Accounting Theory Approach

THE NATURE OF ACCOUNTING THEORY

APPROACH
The primary objective of accounting theory is to provide

a basis for the prediction and explanation of accounting

behavior and events.
No single comprehensive theory of accounting exists at
present.

 theory defined as:-

a set of inter-related constructs (concept), definitions and

propositions (suggestions) that present a systematic view of
phenomena by specifying relations among variables with the
purpose of explaining and predicting phenomena.

 The General Acceptance of Accounting Principles

(GAAP) guide the acctg profession to choose acctg

techniques and prepare FS considered to be good
acctg practice.
The GAAP are subjected to the reexamination & critical

analysis with regards to the changes in environments,

values and information needs.

 Changes in principles may occur as a result of providing

solutions to emerging accounting problem and

formulating a theoretical framework.
Provide a rationale for what accountants do or expect to

be doing.
The process of theory construction should be completed

by theory of verification or validation.

5

 Machlup (1955) defined the process:

The statement implies that the theory should be subject to a

logical or empirical testing to verify its accuracy.

If the theory is mathematically based, the verification should be

predicted based on logical consistency.

If the theory is based on the physical and social phenomena, the

verification based on the deduced events & observations in

the real world.
6

 Therefore, acctg theory should result from both

process of theory construction and verification.

A given theory should explain and predict the acctg

phenomena.
If a given theory is unable to produce the expected

results, it is replace by a better theory.

7

APPROACH IN ACCOUNTING THEORY

1 The Traditional Approach

2 The Regulatory Approach
3 The Positive Approach
4 The Behavioral Approach
5 The Paradigm Approach

Traditional approaches to accounting

theory
Non-theoretical, practical or pragmatic (informal)
2. Theoretical:
a. Deductive approach
1.

b. Inductive approach
c. Ethical approach
d. Sociological approach
e. Economic approach

1.

Non-theoretical approaches (P&A)

The pragmatic approach:

10

consists of the construction of a theory that conforms to realworld practices and suggests practical solutions

Means that property which fits something to serve

or facilitate its intended purposes

usefulness to users & relevance for decision making

The authoritarian approach:

11

The formulation of AT, which is employ primarily by

professional organization, consists of issuing
pronouncements for the regulation of accounting practices

 Both approach assume AT (pragmatic & authoritarian) & the

resulting technique must be predicted on the basis ultimate

use of financial reports, if accounting is to have useful
function.
A theory without practical consequence is a bad theory.

12

 However;
The approaches have been largely unsuccessful in reaching

satisfactory conclusions in their attempt to construct an AT.

For example; balance sheet approach & profit-oriented;

pragmatic & authoritarian approach absence on theoretical

foundation.

13

2. The Deductive Approach

Constructions of AT theory begins with basic propositions &

proceeds to derive logical conclusions about the subject

under considerations.
Move from general to particular

14

Steps used to derive the deductive approach

1. Specifying the objectives of financial statements
2. Selecting the postulates of accounting
3. Deriving the principles of accounting
4. Developing the techniques of accounting

15

3. The Inductive Approach

The construction of theory begins with observations &

measurements & moves toward generalized conclusions.

Lead to Positive approach

16

Involved four stages, i.e. :1. Recording all observations

2. Analysing and classifying these observations to
detect recurring relationships
3. Inductive derivation of generalisations and
principles of accounting from observations that
depict recurring relationships
4. Testing the generalisations

17

Comparing deductive and inductive

approaches
In the inductive approach, the truth or falsity of the propositions does not

depend on other propositions, but must be empirically verified

In the inductive approach the truth of the propositions depends on the

observation of sufficient instances of recurring relationships

Accounting propositions that result from inductive inference imply

special accounting techniques only with high probability

Accounting propositions that result from deductive inference lead, on

the other hand, to specific accounting techniques with certainty (confidence)

18

 Note;
The general proposition formulated through inductive process
Principles & technique from deductive process
e.g.; Paton (deductive theorist) & Littleton (Inductive theorist)

19

4. The Ethical Approach

20

The basic core consists of the concepts of fairness, justice,

equity and truth
In general, the concept of fairness implies that accounting
statements have not been subject to undue influence or bias
Justice; equitable treatment of all interested parties
Truth; with true & accurate accounting without
misreprsentation

For example:

21

The committee on auditing procedures refers to concept of

fairness of presentation as:
1. conformity with GAAP
2. disclosure
3. consistency
4. comparability

5.

