1. Introduction to Accounting Theory
Lecture 1
Introduction to Accounting Theory

2. Doris Merkl-Davies Division: Financial Studies
Location: Room 1.08, Hen Goleg
Telephone:
Reader in Accounting
MA, PGCE (Vienna University), MBA, PhD (Bangor University)
Office hours: Mon ; Wed (Hen Goleg, Room 1.08)

3. Doris Merkl-Davies Research interests Corporate narrative reporting
Impression management
CSR reporting
Accounting theory

4. Doris Merkl-Davies
Can’t live without
Motto

5. BBS film club Venue: Alun A0.01, 3.00-5.00pm
WEEK 3 (WEDNESDAY 15 OCTOBER): Wall Street (discussant: Doris Merkl-Davies)
WEEK 5 (WEDNESDAY 29 OCTOBER): Office Space (discussant: Tony Dobbins)
WEEK 9 (WEDNESDAY 26 NOVEMBER): Citizen Kane (discussant: Bernardo Batiz-Lazo)

6. Module format Lectures: Mon. 10-12 in Drama Rehearsal Room Tutorials:
Group A: Mon, LR5
Group B: Tue, LR1

7. Recommended Textbooks
Deegan, C. and Unerman, J. (2011). Financial Accounting Theory. European edition. 2nd ed. McGraw-Hill. (D&U) [Main text I]
Rankin, M., Stanton, P., McGowan, S., Ferauto, K., Tilling, M. (2012). Contemporary Issues in Accounting. 2nd ed. Wiley. (R) [Main text II]
Godfrey, J., Hodgson, A., Holmes, S. and Tarca, A. (2010). Accounting Theory. 7th ed. Wiley. (GHHT) [additional reading]
Additional journal articles will be posted on blackboard for you to download.

8. Background reading for Lecture 1
D&U Chapter 1
Rankin et al. Chapter 1; Chapter 5, pp
GHHT Chapts. 1&3

9. Overview of Lecture 1 Definition of accounting theory
Types of accounting theories
Accounting theory development over time
Relationship between theory and research
Evaluation of theories

10. Exercise 1: What is a theory?
In groups of 6 find an example of a famous theory
Discuss the main features of the theory
What does this theory do?
What do we use it for?
Nominate a group member to report back to the class

11. What is a theory? An organized way of thinking about a subject
A set of ideas that explains something
‘a scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’ (Oxford English Dictionary)
“theory is a statement of concepts and their interrelationships that shows how and/or why a phenomenon occurs” (Corley & Gioia, 2011: 12)

12. What is the purpose of theories?
To make sense of the world (physical, social, psychological phenomena) and communicate that understanding to others
To make sense of (financial) accounting information
Financial statements, corporate annual reports
Accounting info is compiled and interpreted by people

13. Types of theory Type of theory Users Example Common-sense theory
Lay people (personal experience)
It is not what you know, but who you know
Working theory
Managers, investors, auditors
(Generalisations made in particular professions)
Crisis communication should prioritise key stakeholders
Scholarly theory
Academics
Accounting choice is driven by managerial self-interest
Positive Accounting Theory

14. Scholarly theory Has undergone systematic research
Provide more thorough, accurate, and abstract explanations for financial accounting than common-sense or working theories

15. What is the purpose of theories?
Theories are used to
Describe what people do = Descriptive theories
Suggest the best way (i.e., prescribe) to deal with specific types of human behaviour = prescriptive or normative theories
Explain and predict what people do = predictive or positive theories

16. 1. Descriptive theories Describe what people do
Based on common practice
Describe
Common practise of bringing up children
Common practises for dealing with underage binge drinking in various countries
Describe accounting practice
Common practise of accounting for fixed assets
Future accountants are trained by practising accountants

17. Descriptive theories Advantage: Disadvantage:
Tends to be accepted by majority
Disadvantage:
Does not entail critical evaluation
Does not allow for change

18. 2. Prescriptive (= normative) theories
Also called normative theories
What people should do
Suggest best way to
Bring up children, i.e., authoritarian, laissez-faire style, etc.
Prescribe particular accounting practices
Account for fixed assets, i.e., historical cost, current cost, exit price, etc.
Advantage
Can improve accounting practises
Disadvantage
Assumes that there is one “best way”

19. 3. Predictive (= positive) theories
Also called positive theories
Concerned with explaining reasons for behaviour and predicting future behaviour
Explain characteristics of children are most likely to engage in binge drinking, i.e., social class, gender, parenting style
Predict what effect a change in licensing laws will have on underage teenage drinking
Explain and predict accounting method choice
Characteristics of companies most likely to revalue their assets
What effect a change in accounting standards on leases will have on the way firms finance their assets

20. Comparison of descriptive, prescriptive and predictive theories

21. 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
predict that accounting information is used to present organisations as legitimate

22. Accounting theories Accounting is a human activity
Explain the behaviour of people within and outside of organisations with respect to accounting information
Theories of accounting consider:
Why people within organisations elect to provide particular information (preparer perspective)
People’s behaviour with respect to accounting information (user-perspective)
People’s needs for accounting information (user-perspective)

23. Accounting theories Accounting is a social phenomenon
Accounting theories are theories about human behaviour
Borrow from disciplines dealing with human behaviour
Psychology, sociology

24. Exercise 2
Which of the following is NOT an assumption used in normative theory construction?
A. Profit and value can be measured precisely
B. Financial accounting is useful for making economic decisions
C. There are multiple available profit measures
D. Markets are inefficient and can be fooled by 'creative accountants‘
E. All of the above

25. Why do we need accounting theories?
Accounting is viewed as a ‘practical’ discipline
Learning how to apply accounting rules
Theories are necessary to understand the (social) world we live in
They provide a basis for the decisions we make, e.g. whether to include an item in the financial statements or not (materiality and recognition criteria)

