1

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Inductive and
deductive approaches
to accounting theory

Inductive and deductive approaches to accounting theory

Theories can be categorised as being discovered through inductive reasoning or derived from
deductive reasoning. These differences in approaches to the development of accounting theory
are relevant to an understanding of the role that a framework might perform. Both the inductive
and deductive approaches to the development of theory share common basic elements.
However, as illustrated in Figure1, the logic linking theelements flows in opposite directions.

Figure 1
Comparison of approaches to theory development
INDUCTIVE
(specific general)

DEDUCTIVE
(general specific)

Objectives

Objectives

Assumptions

Assumptions

Principles

Principles

Definitions/Actions

Definitions/Actions

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Discovering a theory (inductive logic)

A person discovering a theory would begin the task by starting from the bottom of the left
column in Figure 1by observing definable activities and actions. Havingrecorded the definable
activities and actions, the observer would then infer (orarrive at) the principles to which his/her
observations conform. Having inferred certain principles on the basis of detailed observation,
the researcher might then attempt to infer higher-level assumptions and objectives.
In summary, a person discovering a theory always moves from the lower levels of the diagram
to the upper levels, employing what philosophers refer to as inductive logic. Inductive logic
is a process of reasoning whereby lower-level outcomes are used to identify or specify higherlevel ones. In the scientific literature, this is referred to as moving from the specific to the
general (i.e. using individual observations of the phenomena to make an inference about the
generalpopulation).
Inductive logic can be used to develop a descriptive (or positive) theory. A descriptive theory
sets out the way things arethat is, descriptive theory describes. Early attempts by members
of the accounting profession to codify accounting activity on the basis of observation can
be traced back to the 1920s. One of the most famous codification exercises was that
carried out in the US by Paul Grady, an accounting researcher. After a long period of detailed
observation, Grady (1965) produced an inventory of generally accepted accounting principles,
moreconveniently referred to as GAAP. In view of the inductive research methodology used,
theexpression generally accepted is fitting.

Example
To illustrate an inductive approach, let us consider how we might develop
a theory to explain why some gains and losses are recognised in profit or
loss, while others are recognised as part of other comprehensive income,
thatis, recognised directly in equity. The theory will be going beyond a simple
explanation of compliance with accounting standards, to derive underlying
principles and objectives reflected in the accounting treatment prescribed or
permitted by accounting standards.
Actions
Under the deductive approach, we would commence with observations of gains/
losses that are recognised in profit and gains/losses recognised directly in equity.
For simplicity, we will just consider a few observations of accounting treatment
(actions).
Gains/losses recognised in profit

Gains/losses recognised directly

inequity

Downward revaluation of property,

plant and equipment

Upward revaluation of property,

plantand equipment

Change in fair value of held-for-trading

financial instrument

Change in fair value of financial asset

classified as available-for-sale

Change in fair value of a biological

asset
Principles
The next step would be to identify principles that are consistent with the observed
actions. Forexample, a principle that gains should be recognised in equity while
losses should be recognised in profit or loss is not consistent with all of the
observations. It holds for property, plant and equipment, but is inconsistent for
biological assets where all changes in fair value are recognised in profit or loss.
Your turn. Think of a principle that might explain one of the above observations
and then test whether it is robust to the other observations.

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For the sake of the illustration, we will now assume that we have derived the
following principles from our observations:
1 All fair value adjustments should be recognised in profit if they:
relate to assets that are held-for-trading and which can be traded in a
highly liquid market; or
capture biological transformation that reflects the performance of the entity
during the period.
2 Other fair value adjustments should be recognised in equity if the fair value is
easily determined.
3 Where the fair value is not easily determined, the use of fair value should be
discouraged by requiring downward revaluations to be charged against profit
while not allowing upward revaluations to be included in profit. (Please note,
these principles are merely made up for the purpose of illustrating inductive
reasoning, and are not intended to suggest that these were the basis for the
conclusions of the standard setters.)
n

Assumptions
Identify assumptions that have been made in identifying the principles, such as
assumptions about performance measurement, what is meant by profit and the
rationale for the observed actions. For example, the first principle assumes that
profit is more relevant to measuring performance than is comprehensive income
(in fact, the alternative proposition is made in accounting standards). Thesecond
and third principles assume that the measurement of the fair value of financial
instruments iseasily determined, while the fair value of property, plant and
equipment is not easily determined.
Objectives
Lastly, broader generalisations are made from the principles and assumptions
reached by the researcher or theorist. For example, a broad generalisation may
be made about the objectives for the reporting of profit and comprehensive
income, and about what they should comprise. This would provide general rules
that could then be applied to new observations or emerging issues, such as
how to account for changes in the fair value of assets arising from emissions
tradingschemes.
Limitations of an inductive approach
Inductive logic is useful for developing theories to describe and explain accounting practice.
It is not well suited to the development of a set of conceptual and pragmatic principles that
provide a general framework for accounting. The limitations of descriptive accounting theory
indeveloping a conceptual framework include:

A tendency to maintain the status quo. The inductive approach does not question
whether there might be better ways of doing things. Accounting is defined as
whataccountantsdo.