The Sociological Approach

Emphasizes the social effects of accounting

techniques
According to this approach, a given accounting
principle or technique is evaluated for acceptance on
the basis of its reporting effects on all groups in
society
Implies that accounting data will be useful in making
social welfare judgments

22

 Evolution to new accounting sub discipline, socioeconomic

accounting
The main obj encourage business to account their impact on
business activities on social environment through
measurement, internalization, & disclosure in their FS.
Probably play a major role in future formulation of AT.

23

6. The Economic Approach

Emphasizes

controlling the behavior of

macroeconomic indicators that result from the
adoption of various accounting techniques

The choice of different accounting techniques

depends on their impact on the national economic

good

Accounting policies and techniques should reflect

economic reality, and the choice of accounting

techniques should depend on economic
consequences

e.g. LIFO method during continuing inflation

period

24

The Eclectic (combination) Approach to the Formulation of

Accounting Theory
In general, the formulation of accounting theory and

the development of accounting principles have

followed an eclectic approach.
a combination of approaches, rather than just
one approach.

25

Continue to second approach..

26

The Regulatory Approach

27

 Acctg standards dominate accountants work.

Standards are being constantly changed, deleted and/or

added.
They provide practical & handy rules for the conduct of the

accountants work.
They generally accepted as firm rules, backed by sanction for

nonconformity.

28

Accounting standards usually consist of three parts:

1.
2.
3.

29

a description of the problem to be tackled

a reasoned discussion on ways of solving the problem, then,
in line with the decision or theory, the prescribed solution

Why Examine Theories of Regulation

Better placed to understand why some accounting

prescriptions become part of legislation while others do not

accounting standard-setting is a very political process
while some proposed requirements may be technically sound

and logical, they may not be mandated due to political

power or influence of some affected parties

30

Theories to Explain Regulation

Public interest theory
Capture theory
Economic interest group theory (private interest theory)

31

To be continue

32

1.Public Interest Theory

Regulation put in place to benefit society as a whole rather

than vested interests

regulatory body considered to represent interests of the

society in which it operates, rather than private interests of

the regulators
assumes that government is a neutral arbiter

33

Criticisms of Public Interest Theory

Critics question assumptions that economic markets operate

inefficiently if unregulated
question the assumption that regulation is virtually costless
others question assumption of government neutrality
argue that government will only legislate and groups will

only lobby for regulation if it will increase their own wealth

34

 The regulated seeks to take charge (capture) the regulator

seek to ensure rules subsequently released are advantageous

to the parties subject to regulation

although regulating initially in the public interest, difficult for
regulator to remain independent

35

2. Capture of Accounting StandardSetting

Walker (1987) analysed capture of Australian standard-setting

through the ASRB. Argued that:

the accounting profession lobbied before the board
established to ensure no independent research capability,
no academic as chair, to receive admin officer not a
research director
priorities only set after consultation with AARF
ASRB fast-tracked AARF submissions but not others
majority of board membership were members of the
accounting profession

36

Criticisms of Capture Theory

No reason to suggest that regulated industry the only

interest group able to influence the regulator

No reason why regulated industries only able to
capture existing agencies rather than procure the
creation of an agency
No reason why regulated couldnt prevent creation of
the regulatory agency

37

3. Economic Interest Group Theory

Assumes groups will form to protect particular

economic interests
groups are often in conflict with each other and will
lobby government to put in place legislation which will
benefit them at the expense of others
no notion of public interest inherent in the theory
regulators (and all other individuals) deemed to be
motivated by self interest

38

Economic Interest Group Theory

cont.
The regulator is not a neutral arbiter but is seen as

an interest group itself

regulator motivated to ensure re-election or
maintenance of its position of power
regulation serves the private interests of politically
effective groups
those groups with insufficient power will not be able to
effectively lobby for regulation to protect its own
interests
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Examples - Application to Accounting Standardsetting

