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3/15/2012 1 THEORY DEVELOPMENT AND VERIFICATION Week 1 – ACC304 CHAPTER 1 INTRODUCTION GODFREY HODGSON HOLMES TARCA Overview of Accounting Theory What is a theory? Hendriksen’s definition: …the coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry. 3 What is an accounting theory? Hendriksen’s definition: …logical reasoning in the form of a set of broad principles that provide a general framework of reference by which accounting practice can be evaluated and guide the development of new practices and procedures. 4 Overview of Accounting Theory Overview of Accounting Theory Whether a theory is accepted depends on how: well it explains and predicts reality well it is constructed both theoretically and empirically acceptable its implications are 5 Overview of Accounting Theory Accounting theory is a modern concept compared to mathematics or physics Even Pacioli’s treatise on double-entry accounting 1495) focused on documenting practice and did not explain the underlying theoretical basis for it 6 3/15/2012 2 Overview of Accounting Theory The development of accounting theory has been mostly unstructured Chambers: Accounting has frequently been described as a body of practices which have been developed in response to practical needs rather than by deliberate and systematic thinking. 7 Overview of Accounting Theory 8 Was developed to resolve problems as they arose – reactive Ad hoc approach Led to inconsistencies in practice e.g. different depreciation methods Accounting standard setting Conceptual framework projects have not resolved inconsistency in practice Pre-theory (1400s – 1800) Goldberg: No theory of accounting was devised from the time of Pacioli down to the opening of the nineteenth century. 9 Pragmatic accounting (1800– 1955) The ‘general scientific period’ based on empirical observation of practice provided an explanation of accounting practice focused on the existing ‘viewpoint’ of accounting 10 Normative accounting (1956-1970) Sought to establish ‘norms’ for the best accounting practice Focused on what should be (the ideal) v. what is 11 Normative accounting (1956-1970) Degenerated into battles between competing viewpoints on measuring and reporting accounting information Two groups dominated: conceptual framework proponents critics of historical cost 12 3/15/2012 3 Normative accounting (1956-1970) Factors prompting the demise of the normative period include: the unlikelihood of one particular normative theory being generally accepted the application of financial economic principles the availability of empirical data and new testing methods 13 Normative accounting (1956-1970) The major criticisms of normative theories were: they do not necessarily involve empirical hypothesis testing they are based on value judgements 14 Positive accounting (1950 to the present day) A shift to a new form of empiricism called ‘positive theory’ Had its origins in the ‘general scientific period’ It seeks to explain the accounting practices being observed 15 Positive accounting (1950 to the present day) Its objective is to explain and predict accounting practice e.g. the bonus plan hypothesis 16 Positive accounting (1950 to the present day) It helps predict the reactions of ‘players’, such as shareholders, to the actions of managers and to reported accounting information 17 Positive accounting (1950 to the present day) Major deficiencies are: ‘wealth maximisation’ has become the answer to explain all accounting practices and reported information it relies excessively on agency theory and dubious assumptions about the efficiency of markets 18 3/15/2012 4 Positive accounting (1950 to the present day) Behavioural research: concerned with the sociological implications of accounting numbers and the associated actions of ‘key players’ emerged in the 1950s despite growing acceptance since the 1980s, positive accounting theory still dominates 19 Recent developments Academic and professional developments in accounting theory have tended to take different approaches Academic research focuses on capital markets, agency theory and behavioural aspects The profession has sought a more normative approach – what accounting practices should be adopted 20 Recent developments 21 Recent developments Conceptual framework – resurrected in 1980s states the nature and purpose of financial reporting Establishes criteria for deciding between alternative accounting practices SACs 1–4 22 Recent developments Conceptual framework – Recent Developments Joint project between IASB & FASB International harmonisation of accounting practices through a single consistent set of international financial reporting standards (IFRS) 23 Recent developments The conceptual framework underpinning the IFRS favours a move toward accounting practices that provide information for enhancing decision making by investors and others recognising all gains and losses in the accounting periods in which they occur measurement using exit values 24 3/15/2012 5 