Financial

Accounting
Theory and Analysis:
Text and Cases
12th Edition
Richard G. Schroeder
Myrtle W. Clark
Jack M. Cathey
Chapter 1

The Development of
Accounting Theory
What is theory?
 Webster defines theory as:
“Systematically organized knowledge, applicable in a relatively
wide variety of circumstances, a system of assumptions, accepted
principles and rules of procedure to analyze, predict or otherwise
explain the nature of behavior of a specified set of phenomena.”
 Two major types:
1. Normative theory
2. Positive theory
 Why is the development of a general theory of accounting
important?
 Allocating scare resources

 Does use of theory help individuals make better decisions?

 Various theories of accounting discussed in Chapter 4
THE EARLY HISTORY OF ACCOUNTING
▪ Denise Schmandt-Besserat
▪ Origins of writing are actually found in counting.
▪ Pieces of fired clay in Middle Eastern archeological sites.
▪ Tokens comprised an elaborate system of accounting that was used throughout
the Middle East from approximately 8000 to 3000 B. C.
▪ Each token stood for a specific item
▪ Used to take inventory and keep accounts

▪ Other accounting records dating back several thousand years have

been found in various parts of the world.
▪ These records indicate that at all levels of development, people desire
information about their efforts and accomplishments.
THE EARLY HISTORY OF ACCOUNTING
▪ For example, the Zenon Papyri
▪ Who was Zenon?
▪ Information about the construction projects, agricultural activities, and
business operations of the private estate of Apollonius for a period of
about thirty years during the third century B.C.

▪ Romans
▪ Renaissance
▪ Italians pursuing trade and commerce needed records
▪ Fra Luca Pacioli
THE EARLY HISTORY OF ACCOUNTING
▪ The evolution of joint ventures into ongoing businesses
▪ Caused need for external financial reporting

▪ By the end of the 19th century commerce was expanding and the
industrial revolution had arrived in the U. S.
▪ Widespread speculation in the securities markets, watered stocks, and large
monopolies that controlled segments of the U.S. economy resulted in the
establishment of the progressive movement
▪ A report reviewing these practices issued in 1900 suggested that an
independent public accounting profession should be established to curtail
observed corporate abuses.
THE EARLY HISTORY OF ACCOUNTING
▪ The “Capital Maintenance” concept evolved
 viewed as a way to curb corporate abuses
▪ Changed from maintaining invested capital intact
▪ To maintaining physical productive capacity
▪ To maintaining real capital
▪ The accounting profession was also evolving at this time
▪ American Institute of Accountants (AIA)
▪ American Association of the University Instructors
in Accounting (AAUIA)
THE EARLY HISTORY OF ACCOUNTING
▪ After WWI, public perception was that business had reformed and
that external regulation was no longer necessary.
▪ The accountant’s role changed
from protector of third parties  to protector of business interests

 Critics of the current accounting practices suggested that

accountants abdicated the stewardship role, placed too
much emphasis on the needs of management and
permitted too much flexibility in financial reporting.

 In 1929 the stock market crashed, the Great

Depression ensued and the possibility of
governmental intervention in the corporate sector
loomed.
ACCOUNTING IN THE UNITED STATES SINCE 1930
▪ Due to fear of government intervention, attempts at self-reform
were instituted
▪ Meetings between NYSE and AIA
▪ AAA
▪ Creation of the SEC
▪ Securities Act of 1933
▪ Securities Exchange Act of 1934
▪ Difference between public and private sector formulation of
accounting principles
ACCOUNTING IN THE UNITED STATES SINCE 1930
▪ 1936 - 1938
▪ SEC: internal debate about whether it
should develop accounting standards
▪ 1938
▪ Accounting Series Release (ASR No. 4)
▪ SEC allowed private sector to set accounting principles
▪ Reports filed with SEC must be prepared in accordance with accounting principles that have
“substantial authoritative support.”

▪ A Statement of Accounting Principles

▪ Because accounting profession did not think it had time to develop theoretical framework of
accounting
▪ “Do what you think is best.”
American Institute of Certified Public Accountants
(AICPA)
▪ Formed in 1936
▪ Influence on development of accounting theory
▪ Committee on Accounting Procedure
▪ Accounting Principles Board
▪ Financial Accounting Standards Board

▪ Each has issued pronouncements

▪ Have become primary source of today’s generally accepted accounting
principles
Committee on Accounting Procedure (CAP)
▪ Formed in 1936
▪ Professional accountants

▪ Accounting Research Bulletins (ARBs)

▪ Pronouncements
▪ Did not dictate mandatory practice
▪ Received authority only from general acceptance

▪ ARBs consolidated in 1953

▪ Accounting Terminology Bulletin NO. 1, “Review and Resume” and ARB No. 43
▪ ARB 44-53 published 1953 – 1959
▪ FASB Accounting Standards Codification (Discussed later in the chapter) includes
recommendations of these bulletins that have not been superseded
THE ACCOUNTING PRINCIPLES BOARD (APB)
▪ CAP criticized
▪ Methods of formulating accounting principles didn’t arise from research
based on theory
▪ Acting in piecemeal fashion & issuing inconsistent standards
▪ Resulted in APB
▪ Formation and structure
▪ Types of pronouncements
▪ APB Opinions
▪ Controversy over accounting for the investment
tax credit (1961)
▪ APB Opinions 2 & 4
▪ Rule 203
THE ACCOUNTING PRINCIPLES BOARD (APB)
▪ Criticism of the APB
▪ Independence of members
▪ Members had full-time responsibilities elsewhere that could influence views
▪ Structure
▪ “Big 8” automatically awarded 1 member
▪ Usually 5 or 6 other public accountants on board
▪ Response time
▪ Part-time members not able to investigate
and resolve emergency issues in timely
manner
THE FINANCIAL ACCOUNTING STANDARDS BOARD
▪ Due to growing criticism of APB
▪ 1971: Board of Directors of AICPA appointed 2 committees:
▪ The Wheat Committee
▪ How to establish accounting principles
▪ The Trueblood Committee
▪ Objectives of financial statements

