Financial Accounting Theory Craig Deegan Chapter 1 Introduction to financial accounting theory Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Learning objectives In this chapter you will be provided with evidence that shows that: there are many theories of financial accounting knowledge of different accounting theories increases our ability to understand and evaluate various alternative financial accounting practices the different theories of financial accounting are often developed to perform different functions, such as to describe accounting practice or prescribe particular accounting practices Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Learning objectives (cont.) theories, including theories of accounting, are developed as a result of applying various value judgements and that acceptance of one theory, in preference to others, will in part be tied to one’s own value judgements we should critically evaluate theories before accepting them there is good reason for students of accounting to study theories as part of their broader accounting education Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

What is a theory? ‘A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry’ (Hendriksen 1970, p.1). ‘A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’ (The Oxford English Dictionary) A theory could be based on numerous observations (inductive reasoning) or developed on the basis of logic (deductive reasoning) Could be ‘positive’ or ‘normative’ Theories can help us make sense of the world in which we live and can provide a structure to understand our (social) experiences Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting theories Accounting is a human activity It would seem illogical to study financial accounting (for example, the accounting standards) without also studying accounting theory Theories of accounting consider people’s behaviour with respect to accounting information people’s needs for accounting information why people within organisations elect to supply particular information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of uses of accounting theories Theories might: prescribe how assets should be valued predict why managers will choose particular accounting methods explain how an individual’s cultural background affects accounting information provided prescribe what accounting information should be provided to particular classes of stakeholders predict that the relative power of a stakeholder group will affect the accounting information it receives explain or predict how accounting disclosures might be used as part of a strategy to legitimise the operations of an organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Why study accounting theories? how elements of accounting should be measured motivation for individuals to support or lobby regulators for some accounting methods in preference to others the implications for organisations and their stakeholders if one accounting method is chosen or mandated in preference to others how and why the capital markets react to particular information whether there is a ‘true measure’ of income Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Overview of theories of accounting Many theories of financial accounting exist No universally accepted theory of accounting different perspectives about the central objective, role and scope of financial accounting No universally accepted perspective about the role of accounting theory different researchers have different perspectives of the role of accounting theory (for example, to explain and predict practice versus prescribing particular practice) a researcher’s own values will influence which theory he or she elects to embrace Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Early development of accounting theory Relied upon the process of induction development of ideas or theories through observation 3 conditions (Chalmers 1982): -large number of observations. -observations repeated under wide variety of conditions. -no accepted observation should conflict with the derived universal law. 1920s to 1960s theories developed from observing what accountants did in practice Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

After observing what accountant did in practice were codified in form of conventions of accounting. Notable theoriests at that time are: Paton(1922), Paton and Littleton(1927), Hatfiled(1927), Canning (1930). Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Prudent concept, monetary unit measurement were observed and then generalized as accounting principles at that time. But after 1960 research based on inductive approach was subject to many criticism like: what is not or what should not be these issues were not addresses. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Example of inductive approach to theory development Grady (1965) undertook research commissioned by the American Institute of Certified Public Accountants (AICPA). Later AICPA went for prescriptive studies for measurement systems be changed from historical cost to a system based on current values.History shows that regulatory bodies rarely accepted prescriptions for significant change to accounting practices. Formed the basis of APB Statement No. 4 ‘Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises’ reflected generally accepted accounting principles at the time Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Theory development—1960s and 1970s Known as the ‘normative period’ of accounting research Sought to prescribe particular accounting practices known as normative theories (normative theories provide prescription) Not driven by existing practices, and hence not typically inductive in nature (that is, not based on observation) Rather, were deductive in nature and, based on logical argument, sought to develop new methods of accounting Theories critical of historical cost accounting Sought to provide improved approaches to asset valuation in a time of widespread inflation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Example of prescriptive theory 1961 and 1962 studies by Moonitz, and Sprouse and Moonitz commissioned by the Accounting Research Division of the AICPA Authors proposed that accounting measurement systems be changed from historical cost to a system based on current values Such research should not be evaluated by reviewing current practice (indeed, there is a general rule that prescriptions about what should be should not be evaluated by reviewing observations of what is) Not supported by AICPA as too radically different from current practice Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Normative theories Based on what the researcher believes should occur in particular circumstances not based on observation Example of normative theory Continuously Contemporary Accounting (CoCoA) by Raymond Chambers Conceptual Framework of Accounting Social and environmental reporting Should not be evaluated on whether they reflect actual accounting practice Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Classifications of normative theories True income theories make assumptions about the role of accounting then seek to provide a single ‘best measure’ of profits Decision usefulness theories ascribe a particular type of information for particular classes of users on the basis of assumed decision-making needs Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decision usefulness theories Decision-makers emphasis undertaking research that seeks to ask decision makers what information they want knowledge then used to make prescriptions about what information should be supplied Decision-models emphasis develops models based on the researchers’ perceptions about what is necessary for efficient decision making Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Theory development—mid to late 1970s Research aimed at explaining and predicting accounting practice rather than prescribing particular practices Known as positive theories Contrast with normative theories Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Positive theories Seek to predict and explain particular phenomena Begins with assumption(s), and through logical deduction enables prediction(s) to be made If predictions are sufficiently accurate when tested against observations of reality, they are regarded as having provided explanation of why things are as they are Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Positive theories (cont.) Positive Accounting Theory developed by Watts and Zimmerman is a specific example of a positive theory of accounting seeks to predict and explain why accountants elect to adopt particular accounting methods in preference to others based on ‘rational economic person’ assumption individuals motivated by self-interest tied to wealth maximisation challenges the view that accountants will be ‘objective’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticism of normative theories—an example Normative theories have been criticised for lack of empirical observation they are based on personal opinion about what should happen positive theorists argue that they would prefer to provide information about expected implications of actions and let others decide themselves what they should do positive theorists also make value judgements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e