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MGT 4160 Accounting Theory Lesson 1: Introduction to Accounting Theory

Lesson Objectives: 1. What is theory? ........................................................................................................................ 2 1.1. 1.2. 1.3. 1.4 1.5 2. The philosophical foundations of theory ......................................................................... 2 The development of western knowledge ........................................................................ 3 Positivism and the scientific method ............................................................................... 4 A framework for scientific theory construction............................................................... 4 Paradigms and scientific revolutions............................................................................... 5 Classifications of accounting theories .............................................................................. 7

What is accounting theory? ..................................................................................................... 6 2.1 How does accounting research impact accounting theory? ................................................... 7

3.

Godfrey, J., Hodgson, A., Holmes, S. & Tarca, A. (2006). Accounting Theory (6th ed.). Milton, Qld: John Wiley & Sons Australia, Ltd. Riahi-Belkaoui, A. (2004). Accounting Theory (5th ed.). London: Thomson Learning Scott, W. R. (2012). Financial Accounting Theory (6th ed.). Toronto, ON: Pearson Canada Schroeder, R.G., Clark, M. W. & Cathey, J.M. (2009). Financial Accounting Theory and Analysis: Text and Cases (9th ed.). Hoboken, NJ: John Wiley & Sons, Inc. Wolk, H.I., Dodd, J.L. & Rozycki, J.J. (2008). Accounting Theory: Conceptual Issues in a Political and Economic Environment (7th ed.). Thousand Oaks, CA: Sage Publications

Lesson 1: Introduction to Accounting Theory 2012, Harjinder Deol

Reference Material Gaffikin, M. (2008). Accounting Theory: Research, regulation and accounting practice. Frenchs Forest, NSW: Pearson Education Australia

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1. What is theory?
According to the Merriam-Webster online dictionary, a theory is a noun, denoting: i. the general or abstract principles of a body or fact, a science, or an art ii. a plausible or scientifically acceptable general principle or body of principles offered to explain natural phenomena iii. a working hypothesis that is considered probable based on experimental evidence or factual or conceptual analysis and is accepted as a basis for experimentation. The word theory is derived from the classical Greek word theoria (), which relates to a way of viewing, or looking at, things. Thus, a theory depends on the world-view of the theorist, which in turn, is derived from the assumptions and motivations of the theorist. The terms propositions and hypothesis are closely related to theory. Propositions are statements derived from a theory expressed in conceptual terms, and can be thought of as yes/no type statements. Hypotheses (plural of hypothesis) are propositions that can be tested for their validity.

1.1. The philosophical foundations of theory There are four key foundations on which a theory is built. a. Ontological assumptions about reality and the existence of things. There can be two radically different sets of ontological assumptions: i. Realism: the conventional world-view that sees the world as full of things that exist independent of humans. ii. Nominalism: the view that things exist only through our construction of them. Social reality is relative, and our concepts of things is socially constructed. Depending on differences in ontological assumptions, two distinct views of the society may exist: i. Order: society is relatively stable, and social order is based on consensus ii. Chaos: society is constantly changing, and any social order is based on coercion, and prone to disintegration b. Epistemological approaches to acquiring knowledge. The term epistemology has its origins in the Greek episteme (knowledge) and logos (reason). Again, there can be two opposing approaches: i. Positivism: the approach that holds that we can explain, predict and develop testable hypotheses about what happens in the world by examining patterns and relationships.

Lesson 1: Introduction to Accounting Theory 2012, Harjinder Deol

MGT 4160 ii.

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Anti-positivism: the approach that believes that while social science cannot create truly objective knowledge by merely observing behavior (experience is necessary)

Depending on epistemological approaches, distinct views exist regarding research, or acquisition of knowledge i. Value-free: It is possible that researchers can conduct objective research without being influenced by their own values (moral/social/etc) ii. Value-laden: It is NOT possible for research to be value-free. c. Methodology adopted to study phenomena. i. Nomothetic methodology relies on the scientific method, hypothesis testing and the use of quantitative research tools. ii. Ideographic methodology focuses on detailed observation of social phenomena. d. Assumptions about human nature i. Voluntarism: humans possess free will and autonomy ii. Determinism: humans are affected by the environment they exist in