▪ The FASB was established

Structure of the FASB
Financial Govern Appoint
Appoint - - - - - - - - Board of Electors
Accounting Trustees
and fund
|
Foundation
| Appoint
| and fund
Financial
Accounting Financial Task Force
Standards Accounting Appoint of the
Advisory Standards Standards
Committee
Board Board
(approx.
20 members)
( 7 members)

Admin Research
Staff Staff
FASB

▪ Mission – establish standards

▪ Types of pronouncements

 Statements of Financial Accounting Concepts

 Statements of Financial Accounting Standards
 Interpretations
 Technical Bulletins
FASB
▪ Emerging Issues
▪ Lack of timely guidance
▪ Standards Overload
▪ Too many standards
▪ Standard setting as a political process
▪ Some users found that best way to influence formulation of
accounting standards is to attempt to influence standard setters
▪ Example: SFAS No. 123 and 123R
▪ Economic Consequences
GAAP
▪ Evolution of phrase:
▪ Changed wording of auditor’s certificate brought about by
meetings between NYSE and AIA
▪ The APB’s definition
▪ “present fairly…in conformity with generally accepted accounting principles:
▪ The Auditing Standards Executive Committee’s definition
▪ No singular reference source exists for all principles
▪ Makes general acceptance of a specific principle
difficult

▪ SAS 69: determining acceptance of a

specific principle is difficult
SFAS No. 162
 Hierarchy of GAAP A
 Four levels
B
▪ FASB codification project
reduced this to 2 levels: C
▪Authoritative
▪Not authoritative D
The FASB’s Accounting Standards Codification
▪ Hundreds of accounting standards promulgated
by several different accounting standard setters.
▪ Accounting standards had evolved to the point
that professionals could not keep up.
▪ For example, using the previously existing structure, an
individual needed to review existing FASB, EITF,
AICPA, and SEC literature to resolve even a relatively
simple issue. As a result, it was easy to inadvertently
overlook relevant guidance
▪ September, 2004: the FAF Trustees approved
funding for the FASB’s codification and retrieval
project
The FASB’s Accounting Standards Codification
▪ June 2009
▪ FASB announced Codification would be
single source of all nongovernmental
US GAAP effective Sept 15, 2009.
▪ Involved following steps:
1. Restructure all U.S. GAAP literature by topic
into a single authoritative codification.
2. Modify the standard-setting process to focus
on updating the codification.
The FASB’s Accounting Standards Codification
▪ Reasons for codification
▪ Researching multiple authoritative sources complicated the
research process
▪ FASB, EITF, AICPA & SEC literature

▪ FASB ASC contains all current authoritative

accounting literature
▪ If guidance is not specified, first source to consider is accounting
principles for similar issue with a source of authoritative GAAP
▪ Nonauthoritative guidance from other sources may be
considered if similar transactions aren’t discovered in GAAP.
THE ROLE OF ETHICS IN ACCOUNTING

▪ The public accountant as a watchdog

▪ What is the basic conflict of interest facing public
accountants?
Accounting in Crisis–The Events of the Early 2000s
▪ Enron and the Accounting Scandals
▪ “Special-purpose entities” (SPEs)
▪ Now termed variable interest entities (VIEs)
▪ Purpose:
▪ Access capital
▪ Hedge risk

▪ Allowed company to increase financial leverage and return

on assets without reporting debt on balance sheet
▪ Losses were kept off Enron’s books
▪ Enron filed for bankruptcy and stock became virtually
worthless.
Accounting in Crisis–The Events of the Early 2000s

▪ Historically, accounting has been considered a highly trustworthy

profession.
▪ But client relationships changed as information technology
advisory services grew in the late 1970s and early 1980s.

 The audit function evolved into a loss leader

offered in conjunction with much
more lucrative consulting engagements.
Accounting in Crisis–The Events of the Early 2000s

Firms began to compete more aggressively

on price for audit engagements

The result was less tests that help detect the likelihood of fraud.
Accounting in Crisis–The Events of the Early 2000s
▪ Two major changes in the accounting profession have
taken place in the wake of the accounting scandals:
1. Arthur Andersen
 formerly one the Big 5 audit firms
 has gone out of business
2. Sarbanes-Oxley Act
 President Bush signed into law July 2002
 imposes a number of corporate governance rules on
publicly traded companies (Discussed in chapter 17)
International Accounting Standards
▪ The concept of harmonization
▪ The IASB
▪ The IASB’s objectives:
1. To formulate and publish in the public interest accounting
standards to be observed in the presentation of financial statements
and to promote their worldwide acceptance and observance
2. To work generally for the improvement and harmonization of
regulations, accounting standards, and procedures relating to the
presentation of financial statements.

▪ 41 Statements of Accounting Standards and 16 Statements

of Financial Reporting Standards to date
 End of Chapter 1
Prepared by Suzanne Sevin, CPA, and Kathryn Yarbrough, MBA

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