this sense, information wasnot incorporated in the economic theorybeing applied. It was often treated as a freegood, despite numerous references to acost-benefit criterion. By contrast, thearea of inquiry known as "information economics" treats information as a conventional economic commodity, the acquisition of which constitutes a problem of economic choice. That is, the product, information, is internalized in this approach tothe formulation of the problem. Previousapplications of economic theory had concerned themselves with the costs andprices of commodities other than information; this approach concerns itself withcosts and prices of information as well.
In the following two sections weexamine some insights provided by information economics. Initially, we review a
22 Statement on Accounting Theory and Theory Acceptance
model for information choice that focuseson a specific individual's demand for information. Then we extend the analysis into adomain of multiple individuals.
The Single Individual CaseIn the single individual case, we view
the demand for information in terms of itsability to improve the quality of the ultimate choice in some choice problem thatthe individual faces. Put another way, thedemand for information is a derived demand; information is valued because it improves the quality of decisions.
To analyze a demand for information,we posit a basic choice problem that an individual must resolve. He must select oneaction from a set of at least two availablealternative actions. The precise outcomethat will follow selection of any specific action is not generally known. Rather, a set ofpossible outcomes is envisioned; only onewill occur, but precisely which one is uncertain.
If the individual's preferences are represented by the expected utility hypothesis, however, we have a precise representation of how his choice will be made. Eachpossible action gives rise to a lottery of outcomes, in which each possible outcome isassigned an action-conditional probability.(These probability assignments may beexogenously specified, as in the von Neu-mann-Morgenstern [1947] axiomatization,or endogenously specified, as in the Savage[1954] axiomatization.) Each possible outcome is also assigned a utility measure.The expected utility of each action is thenmerely the expected value of the outcome-utility measure. One action is preferred toanother if and only if its expected utilitymeasure is greater than that of the other.
Information can now be readily introduced into the analysis. The motive for acquiring information is to learn about whatoutcomes will be associated with what actions. Thus, with outcome possibilitiesassessed with a probability measure, performing an experiment or producing an accounting report is viewed in terms of providing a random outcome whose observance leads to (Bayesian) revision of theoriginal outcome probabilities.
A decision of what information to ac
quire, then, is viewed in terms of a two-stagelotteryorgamble. First, the information source or accounting system will produce some signal or message. Preciselywhat signal will be produced is uncertainand probabilities are assigned to eachpossibility. Second, following signal observance, outcome probabilities are revised and a conditional best action is selected, thereby resulting in an outcome lottery. In turn, theexpected utility ofthespecific source is the joint expectation of theutility of the outcomes associated with theconditional best actions. One reporting system is preferred to another if and only if itsexpected utility measure is higher thanthat of the other. Moreover, at zero cost,less information would never be preferredto more. "> (Further note that the cost of theinformation is accounted for by appropriately adjusting the outcomes that may materialize.)11
We have, in other words, a specificdescription of how information is used(Bayesian revision) and a specific criterion for designing an information or accountingsystem (subjective expected utility maximization). One limitation of thisapproach results from the traditional economic assumption of consistent, rationalchoice behavior.
The Multi-Individual CaseNow consider a situation in which a
number of heterogeneous individuals havea demand for information, such as publicfinancial reports. Analyzing this case in aneconomic manner pushes us into the realmof welfare economics. Two questionsemerge. First, given that we treat information as an economic good, is there any reason to worry about regulating its production, or can we treat the multiple-usersituation in a conventional market setting?Second, if we cannot rely on a market solution and thus must consider regulatory in
to This is Blackwell's theorem. See Marschak andRadner (1972) or Demski and Feltham (1976).
II The basic work in information economics is attributed to Jacob Marschak. See Marschak and Radner(1972). Application to accountingissues is discussedinDemski (1972). Feltham (1972). and Demski and Feltham (1976).
Alternative Theory Approaches
tervention, what is the nature and extent ofthe regulatory activity that should be employed?
The Regulation Question. To shed light onthe first question, we initially review theeconomic arguments for intervention in amarket economy. We then apply thesestandard concerns to an examination of theproperties of information.
If we adopt a normative social choicecriterion of Pareto optimally, to be consistent with this criterion, an allocation ofresources should be interpersonally efficient in the sense that no reallocation canstrictly improve one group's well-beingwithout harming some other group's well-being. Quite naturally, then, Tor intervention or regulation to be an issue, a laissezfaire determination of the production andconsumption of goods and services mustprovide an allocation of resources that isnot efficient.12 Under the usually assumedindividual, firm, and market conditions,however, the laissez faire solution is, infact, efficient.13 That is, a further increasein any group's well-being can occur only atthe expense of some other group. Underthese conditions, there is no incentive forregulation at this point.
That pleasant situation is altered, however, if we recognize the possibility in in-terdependencies that are not properly mitigated by the prevailing market structure.That is, if the market system fails to incorporate all of the interaction effects ofresource allocations, efficiency is notassured. Several examples of these inter-dependencies (or externalities) exist: consumption or production by one may polluteanother; increasing returns to scale maybe present; or the extreme case of a purepublic good (where acquisition by one
12A second argument for intervention is based on"ethical" or "humanitarian" grounds; in such a casethe distribution of goods and services is at issue and.stricUy speaking, we address the questionof movementfrom one efficient point to another. Of course, publicgood and externality aspects are also involved in thedistribution question.
13 See Arrow and Hahn (1971). Debreu( 1959). Henderson and Quandt (1971). Malinvaud (19721,or Quirkand Saposnik (19681 for further discussion.
23
makes the identical amount costlessly andautomatically available to all) may be theissue at hand.
The difficulty in such situations is thatindividual decision agents do not internalize the effect of their choices on others.A polluter, for example, does not naturallyaccount for the effect his pollution has onothers — a fact stressed by recent concernfor social accounting programs. A more extreme case of externalities is the phenomenon of a public good, that is, one availableto a single consumer only if the producerprovides the good to all members of the society. Such goods cannot be appropriatedby some individuals lo the exclusion ofothers. Thus, a price cannot be charged forthe good that will effectively reflect differing individual preferences for the good.For example, consider national defense.The protective benefits of national defenseare enjoyed by all members of society; thebenefit that an individual receives from national defense is not reflected in a price heis willing to pay, since he receives the benefit of national defense production whetherhe pays or not. Thus, private producers ofpublic goods are not able to incorporate intheir decision making the positive effectsof production on nonpurchasers (therebycreating the suspicion of under-production). Without such internalization,market-based solutions may not be efficient and the question of regulationarises. •«
Only the question arises, however.Existence of an externality effect (or itspublic good extreme) is not a sufficientcondition for intervening in the laissezfaire solution. Establishing a correctivemechanism will be costly, and those costsare one of the determinants of whether intervention is desirable. Similarly, the affected parties may be naturally motivatedto resolve their differences privately (e.g.,merger). In other words, intervention is avastlydeeper issuethan mereobservationof a potential inefficiency.
Next we consider whether externalities
14 Analyses are available in the literature. See Dueand Friedlaendcr (1973). Henderson and Quandt(1971). and Malinvaud (1972).
24Statement on Accounting Theory and Theory Acceptance
arelikelytobeassociated withinformationin an otherwise classical economy.
Analysis indicates that financial accounting information sharesmuchin common with the more traditional examples ofexternalities. Its use by one does not necessarily preclude subsequent enjoyment byothers. Once produced, anannual reportornewspaper mayberead bynumerous individuals. And in the extreme, its value toany specific individual may be completelyindependent of who else possesses it.«Coupling the possibility of nondestructioninconsumption with the facts that productionof information is,by nature,a risky activity(uncertainty isanecessary conditionfor information to have value), and thatprevailing property rights may make thetotalbenefit from production notcompletelyappropriable bythe producer, weareledto conclude that, without intervention, toolittle information will be produced (seeArrow, 1962, or Due and Friedlaender,1973). This is one of the standard arguments for such activities as patent lawsanddisclosure policies. Ofcourse,we musttemper this argument by recognizing thecostliness of intervention (see Demsetz,1969)
The possible difficulties are, however,further complicated if oneadmits that thedistributionof informationacross individuals is alsoan important determinantof theconsumption schedules ultimately enjoyedby each. That is, if everyone had the sameinformation, blackmail, sign-stealing inbaseball, and code-breaking in war wouldbe unnecessary. Other illustrations areprovided by moral hazard andadverse selection phenomena. In the phenomenon ofmoral hazard, two parties make an insuranceagreement. Buttheobserved event onwhich the insurance is based is an outcomethat is jointly determined by nature andthe insured. That, in turn, reduces the insured's decision-making incentives (as incost-plus contracting), and we therebyar
ts Gonedes (1975> formulates a problem where theprivate value of information is independent of howmany use it; with costly production this leads to amonopolistic producer. Under conditions thatallow forexclusion ofnonpurchasers heis thenabletocharacterizeefficientproduction anduseconditions.
rive at insurancecontracts that are less efficient in risk sharing than would be thecase with better information.^ This is, infact, a special case of the problem of incomplete markets(seeRadner, 1974).
Adverse selection, on the other hand, occurs when private information provides abasis for self-selection. Individuals with"bad" used automobiles have an incentivetomisrepresent theirautos intheusedautomarket as "good" because a buyer's informationabout the quality of the auto is inferior to that of the seller. Indeed, a potential seller of a "good" used automobilemaybeunable toattracta price thatisconsistent with the auto's quality because ofthe "bad" autos that are misrepresented inthe market. In a similar fashion, sickness-prone people haveastrong incentive toapply for health insurance. In turn,countervailing institutions such as advertising orindependent appraising arise; interventionmay be sought, as in the caseof licensingor mandatory health insurance (see Aker-lof, 1970; Hirshleifer, 1973; and Spence,1973).
These distributive effects associatedwith information differences across individuals have begun to be examined in aninvestment setting. The work of Hirshleifer(1971) and Fama and Laffer (1971), (andcontinuing with that of Gonedes, Dopuch,and Penman, 1975; Jaffe, 1974; Kihlstromand Mirman, 1975; Marshall, 1974; Ng,1975; Radner, 1974; and Wilson, 1974), provide examples. A major implication oftheserelatedexplorations is that it is possible to have overproduction as well as underproduction of information. For example, in a pure exchange economy withhomogeneous beliefs, information production merely redistributes the wealthamong the individuals; no social gainwhatever is produced. Indeed, it is alsopossible to construct examples where —due to the distributive effects — all individuals are unanimous in opposing the production of information (see Marshall, 1974;and Ng, 1975).
16See Kihlstrom and Pauly (1971) and SpenceandZeckhauser(1971) foranalysisof the effect of basinginsurance contractson incomplete knowledge of the insured's behavior.
Alternative Theory Approaches
In summary, externally reported financial information is a public good and thisintroduces the possibility — as is true withother public goods — of underproduction(in this case, underproduction of information). On the other hand, distributive effects of information differences introducethe possibility of overproduction of information. Thus, putting these two phenomena together, it is not at all clear whether inefficiency results in a market setting. Intheory, the answer is clearly affirmative.But in a real-world situation, we simply donot know. No research, to our knowledge,has systematically addressed that question.
