Accounting Theory & Practice OVERVIEW OF ACCOUNTING THEORY ATPB 313 Accounting Theory & Practice Sem 2 2013/2014 (updated October 2013) Topic 2: OVERVIEW OF ACCOUNTING THEORY REF: 1 & 2 (Godfrey et al 2010)

At the end of this lecture, students should be able to: Learning Outcomes At the end of this lecture, students should be able to: Discuss an overview of what accounting theory is Describe the development of accounting theory Describe how accounting theories are formulated and tested Describe how accounting theories are constructed and measured

1.0 What is Accounting Theory? Accounting theory - 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 guide the development of new practices and procedures

1.0 What is Accounting Theory? How well it explains and predicts reality How well it is constructed How acceptable are the implications of the theory The acceptance of a theory will depend on: Explain why & how current accounting practice evolved Suggest improvements Provide the basis for development of such practice Main objectives of accounting theory

2.0 Development of Accounting Theory 1400-1800 Pre-theory period No theory of accounting was devised 1800-1955 General Scientific Period Observe what actually happened Based on empirical analysis i.e. relying on real-world observations not simply on logic 1956-1970 Normative Period Prescribe what should happen 2 group dominated Limitation of the theory Do not involve hypothesis testing Based on value judgment 1970-present Specific Scientific theory Describe, explain and predict accounting practice i.e.: bonus plan hypothesis 3 4 2 1 Positive accounting Pragmatic accounting

2.0 Development of Accounting Theory Behavioural Research Current development Result from the narrow approach of positive theorists Concerned the broader sociological implications of accounting numbers and the associated actions of ‘key players’ Emerged in 1950s Corporate collapses e.g. Enron & WorldCom has triggered question on whether a comprehensive theory of the impact of accounting on behaviour had been developed increase in legislative reporting requirements. convergence

3.0 Approach to formulation of accounting theory   FORMULATING ACCOUNTING THEORY Deductive Inductive General to specific Specific to general

Approach to formulation of accounting theory   Deductive Drawing specific conclusion from detailed observations and measurements A "top-down" approach. Deduction P1 all asset accounts have debit balance. P2 The plant & machinery account is an asset account. Conclusion the plant & machinery account has a debit balance

Approach to formulation of accounting theory Inductive From specific observations to a general conclusion A "bottom-up" approach   Induction P1 the plant and machinery account is an asset account and has a debit balance. P2 the motor vehicle account is an asset account and has a debit balance. P3 the land is an asset account and has a debit balance. Conclusion all asset accounts have debit balance.

Theory development eventually must relate to the real world. 4.0 Parts of a Theory Theory development eventually must relate to the real world.   Theoretical structure Syntactic Pragmatic Semantic

5.0 Testing a Theory self-evidence Dogmatic Scientific Theory testing In developing theory using scientific approach, we need to test a theory using criteria of truth.   Theory testing self-evidence Dogmatic Scientific Syntactic Induction Falsification/Popper Research program /Lakatos Kuhnian Feyeraband

Testing a Theory SCIENTIFIC Dogmatic basis Accept the statements made by people who has the authority Self-evident The justification of self-evidence as a way to determine truth is the reasonableness, sensibility, or obviousness of a statement based on our general knowledge, experience, or observation SCIENTIFIC Syntactic Statements ascertained as valid or invalid by logic or reasoning alone Induction Statements whose truth or falseness can be known only by reference to empirical evidence or its correspondence with observations of real-world phenomena Falsification (Popper) the trial and error testing of speculative hypothesis can never be proven absolutely true, but can be rejected when shown to be false Research Programs (Lakatos) hard core of the research program which stipulate the basic assumptions of science forms a protective belt of hypothesis Kuhnian paradigms Revolutionary i.e. involves the abandonment of one theory and replace by another incompatible theory. Feyerabend’s approach There is no single scientific way of getting ideas.  

6.0 Accounting Theory Construction A useful way to study & assess accounting theories is to classify them according to the assumptions they rely on, how they are formulated and their approach to explaining & predicting actual events. Accounting theory classification:   Pragmatic Syntactic Semantic Normative Positive Naturalistic

Accounting Theory Construction THEORIES EXPLANATION Pragmatic Theories Descriptive pragmatic approach Observe behavior of accountants Psychological pragmatic approach Observe users’ responses to the accountants outputs i.e. financial reports THEORIES EXPLANATION Normative Theories (1950s and 1960s) How to derive the ‘true income’ for an accounting period Type of information useful for economic decisions. Positive Theories (1970s) Testing theories back to the experiences or facts of the real world (to find the reasons) i.e. questionnaires/survey Alternative Naturalistic approaches Tries to explain complex & unique situations using an unstructured approach. Use case studies & individual experiences Try not to generalize. Syntactic rely on logical argument based on a set of premise. Semantic how theories correspond to real-world events.

Accounting Theory Construction   Syntactic and Semantic Theories A theory that has both syntactic and semantic element E.g. historical cost: Proponents: Syntactic: Logic in the sense it is the value recorded on the day transaction is made Semantic: The cost recorded based on real vouchers Opponents: Syntactic: Poor as different monetary measures are added Semantic: Do not consider inflation and no independent empirically observable correspondent to concepts such as profit or assets.

Accounting Theory Construction Issues for auditing theory construction   Development of a theory of accounting Development of a theory of auditing (lag in 1960s) Early writers attempted to document the process of auditing and the duties of expected of auditors.

Development of Accounting Theory Summary: Topic 2 Accounting theory Definition: Logical reasoning in the form of a set of broad principles to provide a general framework of reference by which accounting practice can be evaluated & guide the development of new practices and procedures. Objective: Explain current accounting practice evolved, suggest improvements & provide the basis for development of such practice. Formulate: Deductive: general to specific Inductive: specific to general Parts of Theory: Syntactic . Semantic Pragmatic Testing: Dogmatic . Self-evident Scientific: Syntactic Induction Falsification/Popper Research program /Lakatos Kuhnian Feyeraband Theory Construction: Pragmatic – behavior of accountants & users of accounting information Syntactic – rely on logical argument based on a set of premise. Semantic – how theories correspond to real-world events. Normative – rely both on semantic & syntactic approach. Positive – test hypothesis against actual events. Naturalistic – consider individual cases & try not to generalize. Development of Accounting Theory Pre-theory period (1400-1800) General Scientific Period (1800 – 1955) Normative Period (1956 – 1970) Specific scientific theory/Positive Era (1970 –present)

TUTORIAL 2 (40 MARKS) Q1 Useful theories must eventually relate to the real world. Using examples, please discuss THREE distinct relationships of theories which are: syntactic, semantic and pragmatic. [6 marks] Q2. Accounting theorist attempted to established norms for best practice during the normative period. While, specific scientific theory is to explain and predict accounting practice. i. Explain two groups dominated during the normative period. [4 marks] ii. Explain the reasons why the specific scientific theory arises. [6 marks]

TUTORIAL 2 Q3 Explain TWO (2) limitations of self evidence. Discuss with example. [4 marks] Q4 In your opinion, can accounting theory be constructed as a purely syntactical exercise without involvement by other approaches? Provide your reasoning. Q5 Is it important to account for the effects of inflation on deriving the ‘true income’ in normative theory? Provide your reasoning. [4 marks] Q6 What role(s) can theory play in relation to accounting? Give an example. [4 marks] Q7 Explain FOUR (4) main differences between normative and positive theories. [8 marks]