Accounting theory construction

At the conclusion of this lecture, you should have an appreciation of: pragmatic accounting theories
criticisms that have been levelled at historical cost accounting as a theoretical model normative true income theories and the decision-usefulness approach Introduction to positive accounting theories

Introduction
Accounting theories are classified according to: The assumptions they rely on How they were formulated Their approaches to explaining and predicting actual events Some classifications of accounting theories: Pragmatic Syntactic Semantic Normative Positive naturalistic
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Pragmatic theories
Descriptive pragmatics
observe behaviour of accountants inductive approach no logical assessment of actions does not allow for change

Psychological pragmatics
observe reactions of users

Descriptive Pragmatic Approach

A pragmatic theory is where we observe the behaviour of practising accountants and then copy their accounting procedures and principles.
Advantages: the solutions of practising accountants are related to the requirements of the business world they have developed (and been handed down) over a number of centuries it is a pragmatic approach to solving the problems of accounting. Disadvantages: no logical assessment (not deductive) does not allow change (or change occurs slowly) we perpetuate current practice concentrates on pragmatics and ignores the measurement issues (semantics).

Psychological Pragmatics Approach

Theorists observe the reaction of users to accountants outputs. If users react, then accounting information is said to be useful and contain relevant information. Criticism: Users may act in an illogical manner. Some have preconditioned response while others may not react when they should.

II. Syntactic and Semantic Theories

Some accounting theories are critical of the approach behind the traditional HCA- almost completely a syntactic theory and its semantic content is only on the basis of its inputs (I.e. exchange recorded in vouchers, journals and ledgers of the business). These are then manipulated (partitioned and summed) on the basis of the premises and assumptions of HCA. Inflation or market value are being ignored. The principles are then used to calculate profit/loss and the residual figures go to the balance sheet. The audit verifies the calculations and manipulation

Syntactic and Semantic Theories (criticisms against HCA)

No independent empirical operation to verify the calculated output e.g. income or total assets. These figures are not observed, they are simply summation of account balances and the auditing process is in essence simply a recalculation (no verification of final outputs) The practice of summing several different money amounts assigned to assets doublethink-holding two contradictory beliefs in ones mind simultaneously, and accepting both of them. E.g. valuations are incorporated in balance sheetsbut the balance is not a valuation statement.

Criticisms against HCA (contd.)

Imprecision of definition in accounting. Many of the propositions of conventional accounting are not falsifiable e.g. definition of depreciation (not acceptable as a measurement but simply in accordance with the matching concept).

HC Accountants argue that the purpose of accounting is to allocate the HC of resource usage against revenue the matching concept. In this case assets, liabilities and owners equity are residuals from this process: they are not meant to measure or say anything about value or the financial state of affairs. Thus, depreciation is about matching and not about measurement (valuation).

III. Normative theories (1950s and 1960s as the golden age of normative accounting research)
- theory that prescribes the correct or best way to account > prescribes what should be done Accounting researches become more concerned with policy recommendations and with what should be done, rather than with analyzing and explaining current or accepted practice. Concentration was on true income for an accounting period or discussion the type of information which would be useful in making economic decisions (decision usefulness) In most cases, these theories were based on classical concepts of profit and wealth or economic concepts of rational decision-making and usually made adjustments to account for inflation or the market value of assets They are, in essence, measurement theories of accounting. They are normative in nature because they make the following assumptions:
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Normative theories Assumptions

Accounting should be a measurement system profit and value can be measured precisely financial accounting is useful for making economic decisions markets are inefficient and can be fooled by creative accountants conventional accounting is inefficient (in an information sense) there is one unique profit measure.

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Normative Theories (contd.)

Normative theorists labeled their approach to theory formulation as scientific and in general based their theory on both analytic (syntactic) and empirical (inductive) propositions. Testing the theory is by taking the output data of specific accounting systems that are based on the overall theory and determine if the data help decision maker make the right decision.

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Normative theories (decision usefulness approach)

The decision process
Accounting system of Co. X Prediction Model of user Decision Model of user

Decision makers use accounting data to make predictions of company. Based on these predictions, they decide what to do e.g. sell or buy more share. Theories cannot be tested by the realism of their assumptions, they can be judged only by their predictive power ( Friedman, 1953)

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Normative theories (contd.)

On the other hand, realism stresses the explanatory role of science. The realism approach to accounting theory to be valid, it must also hold as a description of the reality that underlies the accounting phenomena. Under this approach, accounting gains predictive ability only because it gives relevant feedback or descriptive explanation of what has occurred We can also question the logical of using prediction (forecasting) as a scientific test for accounting theory in a dynamic environment where intervening variables cannot be controlled. Predictions in science is more valid when we can control e.g. heat, weight etc. in economic environment, variable like inflation, consumer confidence can only be considered in the form of estimated probabilities for prediction

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IV. Positive theories

- an empirically tested theory that describes, explain or predicts real world phenomena (according to their correspondence with observations from the real world) > searching for the reasons events occur.
Positivism or empiricism means testing or relating accounting hypotheses or theories back to the experience or facts of the real world.

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Positive theories
Today the greater bulk of positive theory is primarily concerned with explaining the reason for current practice and in predicting the role of accounting and associated information in the economic decision of individuals, firms and other parties which contribute to the operation of the market place and the economic However, the underlying assumptions of many positive research projects have been criticized i.e. positive theory is not free from value judgments or prescriptive implications.

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Positive theories vs Normative theories

Normative theories are prescriptive whereas positive theories are descriptive, explanatory or predictive. Normative theories prescribe how people such as accountants should behave to achieve an outcome that is judged to be right, moral, just or otherwise a good outcome. Positive theories do not prescribe how e.g. accountants should behave to achieve an outcome that is judged to be good. Rather they avoid making valueladen prescriptions. Instead, they describe how people do behave (regardless of whether it is right); they explain why people behave in a certain manner; or they predict what people have done or will do.

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Many positive and normative researchers are dismissive of each others value and view. In fact, the theories can coexist and can complement each other. Positive accounting theory can help provide an understanding of the role of accounting which, in turn, can form the basis for developing normative theories to improve the practice of accounting.

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