The Normative Criterion Question. With inefficiency an open question, discussion ofintervention and regulation is, of course,somewhat premature. Furthermore,issues of "fairness" are apparently also involved. Blackmail is generally frownedupon in the sense that an "unfair" distribution of information produces the transfer ofwealth. Similar thoughts are expressedabout "unfair" advertising, incompletecandor in real estate and security sales,and insider trading. (Of course, allowinginsider trading may be a least cost methodof producing the information.) In anyevent, the precise motivation for intervention is ambiguous at this point.
Suppose, however, that we face a situation in which the market allocation is inefficient, or is the product of an undesirableinitial allocation of resources (includingaccess to information), or both. Some formof intervention will be pursued in order toachieve a more desirable, efficient allocation. The question then involves what criterion should govern this policy decision.
Quite simply, the problem is one of finding a criterion to guide nonmarket allocations. Cost-benefit analysis is a popularterm for a large subset of such activity.The concept is deceptively appealing: the"costs" and "benefits" are tallied and analternative with maximal gain is selected.Unfortunately, the concept of employingsome well-defined objective function islargely illusory in that it runs afoul of theArrow Paradox. This concept is furtherdiscussed in Chapter 3.
25
In summary, the information economics approach offers an explicit individual-demand-based analysis of accounting policy questions. Rationality is themajor assumption employed. This approach provides a means for examiningwhether regulatory intervention (i.e., rulesspecifying form and content) is desirablein an external reporting context. Thepower of the approach is in isolatinggeneral relationships and effects of alternative scenarios. At present, however, theapproach is still too general to provide definitive answers to existing policy issues.
Summary
In this chapter we have identified andclassified three prominent approaches tothe construction of accounting theory: (1)classical ("true income" and inductive)models; (2) decision-usefulness; and (3)information economics. Our synopsisclearly indicates many differences in problems addressed, assumptions made, andanalytic methods employed across thevarious approaches. While the differencesare fundamental and starkly visible, andwhile the issues and conclusions are ofteninconsistent among alternative approaches, theorists have had little successin reconciling these differences or in persuading critics that their unique structureis superior to others. Issues are continuallyrecycled and closure appears to be nonearer.
This situation naturally requires explanation, and in the next two chapters thisstatement endeavors to provide it. In Chapter 3 we explore conceptual issues thatarise in the specific accounting environment. As we will see, these issues are currently unresolved and consequently serveto preclude theory closure at this time.Worse still, many of these issues are notamenable to a solution using the mode oflogic and rigorous analysis upon whichtheorists have long relied. In Chapter 4 wegeneralize our Chapter 3 discussion and offer a philosophy of science interpretationof the continuing disagreement (recognizing, of course, that competing modelsexist). That chapter provides insight into
Statement onAccounting Theory andTheoryAcceptance
narvasive basic problem - and other disciplines - such an arduousthe nature of_ thei P«'ress in acCounting task,that makes theory P* e
Alternative Theory Approaches
Appendix
This Appendix contains analyses of thewritings of Sweeney, MacNeal, Paton andLittleton, and Alexander, which are intended to supplement the discussion in Chapter2. Full reference to the works cited in theAppendix will be found in the bibliography.
Henry W.SweeneyStabilized Accounting (1936)
Sweeney's other writings include"Maintenance of Capital" (1930), "Stabilized Appreciation" (1932), "Capital"(1933), and "Income" (1933).
Sweeney was much influenced byFisher. His decision on the dichotomy between capital and income is predicated onthe intrinsic (i.e., economic) attributes ofeach notion. Sweeney aligns himself withFetter in the famous Fisher-Fetter argument over whether the inclusion of capitalgains in income is double counting.
The closest that Sweeney comes to appealing to the needs of users is his statement that "... the true function of accounting is, or should be, to summarize financial data in such a way as to enable amaximum of helpful information regarding an enterprise to be obtained at a minimum of cost" (1936, p. 199). Only in thePreface to Stabilized Accounting does hespecify the users: primarily business management, but also the owners, bankers,federal and state tax authorities, and thegeneral financial public. Truthfulness isthe controlling tenet, but Sweeney does notshow how truthfulness leads to better decisions.
The entire thrust of Sweeney's argument is of the "true income" school, notwithstanding isolated appeals to the needsof various users.
Kenneth MacNealTruth in Accounting (1939)
MacNeal's work is predominantly of the"true income" school, although elementsof a decision model approach recur. Thedecision model is implicit.
Here is the epitome of the "true income" argument:
27
There is one correct definition ofprofits in an accounting sense. Aprofit is an increase in net wealth. Aloss is a decrease in net wealth. Thisis an economist's definition. It isterse, obvious, and mathematicallydemonstrable .... The function ofaccounting is to record, collate, andpresent economic truths.... (p. 295)
MacNeal, however, is not a partisan of discounted present value. The truth, he says,should be "unmodified by future improbabilities, probabilities, [and] even certainties" (p. 46). His preference is for "economic value," which he translates asmarket prices in a free, competitive,broad, and active market (Chapter 7). Inthe case of inventories, market price wouldseem to be selling price, yet MacNeal ordinarily is satisfied by the use of replacement cost as a surrogate. In general, herecommends market prices for "marketable assets," imputed economic values(e.g., appraisals or replacement cost) for"reproducible, nonmarketable assets,"and original cost less amortization or depletion for "nonreproducible, nonmarketable assets" (Chapter 9). These choicesare evidently a concession to the practicalproblems of measurement.
Notwithstanding his dominant true income orientation, MacNeal frequently refers to the information which stockholdersrequire in order to know the worth of theirshares (Chapters 9, 10, and 14, and p. 2).Moreover, "Creditors have the same rightto know the true status of a company as dostockholders. If the facts are misrepresented, creditors are deprived of a sound basisfor deciding whether to extend or withholdcredit. The same reasoning applies witheven more force to depositors and policyholders" (p. 221).
The use of discounted present values,contends MacNeal, "deceives stockholdersand creditors, and deprives them of atruthful basis of present fact upon which tobase their own estimates of the future" (p.146). The requirements of managers arementioned (pp. 180-81). Thus, MacNeal'sconstruct, while an appeal to truth as economic values, nonetheless reflects thevarious uses to which truth is put by diverse readers. MacNeal evinces a greater
TStatement on Accounting Theory and Theory Acceptance
explicit concern for the lot of specific usersthan does Sweeney. Neither author linkstruth to users' specific decision models.
W. A. Paton andA. C. Littleton
An Introduction to CorporateAccounting Standards (1940)
To many readers, this monographmight defy classification as either deductiveor inductive. Insofar as it represents adeductive argument, one would opt for thedecision model approach. Yet notwithstanding the ostensibly normative vein inwhich the argument is sometimes conveyed, the frequent use of the indicativemood recalls the Liltletonian alloy of deduction and induction —a massaged generalization. An example: "The accountant. . . deals primarily with the administration of the affairs of the continuing business institution and accordingly emphasizes the flow of costs and the interpretation of assets as balances of unamortizedcosts" (pp. 10-11). Do the authors implythat this is what the accountant should do,or only what he doesdo? Are they contentwith generalizing from practice and interpolating an integrated rationalization, or isit coincidence that their explanation ofproper accounting largely coincides, atleast in terms of result, with what accounting is? On at least some points (e.g., purchase discounts and "cost or market"), theauthors recommend procedures that appear to depart from settled practice. It isworth noting that one of the reviewers ofthe monograph, a leading practitioner,said that it "attempts to build a coherentstructure on a philosophical foundation,rather than to discover any coherence inthe field of accounting as it is" (Wilcox,1941, p. 75). In that day. practice was diverse, and practitioners were not accustomed to coherent structures. It is doubtfulthat a coherent structure any more faithfullo then extant practice could have beenproduced.
The decision model, if any, is implicit.The authors go no further than. "The purpose of accounting is to furnish financialdata concerning a business enterprise,compiled and presented to meet the needs
ofmanagement, investors, and the public"(headnote, p. 1). Although they underscorethe importance of the absentee owner,their discussion of the possible uses towhich current value information might beput is related to the decisions made bymanagement (e.g., pricing and replacement).
Transaction-based price aggregatesdominate the analysis. Few exceptions inthe accounts and in the body of the financial statements arc tolerated. "The emphasis on the cost basis . . . rejects the proposition that periodic revaluation has a settled place within the regular accountingframework" (pp. 125-20); that is a disturbing tautology. Current values and generalprice-level data, althoughimpermissibleinthe body of the financial statements, maynonetheless appear in supplementaryschedules or reports. These constitute "interpretive" information in the Littletoniansense.
An argument frequently given (pp. 123.135, 141) in support of historical cost is theconstraint imposed by legal requirements.At one place, the term "contractual earnings" is used, evidently connoting the notion of earnings contemplated by contracting parties, or perhaps by legislation andjudicial opinion. The authors do not arguefor an idealized notion of income, and theyare conscious of institutional boundaries.
The authors' persistently positivistform of expression confounds the reader.Another example: "Prom the point of viewof the managers and owners of the enterprise the cost incurred is regularly the significant measure of operating effort . . ."(p. 23). "Ought to be" or "is"? While thestated purpose of accounting, quotedabove, is couched in the indicative mood,the authors elsewhere state that accounting "must represent a practical tool ofbusiness and finance, competent to meetthe legitimate needs of managers, investors, government, and the public atlarge" (pp. 4-5). Fulsomcly normative.
Perhaps the clearest expression of theauthors' view of their mission appears onpage4:
A statement of accounting standardsshould represent an integrated conception of the function of accounting
Alternative Theory Approaches
as a means of expressing the financial facts of business in a significantmanner. It must inevitably embodysome conflict with existing accounting practices, since existing practiceis in conflict with itself at a hundredpoints. It should avoid any appearance of encouraging violations ofexisting law, but it need not accept asgood accounting all definitions, policies, and practices which legislatorsand courts have added to the accounting structure.
In vivid contrast to MacNeal's work, thePaton and Littleton monograph was evidently written so as not to annoy the practitioner audience. At that time, the American Accounting Association was attempting to replace rivalry by collaboration inits relations with the American Institute ofAccountants, as the AICPA was thencalled. Copies of the monograph were distributed without charge to members ofboth bodies, and the authors clearly soughtto achieve a maximum favorable impacton practitioners without sacrificing theirprinciples. This motive could explain theindicative mood.
Much of the writing is Paton's but allthe ideas are not. Price aggregates, andthe dominant "interpretation" theme ofthe final chapter are pure Littleton, Yetmost of Paton's ideas find expression in themonograph.