Lack of guidance on how to handle new or emerging issues and situations. As a
consequence, inductively derived descriptive accounting theories encourage an adhoc
approach to problem-solving. It is clear from this that inductive accounting theories do
notcope well with new ways of doing business.

There is no guarantee that descriptive accounting theories will produce internal consistency
from a logical perspective. Contradictions can, and do, arise in that similar events could be
treated differently in different circumstances.

Practice leads theoretical development, so that undesirable practices emerge in advance
of the development of a principle, or principles, that may have prevented the emergence
ofthe practices in the first place.

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Building a theory (deductive logic)

A person building a theory through deductive reasoning would begin the task by starting from
the top of the right column in Figure 1by setting objectives. Thedeveloper of the theory
sets whatever objectives he/she desires. Having set the objectives, thedeveloper would then
deduce (or derive) the assumptions (if any) that underlie those objectives. Once the objectives
are specified, and any underlying assumptions deduced, the developer of the theory would then
deduce the principles that flowed logically from both the objectives and the assumptions. In turn,
theprinciples would then enable the inventor to deduce the definitions, activities and observable
actions that should result.
In summary, the inventor of a theory always moves from the upper levels of the diagram to the
lower levels, employing what philosophers refer to as deductive logic. Deductive logic is a
process of reasoning whereby higher-level outcomes are used to identify or specify lower-level
ones. Deductive logic has also been described as the process of going from general principles
to specific actions.
Deductive logic can be used to develop a prescriptive (or normative) theory. Prescriptive theory
sets out the way things should be donethat is, prescriptive theory prescribes. Forexample,
Chambers used deductive reasoning to develop a prescriptive theory referred to as continuously
contemporary accounting (CoCoA). An underlying premise of CoCoA is that users of financial
statements need information about the financial capacity of an entity. Under CoCoA, assetsare
represented by current cash equivalents, measured at market exit price, if available. Profitis
measured as the change in wealth after allowing for capital maintenance adjustments.
(Forfurther information about CoCoA, refer to Chambers 1955a, 1995b, 1966, 1980).
Like many other conceptual frameworks of accounting, the FASBs Conceptual Framework is
derived using deductive logic. The FASBs Statement of Financial Accounting Concept No. 1:
Objectives of Financial Reporting by Business Enterprises states (1978, para. 9):
Financial reporting is not an end in itself but is intended to provide information
that is useful in making business and economic decisionsformaking reasoned
choices among alternative uses of scarce resources in the conduct of business and
economic activities. Thus, the objectives set forth stem largely from the needs of
those for whom the information is intended, whichin turn depend significantly on the
nature of the economic activities and decisions with which the users are involved.
Accordingly, theobjectives in this Statement are affected by the economic, legal,
political, and social environment in the United States. The objectives are also affected
by characteristics and limitations of the information that financial reporting canprovide
(paragraphs 17-23).
The FASBs Framework commences with the objective that financial reporting should provide
information that is useful in making business and economic decisions about the allocation of
scarce resources. This objective is underpinned by assumptions about the type of information
needed by those making business and economic decisions. For example, it is assumed that the
effectiveness of decision makers is enhanced by information that reflects the relative standing
and performance of business enterprises (FASB SFAC No. 1, para. 16).
The major problem often associated with deductively derived, prescriptive accounting theories
is that they are not based on observation. For example, prescriptive accounting theories are
not driven by the observation of existing accounting practices. Rather, theyare based on the
opinion of the developer of the particular prescriptive accounting theory about what should
happen. In the context of a conceptual framework, there may be disagreement about the
desirability of an objective. For example, the objective of financial reporting proposed by
the FASB and IASB, to provide financial information about the reporting entity that is useful
to present and potential equity investors, lenders, and other creditors in making decisions,
hasbeen criticised for ignoring the stewardship function of accounting (for discussion, refer to
OConnell 2007). A related limitation of normative theory is the potential invalidity of assumptions
underpinning the objectives and qualities of information that would meet users information
needs. (For further discussion, refer to Walker 2003.)
Although prescriptive theories are not driven by observations, there is potential for empirical
accounting research to inform the choice of objectives and the assessment ofthe validity of
assumptions. For example, considerable accounting research has been undertaken to assess
the decision relevance of various financial and non-financial disclosures.