Content outline Part 1: Accounting theory (chapters 1 – 3) Part 2: Theory contributing to practice (chapters 4 – 10) Part 3: Accounting and research (chapters 11 – 14) 25 Summary Accounting theory Major periods of accounting theory development Normative accounting Positive accounting Conceptual framework IFRS 26 Key terms and concepts Theory Accounting theory Normative theory Positive theory Behavioural theory Conceptual framework IFRS 27 CHAPTER 2 ACCOUNTING THEORY CONSTRUCTION GODFREY HODGSON HOLMES TARCA Pragmatic theories Descriptive pragmatic approach: based on observed behaviour of accountants theory developed from how accountants act in certain situations tested by observing whether accountants do act in the way the theory suggests is an inductive approach 29 Pragmatic theories Criticisms of descriptive pragmatic approach: does not consider the quality of an accountant’s action does not provide for accounting practices to be challenged focuses on accountants’ behaviour not on measuring the attributes of the firm (assets, liabilities, profit) 30 3/15/2012 6 Pragmatic theories Psychological pragmatic approach: theory depends on observations of the reactions of users to the accountants’ outputs a reaction is taken as evidence that the outputs are useful and contain relevant information 31 Pragmatic theories Criticisms of the psychological pragmatic approach: some users may react in an illogical manner some users might have a preconditioned response some users may not react when they should Theories are therefore tested using large samples of people 32 Examples of pragmatic theories (i) an historical record-keeping activity (pragmatic or syntactic theory) (ii) political theories (pragmatic theories) (iii) communication — decision making (pragmatic, syntactic and semantic theories) (iv) accounting as an economic good (pragmatic) (v) accounting as magic or mythology (pragmatic) (vi) accounting as a social commodity to exploit or aid policies or as a social club for accountants (pragmatic) historical record-keeping activity Example: firms use accounting principles to keep a record of their transactions so that they can advise how resources have been used. a language Example: financial statements are used by management to communicate to shareholders how well they have performed in running the business. political theories Example: management use accounting reports to allocate resources among different divisions within the firm, or different levels of employees. magic or mythology Example: Enron management used accounting techniques to hide the losses it suffered from transactions with its special purpose entities. communication — decision making Example: a local bank decided to give loans to a small business after analysing the business’ financial position. an economic good Example: there are costs involved in producing financial reports (not free). Accounting information is demanded to make economic decisions, but there is a cost to its supply since accounting information is a scarce commodity itself. a social commodity Example: government uses accounting numbers (such as profits or research expenditure) to decide whether to give grants to particular firms. ideology and exploitation Example: firms cut down jobs in their unprofitable divisions. 3/15/2012 7 Syntactic theories Semantic inputs are the transactions and exchanges recorded in vouchers, journals and ledgers The inputs are then manipulated on the basis of the premises and assumptions of historical cost accounting But there are no pragmatic test (how people them), or what they mean (semantic test) Eg: the theory of double-entry and historical costs 37 Syntactic theories Criticised because there is no independent empirical verification of the calculated outputs (profits, total assets) The outputs may be criticised for poor syntax inaccurate e.g. different types of monetary measures are added together Adding up value of a machine owned 20 years ago and value of a machine purchased yesterday 38 Disadvantages of Syntactic theories The truth value of any proposition is ascertained by logic or reasoning alone. If the underlying accepted premises of the logic have no reference to the real world or are false, then the conclusions have either no pragmatic usefulness or the conclusion is incorrect. Syntactics alone are only concerned with the derivation of statements from other given statements. Disadvantages of Syntactic theories all manipulations are correct as long as the rules of mathematical bookkeeping are applied there are many acceptable sets of ‘equations’ no semantic verification — not descriptive of real world objects or events. The outputs may be syntactically accurate but nevertheless be valueless due to a lack of semantic accuracy (a lack of correspondence with real-world events, transactions or values) Syntactic theories Historic cost accounting may produce ‘accurate’ outputs but which nevertheless have little or no utility That is, they are not useful for economic decision making