Notwithstanding the authors' frequentreference to "standards." even in the titleof their monograph, their approach cannotfairly be characterized as falling in thesame class as ASOBAT. Paton and Littleton enumerate measurement rules whichare assertedly predicated on the several
29
concepts, conventions, and assumptionsset forth in Chapter 2. If there is a pervasive standard (i.e., normative standard), itis dependability, which is frequently invoked in defense of traditional historicalcost. In fact, the authors did not undertaketo enumerate standards, but instead to laythe groundwork for a future exposition ofstandards.
Sidney S. Alexander"Income Measurement in a
Dynamic Economy" (1950)(revised by D. Solomons in
Studies in Accounting Theory, 1962)
Alexander's attitude toward the existence of "true income" is not easily categorized. Throughout the essay he repeatedlystresses that the utility of a given incomesystem must be assessed in relation to theintended use for the resultant measurements (see Baxter and Davidson. 1902. pp.130, 146,and 164). This strongly hints of thedecision model, rather than the true income, approach to income theory. However, in several places in the essay,Alexander makes statements which suggest that in theory at least an ideal incomeconcept does indeed exist. For example:
... we must find out whether economic income is an ideal from whichaccounting income differs only to thedegree that the ideal is practicallyunattainable, or whether economicincome is inappropriate even if itcould conveniently be measured, (p.159)
In summary, Alexander probably fallssomewhere between the "true income"and decision alternatives.
Chapter 3
Criticisms of Present Theory Approaches
This committee has looked for reasonswhy none of the alternative theory approaches discussed in Chapter 2 has risento a position of singular prominence in contemporary accounting thought. None ofthem has been left unchallenged; indeed, asteady stream of counterarguments andcriticisms appears to have prevented anyof the approaches from gaining a clear majority of accounting theory students as supporters.
Many prominent criticisms of alternative accounting theory approaches wereclearly discernible in 1966, when the Association's most recent major theoreticaldocument, A Statement of Basic Accounting Theory, was written. Since then, additional points of dissatisfaction with one ormore of these approaches have appearedin the literature. Further, some of the traditional criticisms have received renewedsupport.
In this chapter we survey some of thecontemporary points of conflict that arisein the accounting literature. Clearly, eachpoint is not shared by all critics. In the aggregate, however, they apparently serve topreclude a meaningful consensus regarding financial accounting theory. Our survey is not intended to be exhaustive; however, it should convey the fundamentallevels at which objections to proposed theoretical approaches arc raised. Six different issues are summarized in this chapter:(1) the general problem of relating theories to practice; (2) the allocation problem; (3) the problem with normative standards; (4) the problem with basing accounting theories on securities price research ; (5) the problem of cost-benefit considerations in accounting theories; and (6)the danger in assuming that more information is preferable to less. Collectively thesepoints of conflict illustrate why no theoretical approach has yet achieved dominantacceptance within the accounting community.
The Problem of Relating Theories toPractice
Apparently, accountantsexpect or hopethat the process of accounting theorizingwill lead to a sufficient and compellingbasis forspecifying the content of externalfinancial reports. However,even if a singletheoretical approach should rise to prominence,many of the day-to-day issues facedby practicing accountants and auditorsprobably would persist. For example, inmany proposed theories, issues of materiality wouldremain issues. Furthermore,to the extent accountants fail to perceiveand accept limits to the practical coverageprovided by a theory, all theoretical approaches are apt to be controversial because of the gaps they leave in guidingpractical applications.
One possible source of practical dissatisfaction with a theory is its lack of coverage or breadth. For example, some expositions of inductive theories have leanedheavily on statements to the effect that assets are valued at historical cost, and haveneglected those assets, such as cash andreceivables, which are not customarilyvalued at cost, along with all liabilities. Another example is the case of the theoristwho limits his concern with flows to incomestatement changes to the exclusion ofchanges in working capital, even thoughstatements of changes in financial positionare acknowledged to be a vital part of practical accounting. Theories with such gapsare bound to be perceived as inadequatefor yielding the answers that practitionersseek.
Another practical problem with theories is that they do not always recognizealternative possible features of the environment and specify how to deal withthem. This "weakness" of theories may beassociated with unrealistic assumptionsmade by the theory, such as competitiveequilibrium, zero transaction costs, immaterial fringe acquisition costs of commodi-
31
32 Statement on Accounting Theory and Theory Acceptance
ties and services, complete markets, zerocostsof producing and utilizing accountingdata, stability ofthemonetary measuringunit, homogeneity of decision modelsamong members of a user group, and mutuality of interests of owners and managers. Observed inconsistencies betweensuch assumptions (and the resulting simplifications of the theories) and the environment in which accountants work maycause practitioners to lose faith in ailtheories.'
It is not clear that theorists can overcome the problem of incomplete specification by adding realism to their assumptions; the real world is very complex andcomplexity is alsoa weakness in a theory.A complex theory may be more difficult toapply, and therefore its popularity amongpractitioners will be lessened. For example, the evaluationof information systemsin accordance with the approach of information economics may escape the criticisms of narrow coverage or inadequateprovision for variations in the environment. But the complexity of the information evaluation task, as outlined in the information economics section of the previous chapter, may well cause many accountants to avoid it. Similarly, if a theorist specifies a large number of normativecriteria that an accounting method shouldmeet, the practitioner may not be able tomake the complex set of trade-offs that arerequired to apply the theory. Perhaps thenotion of an optimal quantity of data thataccountants should provide to users in order to maximize the net value of information can be adapted to apply to the amountofdetailed specifications in an accountingtheory. Butdifferencesamongaccountantsin their tolerance (or desire) for detailedguidance are bound tosubjectany theoryto criticism by some of its users! An admirably simple accounting theory is notlikely toyield immediate and unequivocalanswers to all accounting decision situa-
1The question ot whether a theoryshouldhe evaluated on the basis of the realismof its assumptionsinaddiiion to its predictive power remains unsettled. Cf.Friedman(195.11. Nagel(195.1), Samuelson (196,1), andCarsbcrg. Arnold,and Hope(1977).
lions. To the extent that accounting theories are evaluated on these criteria, notheory is likely to be wholly satisfactory.That is one possible explanation for thelack of general acceptance of any theoretical approach.
The Allocation Problem
Most of the alternative approaches tospecifying the content of external financialreports rely heavily upon allocation processes. Even if allocation procedures areavoided in formulating the general framework of a proposal, they are frequently introduced at a more specific level. Thomas(1969, 1974) has argued that the allocationproblem is an inherently insoluble one thatpervades most external reporting proposals.
The most serious objection to allocationtechniques is that many are inherently arbitrary. A familiar example of arbitraryallocation in U.S. accounting principles isthe oft-quoted description of depreciationaccounting published by the AICPA in1953: ' 'Depreciation accounting is a systemof accounting which aims to distribute thecost or other basic value of tangible capitalassets, less salvage (ifany), over theestimated useful life of the unit (which may bea group of assets) in a systematic and rational manner. It is a process of allocation,not of valuation . . . ." The absence of anyguidance as to the meaning of "rational" inthis context has enabled accountants to defend widely varying time-patterns of depreciation. Many accountants agree withThomas that this is a weakness in thosetheoretical statements reflecting U.S. accounting principles, such as ARS No. 7(Grady, 1965,pp. 148-51).
The extent of dissatisfaction with accounting procedures involving allocationsappears to vary widely. One probable reason that dissatisfaction varies is that themeanings attributed to the term "allocation" vary. Some accountants limit theirapplication of the term to cases in whichone monetary amount is split among several accounts or periods without direct reference to either physical or monetary evidence as a basis for the split. Others extendthe term to such cases as splitting rentamong departments on the basis of floor
Criticisms ofPresentTheory Approaches
space occupied, or even to charging thesalaryofan employee tothedepartment inwhich he worked. In the view of many accountants, there is a vast difference in thearbitrariness of these various procedures.Nevertheless, it seems safe to say thatthere is widespread dissatisfaction withthose procedures that appear to fall at themore arbitrary end of the spectrum.
The fact that an allocation technique isarbitrary does not mean that it is indefensible. On the contrary, in Thomas' ownwords:
The difficulty is more subtle: for eachsituation in which allocation is contemplated, there isa variety of possible allocation methods, each of which could bedefended. The allocation problem arisesbecause there is no conclusive way tochoose one method in preference to allothers, except arbitrarily. (1974, p. 2)
Thomas illustrates at length the arbitrariness of various classes of allocation techniques and the inability to defend thesetechniques rigorously to the exclusion ofavailable alternatives. Since conclusive selection is impossible, endless argumentation ensues. While some may disputeThomas' conclusion that (given our current state of knowledge) allocation techniques are totally arbitrary, at a minimumit is apparent that such allocations giverise to vexing controversies.• The irresolv-abilitv of these allocation-induced controversies explains, at least in part, why the-
2 An interesting manifestation of the allocationdilemma arises whenweattempt to define the conceptofincome inan uncertainty setting Following theHick-sian tradition, we think in terms of temporal wealthmeasurement. Yet future cash flows, in an uncertainlysetting, arccharacterized by probability distributions.Ina complete embracing ofstate Indexed commodityproduction and exchange (eg.. Debrcu 1959), however,nodifficulty is encountered. K.ach possible distributionof future cash flows has a known markc! priceandwealth calculations arc straightforward. But difficulties emerge if we donot have access to these marketprices-lhat is. ifthe markets are incomplete. Here thetraditional allocation dilemma again emerges,bothinterms of "assigning" periodby period components ofthecashflow as well as (recognizing slate dependence)in interpreting the resultant income measure. However, market incompleteness andtheresultant allocation dilemma, notuncertainty perir, IsIhecause ofthedifficulty.
33
oretical approaches in which allocationplays an integral role have not gainedwidespread acceptance.
The Difficulty with NormativeStandards
As discussed in Chapter 2. some theories of external reporting incorporate nor-matively posited standards that provideabasis for choosing information to be includedinexternal reports. Such standardsinclude objectivity, verifiability, and timeliness, amongothers. Oneimportant characteristic ofsome ofthese standards is thattheyrefer toproperties thatare intrinsic totheaccounting numbers themselves; theyare not inferred from the personal preferences of the individual users of accountingdata. As a consequence, the relationshipbetween theproposed normativestandardsand the individual preferences of decisionmakers is indirect. Since normative standards that arc divorced from individualpreferences cannot completely surrogatethose preferences, the imposition of suchstandards presents serious difficulties.Specifically, if weassume that an accounting system should be designed to maximize,say, the expected utility of the usersof accounting data, the data chosen to conform to imposed standards will not consistently lead to that result.
Consider an individual user of accounting data whose preferences can be represented by the expected utility hypothesis;that is, he guides his behavior in a mannerthat results in maximum expected utility.Further assume that our individual usesaccounting information to make more thanone type of economic decision. Since eachtype of decision incorporates potentially diverse dimensions, each distinct decisioncategorymay result inemphasison different properties of the financial phenomenaat hand. For example, if accounting policymakers adopted objectivity as a criterionfor selectinginformation to be reported tothis individual, the resultant informationsystem might actually maximize the expected utility forone typeofdecision madeby the individual. That is, the preferencesof the individual in the context of a specifictype ofdecision mayrequire that objectivity be the dominant criterion in construct-
34 Statement onAccounting Theory andTheory Acceptance
ing the system from which he obtains information input to his decision process. However, if the same individual uses the sameinformation in the context of a differenttype of decision, his preferences may require that objectivity not be the dominantcriterion in the second context.