Industry groups may lobby to accept or reject a particular

accounting standard
eg. insurance oil & gas industry
large politically sensitive firms found to lobby in favour of
general price level accounting in US (led to reduced profits)
accounting firms lobbying to protect their own interests

40

Accounting Regulation as an output

of a Political Process
The view that financial accounting should be objective,

neutral and apolitical can be challenged

will inevitably be political as it affects wealth distribution
within society
standard-setters encourage affected parties to make
submissions on drafts of proposed standards

41

 If standard-setters give consideration to views in submissions,

accounting standards and therefore financial reports are the

result of various social and environmental considerations
tied to the values, norms and expectations of the society in
which standards are developed
questionable whether financial accounting can claim to be
neutral and objective

42

 Compliance with accounting standards usually seen to

indicate financial statements are true and fair ???

can accounts based upon standards determined from various

economic and social consequences be deemed to be true?

Users may not be aware that financial reports are the

outcome of various political pressures

should regulators consider preparers views given that
standards are designed to limit what preparers do?

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Influence of the Accounting Profession on

Standards
Standards that do not have support from accountants and/or the
business community could result in:
1.
2.
3.
4.

lobbying by particular interest groups

non-compliance
refusal of companies to contribute to or participate in the standard-setting
process
threat of governmental regulatory intervention

It is in the AARFs best interests to issue standards that are accepted

by the business community and the accounting profession

44

Private-sector Regulation of Accounting

Standards
Advantages
The AASB is responsive to various constituents
The AASB attracts as members people who possess the
necessary technical knowledge to develop and implement
alternative measurement and disclosure systems
The AASB is successful in generating a reasonable amount of
response from its constituency base and in responding to this
input

45

Disadvantages
The AASB lacks statutory authority and faces the challenge of
being overridden by government
The AASB has been accused of lacking independence from
dominating interests, such as the accounting profession
The AASB has often been accused of responding too slowly to
major issues that are of crucial importance to some of its
constituents

46

Arguments in favour:
The ASIC acts as creative irritant and as a catalyst for change,

since the private sector and market forces do not provide the
leadership necessary to effect such change
The structure of securities regulation established by the 1991
Corporations Law serves to protect investors against perceived
abuses

47

 The ASIC is motivated by the desire to create a level of public

disclosure deemed necessary and adequate for decision

making
Unlike the AASB, the ASIC is secured greater legitimacy
through its statutory authority
Private-sector objectives may sometimes contradict the public
interest.

48

49

Arguments against:
There is a high corporate cost for compliance with
government regulation of information
Bureaucrats have a tendency to maximise the total budget of
their bureau
There is the danger that standard setting may become
increasingly politicised
Government regulation backed by police power may hinder
the conduct of research and experimentation of accounting
policy and is not essential to achieving standardisation of
measurement

Accounting Standards Overload

Too many standards
Too detailed standards
No rigid standards, making selective application difficult
General-purpose standards fail to provide for differences in preparers,
users and CPAs needs
General-purpose standards fail to provide for differences between:
public and non-public entities
annual and interim financial statements
large and small enterprises
credited and non-audited financial statements
Excessive disclosures and/or complex measurements

50

Effects of Accounting Standards

Overload
Accountants may lose sight of their real jobs because of the

excessive data required to comply with standards

Audit failures may result because the accountant may forget to
perform basic audit procedures
The proliferation of complex accounting regulations may lead to
non-compliance

51

Solutions to the Standards Overload

Problem
The AICAP Special Committee on Accounting Standards
evaluated the following possible approaches:
no change
a change from the present concept of a set of unitary GAAP
for all businesses, to two sets of GAAP
change GAAP to simplify application to all business
enterprises
establish differential disclosure and measurement alternatives

52

 a change in CPAs standards for reporting on financial statements

an alternative to the GAAP as an optional basis for presenting

financial statements

53

The Positive Approach

54

 The subject matter of positive approach is:

existing accounting practices
managements attitudes towards those practices

Proponents of the positive approach argue that the techniques can

be derived from and justified on the basis of their tested use, or

that management plays a central role in determining the techniques
to be implemented

55

 Basic subject matter:

information is an economic commodity
acquisition of information amounts to a problem of economic
choice
Accounting information is evaluated in terms of its

ability to improve the quality of the optimal choice in a

basic-choice problem that must be resolved by an
individual
The information system with the highest expected
utility is preferred
56

Positive theory of accounting

The positive theory of accounting is based on the

propositions that managers, shareholders and

regulators/politicians are rational and attempt to maximize
their utility
Their choice of accounting policy rests on comparing the
relative costs and benefits of alternative accounting
procedures so as to maximize their utility

57

We move to third approach..PAT

58

The central ideal of the positive

approach
1.