except to verify accounting entries 41 Semantic theories connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic. measurement theories: Eg measuring the effects of inflation on assets and liabilities and adjusting the accounts to reflect these adjustments accounts then have semantic content Argument: the purpose of undertaking accounting is to impart semantic content to the numbers then they should be verified 3/15/2012 8 Normative theories 1950s and 1960s ‘golden age’ policy recommendations what should be concentrated on deriving: true income (profit) practices that enhance decision-usefulness based on analytic and empirical propositions 43 Financial statements should mean what they sayFinancial statements should mean what they say Normative theories True income: a single measure for assets a unique and correct profit figure 44 Normative theories Decision usefulness: the basic objective of accounting is to aid the decision- making process of certain ‘users’ of accounting reports by providing useful accounting data 45 Normative theories The decision process 46 Accounting system of company X Accounting system of company X Prediction model of user Prediction model of user Decision model of user Decision model of user Positive theories Expanded during the 1970s Based on ‘experiences’ or ‘facts’ of the real world Explain the reasons for current practice Predict the role of accounting information in decision-making 47 Positive theories The main difference between normative and positive theories is that normative theories are prescriptive positive theories are descriptive, explanatory or predictive 48 3/15/2012 9 Which one is positive or normative? (a) Historical cost accounting should be replaced by a market value system. (b) Historical cost accounting provides information used by creditors. (c) Historical cost accounting is used by many managers to allocate costs in determining divisional performance. Different perspectives Scientific approach: has an inherent assumption that the world to be researched is an objective reality is carried out by incremental hypotheses has an implied assumption that a good theory holds under circumstances that are constant across firms, industries and time 50 Procedures of Scientific approach: Start with prior knowledge or theory constructions Observe real world behaviour Does not concur: a research problem to be explained Develop a theory to explain the behaviour and develop testable hypotheses Follow structured procedures for data collection and analysis Validate the hypotheses Make conclusions about theory Different perspectives Criticism of the scientific method: large-scale statistical research tends to lump everything together it is conducted in environments that are often remote from the world of or the concerns of accountants 52 Different perspectives Naturalistic approach: implies that there are no preconceived assumptions or theories focuses on firm-specific real-world problems 53 Different perspectives Alternative ways of looking at the world: 54 CATEGORY ASSUMPTION 1. Reality as a concrete structure 2. Reality as a concrete process 3. Reality as a contextual field of information 4. Reality as a symbolic discourse 5. Reality as a social construction 6. Reality as projection of human imagination CATEGORY ASSUMPTION 1. Reality as a concrete structure 2. Reality as a concrete process 3. Reality as a contextual field of information 4. Reality as a symbolic discourse 5. Reality as a social construction 6. Reality as projection of human imagination 3/15/2012 10 Different perspectives For categories 1 – 3 it is more appropriate to use the scientific approach For categories 4-6 the naturalistic approach is more appropriate 55 Different perspectives 56 Scientific approach applied to accounting Misconceptions of purpose Make scientists out of accounting practitioners Researchers = practitioners The desire for ‘absolute truth’ 57 Scientific approach applied to accounting The scientific method does not claim to provide ‘truth’ It attempts to provide persuasive evidence which may describe, explain or predict 58 Issues for auditing theory construction Auditing is a verification process that is applied to the accounting inputs and processes 59 Issues for auditing theory construction 60 Auditors provide an opinion on whether the financial statements accord with the applicable reporting framework whether the statements give a true and fair view . 3 /15 /2 012 1 THEORY DEVELOPMENT AND VERIFICATION Week 1 – ACC304 CHAPTER 1 INTRODUCTION GODFREY HODGSON HOLMES TARCA Overview of Accounting Theory What is a theory? Hendriksen’s. (chapters 1 – 3) Part 2: Theory contributing to practice (chapters 4 – 10 ) Part 3: Accounting and research (chapters 11 – 14 ) 25 Summary Accounting theory Major periods of accounting theory development . accounting 14 95) focused on documenting practice and did not explain the underlying theoretical basis for it 6 3 /15 /2 012 2 Overview of Accounting Theory The development of accounting theory has