Furthermore, no two decision problemsare identical. New environmental dimensions can suddenly materialize even in recurring, somewhat standardized decisionareas. In other words, the processof defininga "type of decision" for which a specified normative standard will be appropriate cannot be expected to be stable as environmental changes occur. As a consequence, there is no guarantee that a normative standard consistent with utilitymaximization on one occasion will necessarily lead to utility maximization in an altered decision environment. (Indeed, thesetting becomes more perverse if we allowthe individual's preferences to shift overtime, and we have no basis for assumingthat this is a rare occurrence.)3
3Ofcourse, one might argue that,intheideal case,the standardswillbe rich enough to "work" in all settings. However, this cannot be the case because thenecessary and sufficient conditions for such a state ofaffairs, as specifiedby Blackwell's theorem (see Marschak and Radner, 1972), preclude any such universalset of standards.
This argument is presentedby Demski (1973a). Itsessence is as follows. Without loss of generality, assumethe policy maker is faced withchoosing betweentwo accountingalternatives, if andrf. Further assumethatrj" andrj" can be compared in termsof fineness,wherein T is said to beas fine asr)" if1' provides asmuchinformation as rf and possibly more. Forexample,deferral of incometaxeswould appearlobeas fineas nondeferral, since deferral contains as much information as nondeferral, and perhaps more. If f andri*are costless, il is clear that rras fine asry is sufficienttoinduce the policy maker todesirerf at leastasmuchasrf. However, rj" as fine asn- isalsoa necessary con-dition for rf tobeatleast asdesirable asrf. <This istheessence of Blackwell's theorem.) Therefore, anystandards which are used to surrogate preferencesmust also surrogate fineness.
Thedifficulty is thatfineness isnotacomplete relation—some Information systemsarenotcomparable intermsof fineness. For example, UFO andFIFO probably cannot be compared on a fineness dimension.Since fineness is incomplete, there are coses in whichstandards cannot possibly surrogate fineness and, inturn, preferences. Therefore, standards surrogatingpreferences are. ingeneral,animpossibility.
In a more realistic portrayal of the reporting environment, the problems of using normative standards to specify the information system are complicated evenfurther by the obvious existenceof manyindividual users. Observation of human behavior suggests that the preferences of individuals are diverse. To cite a few examples, some individuals may valueprosperity highly, whileothersstrive merely fora"comfortable" living standard; some pursue increments to wealth under highlyrisky conditions,whileothers will not; andsome have a more highlydeveloped socialconscience than do others. Since individuals in a multi-person setting have diversepreferences, no single set of standards forexternal reporting is likely to be consistentwith thosediversepreferences.4 Moreover,the question of how diverse individualswould or should specify public reportingpolicies is largelyopen. And we simply donot know the relationship betweenany setof standards and such group-level choicebehavior.
Thus whether viewed in a single- ormulti-person setting, normative standardsdo not appear to offer a noncontroversialbasis for theory building or policychoice.
Difficultiesin InterpretingSecurityPrice-Behavior Research
As we noted in Chapter 2, considerableempirical research based on the efficientmarket hypothesis has attempted to discern how investors, viewed in the aggregate, use accounting measures. Briefly,that research tries to interpret the contemporaneous association of information flowwith unexplained variations in rates of return on securities as an indication of "informationcontent." Twocaveats are, however, important when we undertake to interpret these types of studies.5
4Some of the objections raisedagainstthe decision-usefulness, decisionmodelapproach are based on thispoint. Specifically, that approach seeks to provide information specified by the decision modelof a certaincategory of users. But this Ignores the potential redis-tributive effects on other users whose information desires are excluded fromthe analysis.
5Some, such asThomas 11874, pp. KWl),reject allsuch evidence on grounds that the individual behaviorsthat are aggregated in market statistics are them-
Criticisms of Present Theory Approaches
First, whether we interpret the studiesas attempts to assess consequences or desirability of measurement methodchanges, we nevertheless confront the traditional experimental concerns of internaland external validity (as we do in all empirical studies). Most clearly, thetestsarebasedon controlling for all "obvious" return factors (such as market-wide phenomena, arrival of other information, andrisk changes); the tests are thereforelimited by our ability to identify and allowfor the effect of such factors. Whether acorrelated variable is overlooked remainsproblematic (see Gonedes and Dopuch,1974).
Second, when one interprets the association measure as an indicator of either theconsequences or the desirability of measurement method changes, he must alsorecognize the inherent simplificationsbeing relied upon. In terms of consequences, price changes per se are not likely to indicate fully the impact of reallocation in a regime of incomplete markets,simply because of less than complete marketability. For example, questions of amanager's nonmarketable human capitalbecome an issue at this point, and with lessthan complete marketability, strict focuson market aspects may miss important dimensions of the consequences.
In terms of desirability, however, theargument is, perhaps, more subtle. Consider a strict presentation issue, as inBeaver and Dukes (1972,1973), where theunderlying depreciation and tax allocationdata were available to the reader and thenarrow question addressed was how to present these data. Subject to internal and external validity concerns, one might conclude that the "statement-proper" presentation yielding the highest contemporaneous association provides the data that individuals prefer to employ, and shouldtherefore be the accountant's choice(thereby saving on users' processingcosts).
But even if this line of attack is successful in pinpointing desirable (that is, efficient) modes of presentation, it falls short
selves the results of "bad" judgments or prior beliefsand hence cannot be relied upon in the search for a"good" measurement system.
35
of answering more basic questions.6 Forexample, Beaver (1972), and May andSun-dem (1973), point out that this approachcannot be employed to assess the desirability of unreported alternatives such as current values (assuming that the underlyingevents are not reported by competingsources of information). More fundamentally (as noted by Beaver and Demski,1974; and Gonedes and Dopuch, 1974), theapproach breaks down when it is pushedbeyond narrow format questions to the extreme of using market association studiesto rank accounting alternatives in general.Other criticisms are summarized by Sterling and Harrison (1974,pp. 146-48).
A similar question is whether the traditional guides of market prices and the market value maximization rule can be used torank accounting alternatives. The answer,unfortunately, is negative if the marketstructure is incomplete (Radner, 1974).This result is also articulated by Gonedesand Dopuch (1974). In their analysis, markets are initially assumed to be perfect andthe goal of firms is to maximize the currentmarket value of common shares; that is,firm decisions follow the market valuerule. Information is regarded as merelyone of the outputs that firms may producefor sale. Gonedes and Dopuch further assume that firms are capable of limitingconsumption of their information output tothose who actually purchase it and that nointer-user externalities arise. Under suchconditions, a market for information wouldexist; firms could observe prices in thismarket and assess marginal revenue andcost relationships to determine information output. Further, share prices would reflect changes in the value of the firm associated with its information production activities. Hence market value maximizationwould lead to efficient resource allocation.
However, difficulties emerge if we positthat firms do not have the ability to limituse of produced information to those whoactually purchase it. The inability to exclude nonpurchasers causes evaporation of
* Marshall (1975). for example, stresses the internal validity concerns in specifying the "abnormal performance index" as a measure of the association between unexpected earnings and unexpected pricemovements.
36 Statement onAccounting Theory andTheory Acceptance
the market for information, since information canbecostlessly obtained by all.? Thisinduced market incompleteness precludesdecisions about information productionthat are based on considerations of marginal revenue and cost.To illustrate, considera firmproducing information that, inthe presence of an information market,would add valueto the firm. However, theinformation produced has negative cashflow implications for the firm's noninfor-mation activities. In the absence of an information market, share price will fall,since no increase in the firm's value due toinformation production will occur to offsetthe loss in value related to noninformationactivities. Hence, as long as informationmarketsareincomplete, nogeneral correspondence between the desirability of information production decisions and sharepricemovementswillexist. Consequently,observation of market reactions may notbe helpful in resolving certain controversiesregardingaccountingalternatives.
The Problem of Cost-BenefitConsiderations inAccounting
TheoriesIn assessing the desirability of various
financial reporting alternatives, accounting theorists have generally not determined the benefits and costs related totheirrecommendations. The opinion that aspecified reportingalternative, such as accounting in units of general purchasingpower or extensions of interim reporting,should not be adopted because it is toocostly for the benefits received is expressed frequently, but supporting dataarerarelypresented. Thisis notsurprisingsince thebenefits andcosts ofanyproposalare exceedingly difficult to identify andmeasure. However, until such a demonstration occurs, it is not possibleto defendconclusively a particular accounting policyagainst competing alternatives. More generally, except for the informationeconomics approach that incorporates cost-benefitconsiderations at anabstract level, allapproaches to accounting theory fail to provide explicitly for the measurement and
7 Similarobservations emergewhenwereflectonthenotion ofa price that"reflects" allcurrently availableinformation (seeGrossmanandStiglitz,1976).
comparison of benefits and costs of accounting options. Many accountants feelthat this is a crippling weakness which willalways prevent them from achieving consensus regarding solutions to accountingissues.
Thus, formally incorporating the cost-benefit orientation of information economics offers an appealingavenue of theoretical pursuit. However, difficulties exist.Most obvious is the practical issue of howone operationalizes the expected utilitymeasures. With the proper axiomatic foundation, the mathematical existence of suchmeasures surely is guaranteed. But thistheoretical existence provides little guidance forconstructing such a measure andincorporating actual numbers—as must bedone to implement the approach in a real-world setting.
An even deeper problem also exists,however. That is, even the mathematicalexistenceof the preference, orcost-benefit,measure may be denied in a multi-personsetting. Recall that in a multiperson setting we seek nonmarket allocation criteriawhen considering how to intervene in orsupplement a laissez faire allocation process. An example arises when the FASBconsiders some disclosure policy. The issueis, what criterion should govern theFASB's deliberations. And the difficulty,known as Arrow's Paradox, is that a completeandtransitiveranking of the alternative criteria does not, given a set of seemingly innocuous assumptions, exist. Thatis, existence is denied.
Briefly, the problem as posited byArrow (1963) is oneof moving from individualtosocial preference. Tomake the problem interesting, at least two individualsand three alternatives are recognized(which is hardly a problem in an accounting setting). Arrow imposed four conditions that this relationshipshouldsatisfy:
1) Universal Domain. The individualsare unrestricted except that theymust display complete and transitivepreferences. Similarly, the socialpreference that emerges must becomplete and transitive.
2) Pareto Optimality. If all individualsstrictly prefer one choice to another,
Criticisms of Present Theory Approaches
then the social ordering should strictly prefer the one to the other. Thisconfines the choice to those alternatives that are efficient and hardlyseems debatable. Abandoning itwould amount to proposinga methodof choice based on systematicallydenying those affected what theywant.