2.

To enhance the reliability of prediction, based on the

observed smoothed series of accounting numbers
along a trend considered best or normal by
management
To reduce the uncertainty resulting from the
fluctuations of income numbers in general and the
reduction of systematic risk in particular by
reducing the covariance of the firms returns with
market returns

59

The central problem in positive

theories
The central problem is to determine how accounting

procedures affect cash flows, and therefore managements

utility
Theoretical assumptions guiding resolution of the problem
are:
the agency theory evolves to a view of the firm as a nexus of

contracts
given this nexus of contracts perspective, the role of accounting
information is to monitor and enforce these contracts to reduce the
agency costs of certain conflicts of interest
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The agency problem (dominant theory in positive

approach)

The basic agency problem is enriched by different

options concerning:
1.
2.
3.

the initial distribution of information and beliefs

the description of the number of periods
the description of the firms production function in terms
of:
amount of capital supplied by the principal
agents level of effort
an exogenously determined, uncertain-state realisation

61

4.
5.
6.
7.

8.

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the description of the feasible set of actions from which

the agent chooses
the description of the labour and capital markets
the description of the feasible set of information
systems
the description of the legal system that specifies the
type of behavior that can be legally enforced, and what
is admissible evidence
the description of the feasible set of payment systems

9. the description of the solution to the basic agency

model
10. the role of self-interest
11. the solution concept and the nature of optimality

63

Income smoothing
Propositions on income smoothing
The criterion a corporate management uses to select
among accounting principles is the maximisation of its
utility or welfare
2. The utility (effectiveness) of management increases with:
job security
the level and rate of growth in managements
income
the level and rate of growth in the corporations size
1.

64

3.

4.

65

The achievement of the management goals stated in

proposition to depends in part on the stockholders
satisfaction with the corporations performance
Stockholders satisfaction increases with the average rate of
growth in the corporations income

Gordons Theorem
Given that Gordons four propositions are true,
management would within the limits of its power:
1.
2.

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Smooth (persuasive) reported income

smooth the rate of growth in income

Motivations for smoothing

According to Heyworth, motivations for smoothing

include improvements of relations with creditors,
investors and workers, as well as dampening of business
cycles through psychological processes
Beidelmans two motivating reasons:
1.

2.

a stable earnings stream is capable of supporting a higher

level of dividends, having a favourable effect on the value of
the firms shares
smoothing counters the cyclical nature of reported earnings
and reduces the correlation of a firms expected returns with
returns on the market portfolio

67

Constraints leading to smoothing

Three constraints are presumed to lead managers to
smooth:
1.
2.
3.

68

the competitive market mechanisms, which reduce options

available to management
the management compensation scheme, which is linked
directly to the firms performance
the threat of management displacement

Dimensions of smoothing
Barnea and others distinguished between three
dimensions:
1.
2.
3.

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smoothing through events occurrence and/or recognition

smoothing through allocation over time
smoothing through classification

The accounting choice

The accounting choice rests on variables that

represent managements incentives to choose
accounting methods under bonus plans, debt
contracts and the political process
There are three hypotheses:
1. The bonus plan hypothesis maintains that managers of

firms with bonus plans are more likely to use

accounting methods that increase current-period
reported income

70

The accounting choice (contd)

2. The debt/equity hypothesis maintains that the higher

the firms debt/equity, the more likely managers are

to use accounting methods that increase income
3. The political cost hypothesis maintains that large firms
rather than small firms are more likely to use
accounting choices that reduce reported profits

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We have finished
Non theoretical approach
2. Regulatory Approach
3. Positive Accounting Theory
4.
1.

