GODFREY HODGSON HOLMES TARCA CHAPTER 1 INTRODUCTION

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.

Overview of Accounting Theory 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.

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

Overview of Accounting Theory Accounting theory is a modern concept compared to mathematics or physics Even Pacioli’s treatise on double-entry accounting focused on documenting practice and did not explain the underlying theoretical basis for it

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.

Overview of Accounting Theory 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.

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

Normative accounting (1956-1970) Sought to establish ‘norms’ for the best accounting practice Focused on what should be (the ideal) v. what is

Normative accounting (1956-1970) Degenerated into battles between competing viewpoints Two groups dominated: conceptual framework proponents critics of historical cost

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

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

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

Positive accounting (1950 to the present day) Its objective is to explain and predict accounting practice e.g. the bonus plan hypothesis

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

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

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

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

Recent developments

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

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)

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

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)

Summary Accounting theory Major periods of accounting theory development Normative accounting Positive accounting Conceptual framework IFRS

Key terms and concepts Theory Accounting theory Normative theory Positive theory Behavioural theory Conceptual framework IFRS