3) Independence of Irrelevant Alternatives. If two alternative sets of individual preferences agree on a subsetof the alternatives then the corresponding social preferences mustagree on that subset of alternatives.This condition rules out interpersonalutility comparisons. The choice between any pair of alternatives mustbe based solely on the individual preferences for the two alternatives andnot on any other preferences theyhave (such as might be used to "calibrate" interpersonal comparisons).
4) Nondicta torship. There does not existan individual whose preferences arealways identical to society's.
Difficulty arises because these conditions are mutually inconsistent. No suchmethod of moving from individual to socialpreferences exists. As a consequence, thepolicy problem cannot be formulated interms of maximizing some conceptuallywell-defined criterion. That is, even with awell-defined criterion for accounting system design at the individual level, we donot emerge with a specific criterion forregulation.
How, then, does one formulate the problem of regulation or policychoice? Clearly,these choices are presently made and willcontinue to be made. Since whatever method might be employed violates at least oneof Arrow's conditions, one might structurethe problem in terms of selecting whichconditions to violate. Fundamentally, however, the criterion question is an open one.
Quitesimply, then, cost-benefitanalysisdoes not provide the basis for constructinga theory of accounting. Indeed, one cannoteven formulate the question of guiding non-market allocations in terms of costs andbenefits because, accepting Arrow's for
37
mulation of the problem, such measurements do notexists
To summarize, for some accountants,the failure to incorporate cost-benefit considerations in most theoretical approachesserves as a sufficient reason to reject thoseapproaches. On the other hand, propercost-benefit analysis does not appear possible with the present state of economicknowledge. This is not to say, however,that unambiguous social choice criteriacannot emerge in a multi-person setting.To the extent that the individuals involvedcan work out mutually acceptable sidepayments, any externality can beremovedand Pareto-optimal solutions achieved.Nevertheless, in general cases, cost-benefit analysis cannot provide a basis for constructing an accounting theory at the present time.
Limitations of Data ExpansionIn recent years a theoretical approach
to external reporting issues called "dataexpansion" has emerged. Simply stated,proponents of this approach argue thatmore information is assuredly preferableto less. Accordingly, they suggest thatmany types of accounting controversiescan be resolved through expanded disclosures.
Impetus for the data expansion approach arises from two distinct sources. Inone view, accountants' limited knowledgeof users' preferences and behavior makesit difficult to defend a single reporting option against available competing alternatives. As a consequence, it is argued thatthese difficult choices can be avoided bypresenting more detailed disclosures or byreporting simultaneously several alternatives that satisfy some (usually unspecified) logical criteria. Sorter's "events approach" (1969) illustrates this position.
A second perspective, market efficiency, also lends support to the data expansion approach. In this view, the "efficient" market in the aggregate presumably is not misled by the form or content ofaccounting disclosures. As long as there
8 See Beaver and Demski (19741 for an analysis ofthe problem in terms of the political institutions we devise to answer such questions.
V38 Statement on Accounting Theory and Theory Acceptance
are sufficient disclosures, the discloseddata will be evaluated and efficiently impounded in security prices. From the perspective of market efficiency, it makes littlesenseto argue over, say,which reporting format is preferable; disclosure isviewedas a means for resolving such controversies. Debates regarding alternativeforms of lease accounting, for example,would constitute a trivial issue. Completedisclosure is viewed as the critical issueand where—or in what manner—thedisclosure is effected is unimportant. In a similar vein, increased disclosure would beviewed by some as a means of resolvingtraditional measurement controversies.Reporting historical and current-cost numbers to market participants, for example,eliminates the controversy over inflationaccounting.
The net result of both views is the same.There has emerged a theoretical positioncentering around increased disclosure inlieu of resolution of issues by reliance ontraditionaltheoreticalanalysis. But the appeal of data expansion has been resisted onthree grounds: (1) physiological considerations, (2) cognitive processing limitations, and (3) economic efficiency.
The most obvious criticism of data expansion is physiological. Beyond somepoint, additional data could overwhelm adecision maker and make it physically impossible for him to consider and impoundincremental messages—the familiar "information overload" problem. Of course,this criticism does not apply when the incremental data are of modest proportionsand the user is not inundated with data.
However, even when the proposeddataexpansion is small, an important psychologicaleffect suggests that even modest increases in disclosure are not "costless."Increased disclosure levels increase theperceived complexity of the environment.Abundant psychological testing evidenceindicates that such changes in perceivedenvironmental complexity induce changesin decision makers' cognitive processingcapabilities (e.g., Schroder, Driver, andStreufert, 1967). These cognitive processing changes, in turn, can decrease the effectiveness of decision making by causingdecision makers to revert to a more con
crete conceptual level in an attempt to copewith the new, more complex environment(Driver and Streufert, 1969).
The relevance of the cognitive processing effect to accounting reporting issueswas initially raised at a theoretical level(Revsine, 1970b, 1970c, 1973). Subsequentempirical tests in an accounting setting explored the potentially adverse effects of increasing environmental complexity onvarious kinds of decision styles (Driverand Mock, 1975). Dermer (1973) also examined the effect of personality variables onthis process. From a psychological perspective, results of preliminary researchindicate that data expansion is not a panacea. Beyond a certain point, even relatively modest increases in reported dataraise the possibility of adverse decisionmaking effects.!)
The desirability of a data expansionapproach to external reporting is also unclearwhen the issue is examined from the traditional perspective of the economic consequences of information. Here two deep concerns arise, even if we assume that the reporting alternatives are costless. First,placement—as long as the disclosure ismade—may not be a totally neutral aspectof the problem. With alternative placementoptions, choice of one as opposed to anothermay "signal" some additional economicaspect. For example, footnote versus statement-proper disclosure of a potential liability from pendinglitigationmay "signal"different management beliefs as to thelikelihood that the litigation will be adverse. Similarly, the manner in which forecasts are presented may convey informa-
' This brief summary necessarilyomits certain issues. For example, art information specialists subjectto similar adverse effects of increasing complexity?What little evidence is available suggests that the adverse decision effect arises among both abstract andconcrete decision makers (Streufert and Schroder,1965; Driver and Streufert, 1969; and Streufert, 19701.However, the issues of personality variables (Dermer.1973)and decision style (Driver and Mock, I97S) navealso been explored to determine the generalizabib'tyofthese findings. Furthermore, over time the level ofcomplexity that leads lo adverse effects may be increased as learning takes place (Miller and Gordon,1975). However, the general point remains: the possibility of adverse decision effects cannot be ignored indata expansion proposals.
Criticisms of Present Theory Approaches
tion about the quality of the forecasts. Thistype of signalling effect is discussed bySpence(1973) andStiglitz (1975).">
Second, disclosing or producing "more"information even if it is costless may not bebeneficial. In fact, it may be strictly harmful. In a multi-personsetting, such as thatof numerous users of accounting reports, itdoes not necessarily follow that public information is a superior good. Some may beharmed by productionof such information,even if it is costless (see Ho and Chu, 1974;Baiman, 1975; and Demski and Feltham,1976). Perhaps more significantly, in a recently published paper, Hart (1975) demonstrates that in a regime of incomplete markets, openingnewmarkets, say, by providing additional accounting measures onwhich to make event-contingent trades,may not be an economicallydefensibleact.More information, in other words, even iffree, need not be beneficial in a multi-person setting.
In summary, the basic tenet of the dataexpansion approach—more information isassuredly preferable to less—does not apply in either a general economicsetting or
10 Further note that a firm may have elected tohave its statements audited before specific requirements were imposed simply because such behaviorwasa signal of the quality of the statements and the integrity of the management.
39
from a cognitive information processingperspective. Accordingly, theories thatrely on data expansion have not achievedwidespread acceptance.
SummaryIn this chapter, we have reviewed a va
riety of reasons why individual accountants may be dissatisfied with the variousapproaches to developing an accountingtheory. We have not attempted to providean exhaustive enumeration; instead, ourdiscussion illustrates major issues. Although the reader may well have additional points of contention or criticism, thislimited discussion should suggest thebreadth of the problem.
We urge the reader to avoid reading anypartisan intent into our use of the words"criticisms" and "points of contention."We are not assessing specific formulationsof accounting theories. Nor are we defending or criticizing any particular theoreticalapproach. Rather, we have attempted topropound reasons why none of the available theoretical approaches has yielded asufficient and compelling basis for specifying the content of external financial reports. That is, we have examined severaldetailed points of conflict which collectively explain why no theoretical approach hasachieved consensus acceptance.
IF"
Chapter 4
Difficulties in Achieving Consensus: A General View
Accounting researchers, academiccommittees, and professionally sponsoredpolicy groups have attempted, over theyears, to formulate theories of accounting.In Chapter 3, we acknowledged a prevailing expectation among accountants thatthose efforts would lead to some sort of unified theory that would provide a sufficientand compelling basis for specifying thecontent of external financial reports. Wethen summarized a number of problemsthat may have prevented any of the available theoretical approaches from rising toa position of prominence relative to theothers.
Yet, even if each separate approach isperceived to contain serious flaws, members of the accounting community mightstill expect that a process of argument andcounterargument would eventually promote theoretical closure. That is, manymight consider the process of theoreticaldevelopment in accounting to be a type ofevolution. If that be the case, we need onlyto continue the collective struggle to adaptand modify our theoretical structures asenvironmental changes occur.
From an evolutionary perspective, however, specific formulations of accountingtheory will continually face the prospect ofdiminishing relevance unless piecemealmodifications are undertaken to adapt thetheory formulation to environmentalchanges. Furthermore, if environmentalchanges are frequent, the existing theoretical structure is bound to be under constantpressure; that is, the implications of thetheory may not be judged as compellingreasons to constrain or specify the contentof external reports.
The evolutionary view of accountingtheory formation has considerableappeal.It obviously allows for the existence of important, unresolved issues. Furthermore,it also holds the optimistic promise ofmovement toward resolution of these issues.