72

The Behavioural Approach

73

 Most traditional approaches accounting theory construction

have failed to consider user behavior in particular and

behavioral assumptions in general

The behavioral approach to accounting theory formulation

emphasizes the relevance to decision-making of the

information being communicated, and of the individual and
group behavior caused by the information being
communicated
The behavioral approach to accounting theory formulation is

concerned with human behavior as it relates to accounting

information and problems
74

 A new multidisciplinary area in the field of accounting

has been conveniently labeled behavioral accounting

The basic objective of behavioral accounting is to

explain and predict behavior in all possible accounting

contexts

75

Behavioural effects of accounting

information

A more recent and exhaustive attempt by Dyckman, Gibbins

and Swieringa illustrates the nature of studies of the
behavioral effects of accounting information

We may divide these studies into five general classes:

1.
2.
3.
4.
5.

adequacy of disclosure
usefulness of financial statement data
attitudes about corporate reporting practices
materiality judgements
linguistic effects of alternative accounting procedures

76

(1) Adequacy of disclosure

Three approaches were used to examine the adequacy of

disclosure:
1.

2.
3.

the first examined the patterns of use of data from the

viewpoint of resolving controversial issues concerning the
inclusion of certain information
the second examined the perceptions and attitudes of different
interest groups
the third examined the extent to which different information
items were disclosed in annual reports and the determinants of
any significant differences in the adequacy of financial
disclosure among companies

77

 The research on disclosure adequacy and use showed:

general acceptance of the adequacy among financial statements
recognition that the differences in disclosure adequacy among
financial statements are due to such variables as company size,
profitability, and size and listing status of the auditing firm

78

(2) The usefulness of financial statement data

Two approaches were used to examine the usefulness of

financial statement data:
1. the first examined the relative importance of the investment

analysis of different information items to both users and

preparers of financial information
2. the second examined the relevance of financial statements to
decision-making, based on laboratory communication of
financial statement data in terms of readability and meaning to
users in general

79

 The overall conclusions of these studies were

that:
some consensus (agreement) exists between users and

preparers regarding the relative importance of the

information items disclosed in financial statements
users do not rely solely on financial statements when
making their decisions

80

(3) Attitudes about corporate reporting

practices

Two approaches were used to examine attitudes about corporate

reporting practices:
1.
2.

the first examined preferences for alternative accounting

techniques
the second examined attitudes about general reporting issues,
such as how much information should be available, how much
information is available, and the importance of certain items

81

 These research items showed the extent to which some

accounting techniques proposed by the authoritative bodies

are accepted, and also brought to light some attitude (stance)
differences among professional groups concerning reporting
issues

82

(4) Materiality judgments

Two approaches were used to examine materiality

judgments
1. the first examined the main factors determining the

collection, classification and summarisation of accounting

data
2. the second focused on what items people consider to be
material, and sought to determine the degree of
difference in accounting data that is required before the
difference is perceived as material
These studies indicated that several factors appear to

affect materiality judgements, and that these

judgements differ among individuals
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(5) Linguistic effects of accounting data

and techniques
Linguistics and accounting have many similarities
Belkaoui argues that accounting is a language and that

according to the Sapir-Whorf hypothesis its lexical

(relating to words) characteristics and grammatical rules will
affect both the linguistic and the non-linguistic
behavior of users

84

Linguistic effects of accounting data and techniques

(contd)

Four propositions derived from the linguistic relativity

paradigm to conceptually integrate the research
findings of the impact of accounting information on
the users behavior, are as follows:
users who make certain lexical (relating to word)
distinctions in accounting are enabled to talk and/or solve
problems that cannot be solved by users who do not
2. users who make certain lexical distinctions in accounting
are enabled to perform tasks more rapidly or more
completely than those who do not
1.

85

Linguistic effects of accounting data and techniques (contd)

3.

users who possess the accounting (grammatical) rules are

more predisposed (liable) to different managerial styles or
emphases than those who do not.

4.

accounting techniques may tend to facilitate or render more

difficult various managerial behaviors on the part of users.

86

Reasons for cross-cultural research

Cross-cultural research is needed in
accounting for the following five reasons:
1. it would establish the boundary conditions for

accounting models and theories

2. it would enable evaluation of the impact of
cultural and ecological factors on behaviour in
accounting

87

Reasons for cross-cultural research (contd)

3. although variables are often generally confounded
(confuse), the confounding is not complete, as a few
culturist may present deviant (abnormal) cases
4. cultures act as natural grain-experiments by being

high or low on variables of particular interest

5. cultures determine aspects of psychological

functioning

88

Last.combined any 1 to 4

89

Accounting Paradigms

 A paradigm is a fundamental image of the subject matter of

science.
It serve to define what should be asked, & what rules should be

followed in interpreting the answer obtained.