26. Why do we need accounting theories?
We can make better predictions and decisions if we get the contradictions out of our thinking, if we consider what is known on the many sides of the issue
i.e. the various theories which exist on:
The regulation of accounting, e.g. whether we need regulation or not
The provision of financial information, e.g. Why accountants choose particular accounting methods
The way financial information is received, e.g. How people react to particular accounting numbers

27. Why study accounting theories – to understand:
Motivation for individuals to support or lobby regulators for some accounting methods in preference to others ( Regulatory theories)
How and why the capital markets react to particular information ( Positive accounting theory)
Whether there is a ‘true measure’ of income ( Asset valuation theories)

28. 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

29. Accounting Theory Timeline

30. Early development of accounting theory
Descriptive theories
Relied upon the process of induction
Development of ideas or theories through observation
1920s to 1960s theories developed from observing what accountants did in practice
Codified as doctrines or conventions of accounting

31. Criticisms of inductive method
… ‘concentrates on the status-quo, is reactionary in attitude, and cannot provide a basis upon which current practice may be evaluated or from which future improvements may be deduced.’ (Gray, Owen and Maunders 1987, p. 66)
Assumes what is done by the majority is the most appropriate practice
Perspective of accounting Darwinism

32. Example of inductive approach to theory development
Grady (1965) undertook research commissioned by the AICPA
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

33. Theory development - 1960s and 1970s
Sought to prescribe particular accounting practices
Known as normative theories
Not driven by existing practices
Theories critical of historical cost accounting
Sought to provide improved approaches to asset valuation in a time of widespread inflation

34. 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
Not supported by AICPA as too radically different from current practice

35. Theory development - mid to late 1970s
Research aimed at explaining and predicting accounting practice rather than prescribing particular practices
Known as positive theories

36. 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

37. Positive theories - continued
Positive Accounting Theory
Developed by Watts and Zimmerman
Seeks to predict and explain why accountants elect to adopt particular accounting methods in preference to others
Based upon ‘rational economic person’ assumption
Individuals motivated by self-interest tied to wealth maximisation

38. Relationship between theory and research
Theories are used to understand accounting practice better
Accounting researchers use theories
Theories are used in empirical research (i.e., research based on data, such as financial statements, annual reports, share prices) to explain phenomena and make predictions
Theories help us to critically evaluate a phenomenon (i.e., accounting method choice)

39. Relationship between theory and research
"... all research emanates from the researcher’ s implicit or explicit theory of the phenomenon under investigation" (Rocco & Plakhotnik, 2009: 121).

40. Testing a Theory in Research
Theory plane
3. State research question/
hypothesis
2. Develop
theoretical framework
4. Construct
research design
5. Observe
1. Identify
research problem
6. Analyse
8. Assess limitations
and constraints
7. Evaluate
Observation plane

41. Testing a Theory in Research
Identify research problem
Bias in corporate narrative documents
Develop theoretical framework
Agency theory assumptions
Information asymmetry between managers and investors; managers are self-interested (want to maximise their compensation); managers manipulate presentation of information in corporate narrative documents (e.g., annual report)

42. Testing a Theory in Research
State research question/hypothesis
Managers in firms with negative financial performance are more likely to introduce reporting bias (in the form of pro-forma earnings number into corporate narrative documents than managers of firms with positive financial performance
Construct research design
Sample of firms; split into two groups based on positive/negative percentage change in earnings; chairmen’s statements (pro-forma earnings vs. GAAP earnings)

43. Testing a Theory in Research
Observe/Analyse
Conduct statistical association tests
Evaluate
Do findings confirm/disconfirm hypothesis; compare with findings of prior research
Assess limitations/constraints
E.g., small sample size

44. Criteria for evaluating theories
Area of evaluation
What to look for
Accuracy
Has research supported that they theory works the way it says it does?
Practicality
Have real-world applications been found for the theory?
Succinctness
Has the theory been formulated with the appropriate number (fewest possible) of concepts or steps?
Consistency
Does the theory demonstrate coherence within its own premises and with other theories?
Acuity
To what extent does the theory make clear and otherwise complex experience?

45. Evaluation of theories
Theories of accounting are only abstractions of reality
The choice of one theory in preference to another is based on value judgements
Cannot expect to provide perfect explanations or predictions of human behaviour or assess what types on information users actually need

46. Evaluating theories of accounting
When evaluating theories need to consider:
Assumptions: whether you agree with the central assumptions/premises of the theory
Logic: whether the argument supporting the theory is logical
Research methods: Whether the research methods are appropriate
Evidence: whether you accept any supporting evidence provided
Rhetoric: the use of rhetoric used for persuasion

47. The role of assumptions
Even though an argument is logical we might only accept the argument if we accept any critical assumptions being made
If we reject any central assumptions we may reject the prediction

48. Logical deduction
Acceptance of an argument must be based upon the accuracy of the premises
An argument is logical to the extent that if the premises on which it is based are true, then the conclusion will be true
To determine the logic of an argument we do not need to refer to ‘real world’ observations

49. Research methods Generalizing theories from the testing of samples
Methods borrowed from sciences  phenomena will behave the same in all situations
Not possible when dealing with human behaviour
Sample selection (firm size, industry, country of origin, listed/unlisted, etc.)
Keep in mind not only how the argument is developed, but also how it is tested!!!

50. Evidence Is there enough evidence to support the theory?
Is there conflicting evidence?

51. Rhetoric
Thouless (1974) identifies 38 ‘dishonest tricks’ some writers use to support their argument including:
emotionally toned words
statements where ‘all’ is implied but ‘some’ is true
diversion to another question or to a side issue
use of speculative argument
prestige by false credentials
appeal to mere authority

52. Any questions?