In spite of these features, the committeeis led to consider an alternative view. Our
reason is that the accounting literature ofthe past decade or two appears inconsistent with the evolutionary view of accounting theory development. Consider these examples: (1) the apparent consensus on the"matching and attaching" approach totheory formation is disintegrating; (2) issues that are either irrelevant or unresolv-able under that approach continue to be recycled; and (3) there is an expanded arrayof alternative approaches to theory formation, none of which looms as an apparentsuccessor to the cost-based approach ofmatching and attaching. All these factorssuggest that changes in the process of theorizing in accounting may be more revolutionary than evolutionary. Such a perspective was developed as a general view of science by Thomas S. Kuhn (1970) .>
Achieving Paradigm AcceptanceIn his treatise on the pattern of changes
in scientific thought, Kuhn introduces theconcept of "paradigms," which he contex-tually defines as conceptual and instrumental frameworks that "provide modelsfrom which spring particular coherent tra-
) We are sensitive to the potential validity of criticisms that analyses (such as Kuhn's) of scientific practices and methodologies probably were not intended toapply and, in fact, may not be applicable to such diverse areas of intellectual activity as physical sciences, social sciences, and accounting. For example,we note Mark Blaug's conclusion that "both Kuhn andLakatos jeer at modern psychology and sociology aspre-paradigmatic, prolo-scienccs. and although economics seems to be exempted from the charge, Lakatosseems to think that even economists have never seriously committed themselves to the principle of falsifi-ability" (1976). No doubt the vast bulk of accountants'work falls victim to the charge levied upon psychologists, sociologists, and economists. Thus, we must recognize the possibility that Kuhn's views on the development of science may apply less forcefully to accountingthan would be appropriate for other areas of intellectual endeavor which have richer scientific traditions.Nevertheless, we note striking similarities in the general objectives of science and accounting, and our searchfor rationales that apply to the existing stage of accounting thought suggests significant insights to begained from the comparisons drawn in this chapter.
41
42 Statement on Accounting Theory and Theory Acceptance
ditions of scientific research" (p. 10). Theparadigm of an individual scientist specifies the kinds of problems he perceives tobe interesting. It circumscribes the empirical domain over which the individual's theories and research are applied. It indicatesthe kinds of tests or standards that areused to adjudicate contradictory theoretical propositions. And, after a time of research and theorizing, if a paradigm isshared by the scientific community, itleads the research and theorizing processes to a single, prevailing theory of thearea. In other words, a paradigm constitutes a kind of world view and focus for research. Kuhn observes that "men whoseresearch is based on shared paradigms arecommitted to the same rules and standardsforscientific practice" (p. 11).
The current accounting scene includes awide diversity of issues that are deemed tobe important by individual researchers; italso includes a wide diversity of researchmethods employed to address these issues.Such diversity is pervasive. Some authors,for example, consider the issues raised byothers to be trivial and undeserving of attention. Similarly, debate on the relativemerits and weaknesses of alternative research methods provokes a constantstream of argumentative articles, symposia, and speeches. In terms of Kuhn's description, this state of affairs would suggest that accounting theorists do not have ashared paradigm. Rather, we tend to havedifferent perspectives of the world, perceive different issues to be of significance,appeal to different sets of empirical phenomena in searching for answers to theseissues, and accept different tests or standards forresolving theseissues. Further, ifone subscribes to the Kuhnian view, it ishighly unlikely that consensus on thesematters will occur by a cumulative processof scientific inquiry.2
2Wewould emphasize theintention of thischapterlobringadditional perspective to the arrayof theoretical conflict in accounting; the chapter presents onepossibleview of the factors that collectively representa lack of clear direction and focus within the community of accounting theorists and researchers. Readersshould not infer a committee decision to reject alternative perspectives, such as might be provided by ImreLakatos. Indeed.Blaug's (1976) thoughtfulcomparison
Contrary to the idea that scientificknowledge progresses in a cumulative,evolutionary pattern, Kuhn offers a revolutionary description of scientific progress,which proceeds in the following order:
1. acceptance of a paradigm;2. working within that paradigm by do
ing "normal" science;3. becoming dissatisfied with that para
digm;4. searching for a new paradigm;5. accepting a new paradigm.
The most difficult thing to explain is thereason scientists collectively accept a newparadigm. It seems clear that the reason
of Kuhn'sand Lakatos' alternativeviewsonthe historyof scientific thought is recommended for assistance inassessing the significance of Kuhn's arguments, as wellas forsuggesting some of the potential shortcomings inherent in the present application of Kuhn's work. Seealso Lakatos and Musgrave (1970).
In addiiion, this chapter is not intended to infer thatthe existing state of theoretical conflict in accountingmust necessarily be understood in terms of a philosophical perspective of the history of science. Oilier plausible views arc possible.Oneexample of an alternativeview arises from an economicinterpretation, wherebywe (1) assume rational behavior, (2) recognize sufficient externalities to yield some kind of central policymaking as an efficient means of establishingaccounting practices,and then (3) perceivethe alternativeapproaches to developing accounting theories not as"paradigms" or as "scientific theories" but rather asindividual or group proposals for specifying how accounting ought to be done, or specifying how accountants ought to go about deciding how accounting will bedone. In this situation, we observethat the problem ofselectingthe best accountingpoliciescannotbe set upin a cost-benefit settingbecause the requisite conceptof social preference is missing (a la Arrow's theorem).Also, whatever policies will finally be chosen will depend upon the institution orstructureby which thepoliciesarechosen.Even if the decisionis to selectthe policies by voting,the outcomewill dependuponIhevotingsystem we impose.
From this economic perspective, disagreement ensues because we have heterogeneous opinions andtastes, and there is no neat, defensible method of putting our conflicting tastes and beliefs into a grand social function.Thus, the problem is by nature oneofconfrontation, and there is no generally accepted way ofcoming to agreement. Different "theories" or proposals lead to different resourceallocations, andwe generally have conflicting views over which resource allocations are better, and there is no theory to guide us incounterbalancing conflicting opinions. So it is understandable that the current state of "theoretical" conflict in accounting exists and does not appear to be resolvable at the present time.
Difficulties in Achieving Consensus: A General View 43
they reject an existing paradigm is because anomalies arise, which cause scientists to become dissatisfied with that paradigm. This dissatisfaction motivates a subset of the scientists to search for a new paradigm while other scientists continue to tryto work within the older paradigm and toeither rationalize or ignore the anomalies.
What is happening in accounting todaycan be described in similar terms. Thereare a number of theorists who have become dissatisfied with the old matching-at-taching approach to specifying the contentof financial reports. In its place, they haveturned to several alternative approaches toanswering accounting questions. Depending upon the level of generalization atwhich one might choose to apply this view,the decision-usefulness approach and theeconomic approach to analyzing accounting information issues might each betreated as an alternative paradigm. At another level, one might treat each of the alternative valuation schemes as reflectingalternative approaches to resolving accounting questions.
Not all of these alternative paradigmsare necessarily advanced as a sufficientbasis for making accounting policy decisions; often proponents of a particular approach readily acknowledge numerous uncertainties and unsettled implementationissues. Indeed, some proponents of an alternative may caution against the suggestion that the alternative constitutes an approach to theory formation in accountingat all. In these cases it would appear thatan alternative is intended only to bring interesting evidence to bear upon the matterof making policy decisions. Nevertheless,each of the accounting approaches currently advocatedinvolvesa unique way of looking at the accounting problem at hand,whatever it may happen to be. Indeed,eachapproachtends toself-select the problems with which it will deal as well as themeans it will employ to attack these problems. In short, each approach begins totake on the attributes of a distinctive paradigm. At the same time that many theorists and researchers are working out theaccounting implications of these new paradigms, others are unwilling to accept anyof the new paradigms. Rather they contin
ue to try to solve problems within the context of the old paradigms.
In this state of dissatisfaction with existing paradigms we can note that eachtheorist attempts to provide his own foundation for the field. In regard to Newton'stheory of optics, Kuhn writes :
Being able to take no common body ofbelief for granted, each writer on physical optics felt forced to build his fieldanew from its foundations. In doing so,his choice of supporting observation andexperiment was relatively free, forthere was no standard set of methods orof phenomena that every optical writerfelt forced to employ and explain. Underthese circumstances, the dialogue of theresulting books was often directed asmuch to the members of other schools asit was to nature. That pattern is not unfamiliar in a number of creative fieldstoday, nor is it incompatible with significant discovery and invention, (p.13)
This seems to be an apt description of whatis happening in accounting at the presenttime. Many theorists seem to feel the needto start from some basic foundations tobuild the field of accounting anew. For example, a recent managerial accountingstudy started with very fundamental kindsof observations and then attempted to reconstruct the discipline on the basis ofthose foundations (Demski and Feltham,1976). Theorizing from efficient marketsresearch has proceeded in a similar vein(Fama, 1970). Valuation theorists havealso started with very elemental or fundamental assumptions. For example, Chambers drew heavily on a large number ofother disciplines in order to derive his particular theory of valuation (1986).
One of the few attitudes that is sharedby most contemporary accounting theorists is dissatisfaction with the prevailingmatching-attaching paradigm. They sharelittle else in regard to problems that oughtto be solved or methods that ought to beemployed. Indeed, different individualsmay not even agree on what constitutes a"fact" in the absence of a shared paradigm(Sterling, 1970b). Therefore, since different theorists may each employ differentimplicit paradigms, they may simultaneously each perceive different facts. As
44 Statement on Accounting Theory and Theory Acceptance
Kuhn makesclear, thisis not uniqueto accounting:
Excluding those fields, like mathematics and astronomy, in which the firstfirm paradigms date from prehistoryand also those, like biochemistry, thatarose by division and recombination ofspecialties already matured, the situations outlined aboveare historically typical Inparts ofbiology—the studyof heredity, for example—the first universally received paradigms are stillmore recent; and it remains an openquestion what parts of social scienceshave yet acquired such paradigms atall. History suggests that the road to afirm research consensus is extraordinarily arduous, (p. 15)
Obviously, the road to a research consensus in accounting has beenextraordinarilyarduous as is evidenced by the fact that wehave not achieved that consensus. Kuhncontinues:
History also suggests, however, somereasons for the difficulties encounteredon that road. In the absence of a paradigm or some candidate for paradigm,all of the facts that could possibly pertain to the development of a given science are likely to seem equally relevant.As a result, early fact-gathering is a farmore nearly random activity than theone that subsequent scientific development makes, (p. 15)
Thus, in the absence of an agreed-uponparadigm, thereis noconsensus regardingwhich environmental characteristics areespecially important as a basis for theorydevelopment. All facts appear to be equally relevant. Some theorists will then suggest a particular paradigm which, amongother things, specifies what are facts andwhat are nonfacts. The problem is that oneparadigm will lihely specify a different setoffacts from thatspecifiedby a competingparadigm.
This is the process that results in disjoint paradigms and, in turn, is the reasonthat oneparadigm cannot be used to judgeorassess another. Kuhnstates it directly:
We have already seen several reasonswhy the proponents of competing paradigms must fail to make complete contact with each other's viewpoints. Col
lectively these reasons have been described as the incommensurability ofthe pre- and postrevolutionary normal-scientific traditions, and we need onlyrecapitulate them briefly here. In thefirst place, the proponents of competingparadigms will often disagree about thelists of problems that any candidate forparadigm must resolve, (p. 148)
He goes on to point out that:Communication across the revolutionary divide [of different paradigms] isinevitably partial, (p. 149)
The proponents of competing paradigmsalmost inevitably find their argumentativediscourse to be fraught with communication failures.That is, those who employ different paradigms find it difficult to communicate with one another. Numerous examples can be observed in accounting debates.Consider a discussion of accountingfor special purpose manufacturing equipment that has no resale value, where theparadigm of one discussant has led him toadopt a current exit price theory of accountingvaluationand the paradigmof theother discussant has led him to adopt a replacement cost theory of accounting valuation. In proposing the balance sheetamount to be reported, the two discussantswould likely disagree. Further, in attempting to resolve the dispute, the two discussants would likely appeal to different facts.The exit price accountant would look to thezero resale value of the equipment, whilethe current entry price accountant wouldgenerally look to the replacement cost ofthe equipment. In the usual case, the exitprice would be an irrelevant fact to theentry price accountant, and to the exitprice accountant the entry price wouldusually be irrelevant to the investigation.Thus, the divergent paradigms employedby each partylead todifferent perceptionsof what "facts" should be observed to resolve the problem. After a while, eachparty to the discussion may conclude thatthe other simply doesn't understand theproblem, or doesn't understand the role ofaccounting. What one sees as relevant"facts," the other may reject as totally irrelevant to the situation.