The paradigm is the broadest unit of consensus within a science &

serves to differentiate one scientific community from another.

It subsumes, defines, & interrelates the exemplars, theories,

methods, & instruments that exists within it.

 The value of the predication of a theory to users influences its

uses, it does not solely determined the success

Because cost of errors & the implementing vary, several theories

about the phenomena can exist simultaneously for predictive

purposes.

However, only one will generally accepted by theorist.

In accepting one theory over another, theorist will be influenced

by the intuitive appeal of the theorys explanation for the

phenomena & the range of phenomena it can explain & predict as
well as by the usefulness of the predictions to users.

 AAA publication of Statement of Accounting Theory &

Theory Acceptance;
1. The anthropological / inductive paradigm
2. The true-income / deductive paradigm
3. The decision usefulness / decision-model paradigm
4. The decision usefulness / decision maker/ aggregate
market- behavior paradigm
5. The decision usefulness / decision-maker/ individual user
paradigm
6. The information / economic paradigm

1. The anthropological / inductive

paradigm
Concern for inductive approach to construction of accounting

theory & a believe the value of accounting practice.

The research concern on significance of historical cost in term of
accountability & decision making.
Those who adopt this paradigm, the basic subject mater is;
Existing accounting practice
Management attitude towards those practice (management plays a

central role in determined technique to be implemented)

 Four theories under this paradigm

Information economics
II. The agency model
III. The income smoothing / earning management hypothesis
IV. The positive theory of accounting
I.

2. The true-income / deductive paradigm

The basic subject matter is a concept of ideal income based on

some other method than the historical cost method.

It generally employed analytic reasoning to justify the
construction of an accounting theory or to argue the advantage of
particular asset-valuation / income determination model other
than historical-coat accounting.
The theories;
Price level adjusted accounting;
II. Replacement cost accounting;
III. Deprival-value accounting
IV. Net realizable value accounting
V. Present-value accounting
I.

3. The decision usefulness / decision-model paradigm

Rely on empirical technique to determined predictive ability of

selected items of information.

Two related theories;
i.
ii.

Decision models associated with business decision making

(EOQ, Capital Budgeting etc.)
Deals with different economic events that may effect a going
concern.

4. The decision usefulness / decision maker/ aggregate market- behavior

paradigm

Important relationship between accounting data and market

behavior.
Aggregate market behavior & accounting variables is based on
theory market efficiency.
Those theory include;
The efficient market model
II. The efficient market hypothesis
III. The capital asset pricing model
IV. The arbitrage pricing theory
V. The equilibrium theory of option pricing
I.

5. The decision usefulness / decisionmaker/ individual user paradigm

Is the study of how accounting functions & reports influence the

behavior of accountants & non accountants.

The basic subject matter is the individual-user response to accounting
variables.
The objective is to understand, explain & predict human behavior
within an accounting context.
The theories include;
I.
II.
III.
IV.

Cognitive relativism in accounting

Cultural relativism in accounting
Behavioral effect of accounting information
Linguistic relativism in accounting

6. The information / economic paradigm

The usefulness of information to the future development of

accounting theory.
The basic subject matter is;
Information is an economic commodity
The acquisition of information amounts to a problem of economic

choice
Generally employ analytic reasoning based on statistical decision

theory & economic theory of choice.

Central to the information/economic paradigm is the traditional
economic assumption of consistent, rational choice behavior.

Conclusion

101

 As a conclusion;
No single governing theory of acctg is rich enough to

encompass the full range of user-environment specifications

effectively;
Their existence in accounting literature not a theory of

accounting but collections of theories which can be array

over the differences in user environment specification.

102

To test the theory, according to Propper;

Internal consistency
2. Logical form (empirical or scientific theory)
3. Survive of various test
4. Demands from practice
1.

No necessarily adopt the same steps; theorists ???

103

END OF CHAPTER ONE

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