Kuhn continues with:... the third and most fundamental as-
Difficulties in Achieving Consensus: A General View 45
pect of the incommensurability of competing paradigms. In a sense that I amunable to explicate further, the proponents of competing paradigms practicetheir trades in different worlds ....Both are looking at the world, and whatthey look at has not changed but in someareas they see different things, and theysee them in different relations one to theother. That is why a law that cannoteven be demonstrated to one group ofscientists may occasionally seem intuitively obvious to another, (p 150)
This type of disagreement is evident in accounting also. Some things that appear tobe too obvious to require explicit statementby one group are seen by another group asunfounded assertions that are unacceptable unless supported by evidence and/ordeductive reasoning. Kuhn argues, however, that these different views cannot bereconciled by either logic or empirics. Instead, they are revolutionary shifts inworld views:
Just because it is a transition betweenincommensurables, the transition between competing paradigms cannot bemade a step at a time, forced by logicand neutral experience. Like the gestaltswitch, it must occur all at once (thoughnot necessarily in an instant) or not atall. (p. 150)
Thus, paradigm acceptance is like a gestalt switch, a change in world views. Thatis, it is not possible to prove that one paradigm is superior to another; instead a scientist either sees the new paradigm or hedoes not. Butterfield (1957) summarizedthe point in describing a switch from oneparadigm to another in the physical sciences. He said that the change was not inthe facts observed, but instead it was "atransposition in the minds of the scientists" (p. 17).
Just as Kuhn could not explicate whatprecise factors finally precipitate generalacceptance of a specific paradigm, thiscommittee is unable to identify the factorsthat would lead to such a consensus in accounting. It may be another instance of the"aha" phenomenon. That is, some scientists may look at a paradigm, make a gestalt switch, and, in effect, say, "Aha, I understand that better now." It is a psycho
logical question of great magnitude. Forexample, the paradigm of someaccountingtheorists results in an information economics approach to analyzing accounting issues, which is accepted perhaps becausethe theorists believe that it offers greatpromise for the resolution of accountingproblems. Other theorists have not madethis particular gestalt switch and resist theinformation economics paradigm. They accept other, equally defensible paradigms(such as the decision model approach) andbelieve that their paradigms offer morepromise for resolving accounting issues.The phenomenon is apparently psychological, as suggested by the fact that some ofour greatest scientists have continued toresist particular paradigms even afterthey had become well accepted by the majority of the scientific community. Even ifthe accounting community eventually develops a consensus on a single paradigm,we will not be able to criticize those thatwere discarded:
Still more men, convinced of the newview's fruitfulness, will adopt the newmode of practicing normal science, untilat last only a few elderly holdouts remain. And even they, we cannot say, arewrong. (Kuhn,p. 159)The revolutionary perspective of sci
ence is applied to accounting as a plausiblemeans of interpreting the current conditionof accounting theory. There are a numberof people offering different paradigms. Afew have been converted to each of the paradigms but there is no consensus at thepresent time. Furthermore, it would appear as though there is no quick way to achieve a consensus among competing paradigms. Exhaustive research efforts, fiatpronouncements, and exhortations will notnecessarily work. Perhaps one day soon allothers will say "aha" and accept one of thecompeting paradigms and begin to do thepuzzle-solving and mopping-up operationsof normal science. Note, however, that thisis a description of the process, not an explanation. Scientists must admit that atpresent the process of paradigm selectionis not well understood. The process can bedescribed, but describing it does not assistus in the actual selection of a particularparadigm.
46 Statement on Accounting Theory and Theory Acceptance
Empirical and Logical Testing ofCompeting Paradigms
The traditional scientific response to aproblem of competing alternatives is to examine the logical consistency and empirical implications of each alternative. Competing paradigms should lead to competingtheories. Following the logical positivisttradition, the prerequisite criteria for acceptance of a theory are that it be logicallyconsistent and empirically supportable.3 Ifthese criteria can be applied to select between competing theories, perhaps theycan also serve, by inference, to select between the competing paradigms fromwhich the respective theories were derived.
There are, however, fundamental flawsin this approach, some of which are rathertechnical. One easily understandable flawis that all theories are incomplete, in thesense that additional research is always required. The research process in science isone of continuing to make logical connections or empirical tests. Thus, no theorycan pass those two tests completely, because the testing processes themselves arenever complete. Even within the context ola single paradigm, therefore, the testing ofcompeting propositions and theories maynot provide a permanent basis for selectionbetween the alternatives.
A second, and more damaging, flaw inthe approach of using logical and empiricaltests to select between competing theoriesbecomes apparent if the competing theories issue from competing paradigms.Kuhn explains the problem in the contextof discussing the reasons for chemists' acceptance of Dalton's paradigm:
... it is hard to make nature fit a paradigm. That is why the puzzles of normalscience are so challenging and also whymeasurements undertaken without aparadigm so seldom lead to any conclusions at all. Chemists could not, therefore, simply accept Dalton's theory onthe evidence, for much of that was stillnegative. Instead, even after acceptingthe theory, they had still to beat nature
3 Other criteria such as simplicity and elegancecould be introduced but these are clearly subordinate tological and empirical testability.
into line, a process which, in the event,took almost another generation. When itwas done, even the percentage composition of well-known compounds was different. The data themselves hadchanged, (p. 135)
Thus, at the time a theory is proposed, itmay not pass the typical empirical tests;the evidence may still be negative. Insteadof subjecting the theory to empirical tests,researchers may have to "beat nature intoline" by developing new tests within thecontext of the new paradigm. The acceptance of Dalton's paradigm involved a gestalt switch that changed the very perceptions of the scientists who were doing theresearch. It is this new world view whichallows the scientists to change the data.And these new, changed data are necessary if the new theory is to pass the empirical tests. A recent illustration of this process is the testing of the accounting implications of efficient securities markets. Inorder to assess the information content anddisclosure implications of that theory, analytic devices such as the API metric andother tests related to the capital asset pricing model had to be developed. Withoutthese devices, the theory's implications foraccounting were untestable. Thus, theremust be at least some threshold acceptance of a new paradigm before tests of thetheory arising from the paradigm arepossible.
The point is that, although theoriesmust pass tests of logical consistency andempirical predictability, one cannot expectthese tests to provide a conclusive basis forselecting from among competing paradigms. Ultimately, the design of the testsas well as the perception of the data towhich they apply are dependent upon, ordefined in terms of, the paradigm that is tobe tested. Logic and empirics do not, therefore, provide a sufficient basis for selectingbetween competing paradigms.
Judgmental Selection of a ParadigmAlthough scientists cannot explain the
precise reasons for the acceptance of different paradigms, it is possible to describecertain types of differences among paradigms. One set of such differences relatesto the paradigms' empirical domains.
Difficulties in Achieving Consensus: A General View 47
Each of the currently competing accounting paradigms tends to specify a differentempirical domain over which an accounting theory ought to apply.
For example, one paradigm, whichcould be labeled the "anthropological approach," specifies the professional practices of accountants as the empirical domain of accounting. Following this paradigm, accounting theory is formulated as arationalization of, and by drawing inferences from, extant accounting practices.Another paradigm rests largely upon thebehavior of stock markets to provide theempirical domain over which accountingtheory is constructed and applied. Still another general view of accounting specifiesthe decision processes of individualsand/or extant decision theories as the empirical domain of accounting theory.4 Thistripartite categorization can be further expanded to incorporate both the ideal income approach and the information economics approach, each of which suggests asomewhat unique empirical domain of accounting. It was precisely these differences in empirical domain that providedthe organizational format of Chapters 1and 2.
As we have already suggested, the differences in empirical domain that pervadeeach paradigm reflect basic differences inworld views. Each paradigm has differentembedded premises and objectives; accordingly, each rather naturally focuses onprecisely those empirical phenomena thatare highlighted by those premises and arerelevant or controllable in achieving thedesired outcomes. When viewed from thisperspective, it is apparent that no view canbe per se "correct" or "incorrect." Instead, each must be evaluated in conjunction with contextual factors and personalpreferences.
Because the choice among paradigmsfrom this perspective must necessarily bejudgmental, proponents of different paradigms frequently make basic value judgments (either explicit or implicit) and thenargue that their paradigm, on the basis of
those value judgments, is superior to competing ones. Kuhn argues that this is theusual procedure in science:
Like the choice between competing political institutions, that between competing paradigms proves to be a choice between incompatible modes of community life. Because it has that character,the choice is not and cannot be determined merely by the evaluative procedures characteristic of normal science,for these depend in part upon a particular paradigm, and that paradigm is atissue. When paradigms enter, as theymust, into a debate about paradigmchoice, their role is necessarily circular.Each group uses its own paradigm toargue in that paradigm's defense.
The resulting circularity does not, ofcourse, make the arguments wrong oreven ineffectual. The man who premisesa paradigm when arguing in its defensecan nonetheless provide a clear exhibitof what scientific practice will be like forthose who adopt the new view of nature.That exhibit can be immensely persuasive, often compellingly so. Yet, whatever its force, the status of the circularargument is only that of persuasion. Itcannot be made logically or even probabilistically compelling for those whorefuse to step into the circle, (p. 94)The lengthy debate over alternative ac
counting theories obviously has not led toclosure. Perhaps the extent to which eachtheory's proponents employ circular arguments is most easily discerned by thosewho are aligned with the alternative theories. Kuhn concludes that such circulararguments are inevitable, but not necessarily ineffectual. Individuals can sometimes be persuaded by this kind of debate.Nevertheless, we should not expect that thecontinued debate over accounting theorieswill naturally lead to a dominant consensus.9 Note that we are not in any sense calling for a moratorium on this kind of debate. Rather, we are attempting to articu-
4 For an elaboration of this classification of paradigms by empirical domain, see Sterling (1970b. pp.449-M).
5 For a somewhat different viewon this point, seeWells (1976). That article, which parallels our discussion at several points, did not come to our attentionuntil this document was completed.
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48 Statement on Accounting Theory and Theory Acceptance
late realistic expectations about the consequences of this activity.
SummaryThe purpose of this chapter has been to
develop a plausible explanation for thelack of progress in achieving accountingtheory consensus. An expanding array ofaccounting theories and/or theoretical approaches suggests the existence of severalcompeting paradigms. Each paradigm implicitly incorporates individual beliefs andpremises that cannot be proved or disproved in a logical sense. Further, the
"facts" towards which a theory is directedare themselves a function of the paradigmembraced by the observer. Thus, rigorousexperimental testing, while valuable in thesense of influencing long-run psychologicalsets, cannot be used to resolve the problemof selecting a single paradigm for accounting. As a consequence, defenders of a particular paradigm are forced to rely on persuasion rather than logic and empirics inattempting to defend a proposal. Whileconsensus may eventually develop, thetransformation that occurs is primarily apsychological matter rather than a dispassionately intellectual phenomenon.
Chapter 5
Implications
A committee such as this is formed periodically in order to assess the state of development of accounting theory. Ours wasnot a research assignment; committeescannot efficiently conduct research. Instead, our role was to survey the accounting theory literature. The benefits of thisprocess may be twofold. First, by its verynature, a survey requires generalizationand thus emphasizes important, dominantthemes. This focus eliminates irrelevan-cies and makes primary messages moredistinct. Highlighting important points thatare obscured by the sheer complexity ofthe unclassified environment often generates new perspectives and insights, aswell. Second, a survey may also clarify andunderscore issues that were not explicit inthe original sources. Different language ora more dispassionate, neutral perspectiveis frequently helpful in interpreting andbroadly disseminating somewhat esoteric—and hence potentially obscure—researchfindings. We hope that this report accomplishes these two objectives and therebyprovides a useful perspective regardingaccounting theory approaches.
Implications For ResearchIn addition to these objectives, commit
tee statements of this genre might be expected to have an impact on future researchers and research activities. In thisdomain three major "messages" emergefor researchers in accounting and for thosewho utilize the output of such research.
Perhaps the most fundamental implication of this document is that statementsand pronouncements by "authoritative"bodies—even those comprised of accounting theorists—cannot themselves be expected to lead to near-term closure in thetheory area. Our reason for emphasizingthis point is that it is in marked contrastwith the sentiment that apparently prevails in the accounting community. Manyhave looked with anticipation to past statements of accounting objectives and theoryreports as a means for resolving theoreti
cal debates. Once the awaited report appears, however, there is usually disappointment when it becomes apparent thatthe document does not receive immediateacceptance and thus does not lead to a cessation of debate. Some might then deemthe report to be a "failure." This committee statement will, it is hoped, put the issueof theory closure into proper perspectiveand thereby reduce unrealistic expectations. Our message is clear: theory closurecannot be dictated. Even if based upon rigorous analysis, theories are inevitably derived from the experiential "sets" of thoseproposing them. Such sets (or paradigms)utilized in viewing the world cannot be regarded as uniquely correct. Many divergent sets may simultaneously possess inherent "truth" content. The eventual acceptance of one such approach arises fromits explanatory power or ability to resolveanomalies. In other words, a theory achieves such dominant acceptance becauseof its demonstrated efficacy over time, notbecause of its espousal by some group (forexample, of nine academics) that subjectively deems it to be superior.
A second basic message of this document is that external reporting theory hasa wider scope than that which has beengenerally perceived. In the past, the theoryrealm has been thought to be limited tobasic measurement controversies, natureof users' information desires, cognitiveprocessing characteristics, and other similar issues. The institutional framework bywhich the policy-making process is accomplished has usually been taken as given.However, this committee report emphasizes that the institutional structure andprocedures by which this structure operates are themselves a part of external reporting theory. This perspective immediately introduces questions regarding thedesirability of regulatory intervention andthe form such intervention should take, ifneeded. At present, studies of the socio-political process as it relates to accountingpolicy information, voting strategies,
49
50 Statement on Accounting Theory and Theory Acceptance
means for eliciting "true" preferences,and similar issues have not been widely applied to external reporting issues. However, as discussed in our report, these tooare a legitimate, albeit neglected, elementof external reporting theory deserving ofresearch attention.
Finally, this report has isolated areas ofdisagreement between theory proposals.Explicitly recognizing basic differencesbetween theories could lead to at least twopotential benefits in future research. First,it could serve to reduce the endless argumentation regarding imperfectly understood or even hidden assumptions and consequences that currently inhibits theoryprogress. Second, recognizing inherent differences among theories could place inbold relief the nature of the private and social welfare tradeoffs that may have to bemade in choosing among policy alternatives.
To illustrate this more concretely, consider the following example. At present,one of the most prevalent theoretical approaches employed in contemporary research is the decision-model approach. Inits standard form, this approach exploresmeans for providing relevant informationto a designated user group. Accordingly,the analytic focus is limited to that groupand explores only the expected consequences of the information for their decision effectiveness. But it was indicated inChapter 3 that this approach ignores thepotential economic impact of the theoryproposal on other users and even nonusersof financial information. In other words,the decision-model analysis is a partialequilibrium approach. This raises the possibility of objections to such proposals onseveral bases. Notwithstanding the benefits accruing to the user group that formedthe basis for the analysis, some may objectto a decision model proposal because of unfavorable repercussions to other societalsegments; that is, the issue may be one ofdistributive welfare. Similarly, the socialcosts incurred in generating "better" information to the selected group may not becommensurate with the benefits expectedto accrue to society. Frequently, the realissues underlying debates of this sort arenot recognized. Irresolvable arguments en
sue because the "benefits" perceived byproponents of a proposal may be irrelevantor inconsequential to its critics.
Prior to this committee report, partialities of this sort may not have been widelyrecognized as inherent in various theoryapproaches. By delineating these scopelimitations, needless argumentation maybe avoided. How might this take place? Wehope that this will follow from general acceptance of the view adopted herein regarding accounting theory. Thus, our thirdbasic message is that all theory approaches are flawed when viewed from theperspective of some alternative approach.This problem cannot be avoided. Hence, itis useless to seek the "universally appropriate" theory approach. At best, one approach can take cognizance of its own limitations and attempt to address omitted issues that are likely to generate disagreement when the results are viewed from theperspective of some alternative theory approach.
Summarizing, one of the primary objectives of this committee document is to promote a deeper understanding of the natureof accounting theories, how they differ, andthe issues that arise in selecting among thevarious alternatives. We concluded thattheory choices are vitally dependent uponthe experiential set and preferences of theobserver. Consequently, rigorous analytictechniques serve only a limited role in thisarea as an initial screening device, that is,as a means for identifying and eliminatingproposals that are logically inconsistent orerroneous. Proposals that survive this analytic screen must gain acceptance on someother basis—their explanatory or predictive power, ability to resolve existinganomalies, or conformity to prevailing social preferences. Clearly, research playsan important role in this post-screeningchoice process too. However, dispassionatelogical analysis is only a necessary, not asufficient, condition for eventual theory acceptance. Seemingly, the crucial role of thesufficient conditions has not been widelyunderstood in the past. But failure to comprehend this element of the theory choiceprocess leads to attempts to impose suchclosure by a process that might be termed"theoretical fiat." Such efforts have histor-
Implications
ically been largely unproductive. Our belief is that a better understanding of the nature of the total theory acceptance processwill reduce expectations for achieving theory closure by fiat and redirect researchers to more promising avenues. Thus, theapproach used in this committee documentwas selected with the expectation that itwill facilitate such research progress. It isto be hoped that this expectation will be fulfilled.
Implications For PolicyWhen considering issues of immediate
and crucial importance, policy makers donot have the luxury of sidestepping difficult, unresolved questions. Life goes on,decisions must be made, and policy choicesoccur. Recognizing these facts, our committee statement has certain implicationsfor policy makers seeking direction fromaccounting theories.
The central message to policy makers isthat until consensus paradigm acceptanceoccurs, the utility of accounting theories inaiding policy decisions is partial. Competing theories merely provide a basis forforming opinions on what must remain inherently subjective judgments. While it istrue that consensus will frequently developon certain points, usually this consensusonly narrows the range of disagreement; itoften does not resolve the basic issue thatgives rise to the underlying problem. Thatis, consensus about peripheral improvements may occasionally emanate from applying a theory, but the basic underlyingchoice issues continue to be disputatious.
A non-accounting example illustratesthis point. Consider the issue of whether ornot capital punishment is justified on a social welfare basis. At this level, numeroustheories abound. Most are inconsistentwith one another and it is impossible to objectively state that one such theory dominates all others. Hence the issue of capitalpunishment is unresolvable by theoreticaldebate alone. On this issue, social action isdependent upon the subjective beliefs andpreferences of policy makers. Various theories may be instrumental in shaping thebeliefs of individual policy makers, but nobasis for objectively demonstrating the superiority of any one theory exists.
51
Notwithstanding the continuing disagreement on the overriding basic issue,certain subordinated issues relating to capital punishment are virtually unanimouslyagreed upon. That is, we are often able toconclude that a particular change was forthe general good. Take, for example, thechange from processing executions bydrawing and quartering the criminal to execution by guillotine, hanging, electricchair, or any of the more modern forms ofexecution. The distributive and aggregative welfare effects of these changes defyrigorous analysis. Yet, we would expectgenera] consensus that this was an example of improvement in professional practice.
In a similar vein, virtually all externalreporting issues involve social welfaretrade-offs. Depending on the particulartopic, theories may occasionally narrowthe range of choice by indicating a dominant consensus regarding some facet of thebasic issue. Forms of execution is a non-accounting illustration; the policy changewhich long ago included income statements in published financial reports is anexample from an accounting setting. Frequently, accounting theories will also beuseful to policy makers by providing an improved basis for reaching what must nowbe considered to be an essentially subjective judgment. That is, theories may behelpful insofar as they apprise policymakers of the underlying issues and clarifythe trade-offs implicit in various approaches. But in the absence of paradigmacceptance, it is unrealistic to expect accounting theory to provide unequivocal policy guidance. Different theories will pointto different policies. These theories arisefrom different paradigms. Since there is norigorous analytic means for choosing between paradigms, there is similarly no rigorous means for choosing between theoriesor their derivative policy implications.
This limited theory role will not necessarily persist in the long run, nor is itunique to accounting.1 Changes will occur
1As an analogy, consider the equivocal guidancethat competing economic theories provide to economicpolicymakers.
!. I
52 Statement onAccountingTheory and Theory Acceptance
if, and when, consensus regarding an accounting paradigm is once again achieved.Until such time, however, expectationsabout the roleof theory in guiding policymust be realistic. In clarifying the role oftheory, one of our objectives is to indicatethe futility of attempting to dictate "ultimate theoretical truths." This theory consensus may or may not be achieved in thenear term. If it is achieved, it will arise be
cause of continued accounting theory research and debate about the product ofsuch research. However, the crucial pointis that theory consensus cannot be imposed, not by this group nor by any other.Whatever future influence theory has onpolicy making will be achieved by continued argumentation, new theory development, and debate, not by fiat.
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