1.2. The development of western knowledge Western knowledge has its roots to Classical Greek scholars Socrates, Plato and Aristotle. Aristotle provided a framework for deductive logic called syllogism (an if-then pattern of reasoning). Due to their opposition to the sophists (who believed that all knowledge was relative), these Classical Greek scholars were also responsible for the dominance of realist ontology. During the Dark Ages the rise in power of religious (Christian) scholars saw the emergence of hermeneutics the interpretation of the written word (the Bible). The Renaissance period, ushered the era of modernity with an emphasis on scientific reasoning. Influential philosophers of the period included Thomas Hobbes, John Locke, Adam Smith and Auguste Comte. Thomas Hobbes developed the rational choice theory and social contract theory, both of which influenced heavily the modern neo-classical economic theory. Hobbesian thinking also popularized the notion of rational self-interest. Adam Smith, through his influential work The Wealth of Nations, incorporated Hobbes idea of rational self-interest in his conceptualization of the invisible hand, which is the foundation of the belief in free markets. John Locke emphasized empiricism, the notion that we can only know those things that we can see, hear, touch, smell or taste. Auguste Comte was a believer in a scientific approach to understanding social phenomena, and was an influential promoter of positivism. Lesson 1: Introduction to Accounting Theory 2012, Harjinder Deol 3

MGT 4160 1.3. Positivism and the scientific method

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Positivism, through its tenets of scientific knowledge, became widely accepted as the hallmark of scientific inquiry. It holds that: i. Scientific statements must be empirically grounded ii. Scientific observations must be repeatable iii. A single scientific method must be used to ensure universality of statements and observations iv. Science advances through empirical validation of theories which then become scientific laws v. Scientific laws over time become integrated to form a single system of knowledge and truth Positivism involved notions of reduction (making generalizations on the basis of perceived common characteristics), causality (assumption of cause and effect relationships) and simplicity (a simple explanation is preferable to competing, more complicated, ones). In the early 20th century, these principles were modified by a group of philosophers (including Hans Hahn and Rudolf Carnap) called the Vienna Circle into logical positivism, which held that to be considered meaninglful knowledge must be (i) empirical, (ii) objective, (iii) scientific, (iv) inductively derived and (v) verifiable. Logical positivism became the de facto approach to testing knowledge claims in the social sciences, including economics and accounting. However, with the burden of proof required to meet the verifiability criterion proving to be too arduous, it was later replaced by Karl Popper with falsifiability, the notion that a proposition is meaningful only if it can be falsified through testing. The move to falsifiability served to elevate the importance of testing. Logical positivism, as modified by Popper, is what is commonly referred to as the scientific method. Lesson 1: Introduction to Accounting Theory 2012, Harjinder Deol 4

1.4 A framework for scientific theory construction The starting point of theory construction is assumptions, beliefs about the area or subject to be theorized about. Assumptions can be a priori (knowledge independent of expertise), or a posteriori (knowledge derived from experience). Assumptions form the basis of axioms and postulates (considered to be true without requiring proof), principles and definitions. From these assumptions, concepts are developed. Some concepts are developed following a process called induction (observation of everyday phenomena), while others are developed through a process called hypothetico-deduction (testing hypotheses). Measurement is an important component of the scientific method. Measurement scales represent the hierarchy of the different types of measurement. These include (i) nominal scales, (ii) ordinal scales, (iii) interval scale and (iv) ratio scale.

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The framework for theory development is summarized graphically in figure 1 below.

Figure 1: Scientific theory construction

From: Gaffikin, M. (2008). Accounting Theory: Research, regulation and accounting practice. Frenchs Forest, NSW: Pearson Education Australia [37]

1.5 Paradigms and scientific revolutions In his book, The structure of scientific revolutions, Thomas Kuhn challenged the view that knowledge is cumulative. Each new major theory represents a break from the existing paradigm (dominant world view) because the new theory represents systems of thought that are incommensurable with the existing ones. Later, Imre Lakatos, argued that science develops through research programs rather than a single paradigm. A research program dominates thinking before being supplanted by another, more successful, one.

Lesson 1: Introduction to Accounting Theory 2012, Harjinder Deol

MGT 4160 2. What is accounting theory? As Ahmed Riahi-Belakoui, the author of a well-known text on the subject admits,

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A single generally accepted accounting theory does not exist at this time [although] several attempts have been made to formulate such a theory (p. ix).

Indeed, as Godfrey et al (pp. 18-20) point out, depending on the world view, there exists a range of accounting theories, including: i. Accounting as an historical record ii. Accounting as a language iii. Accounting as intracorporate politics iv. Accounting standard setting as politics v. Accounting as mythology vi. Accounting as magic vii. Accounting as communication-decision information viii. Accounting as an economic good ix. Accounting as a social commodity x. Accounting as ideology and exploitation xi. Accounting as a social club As Wolk et al explain:
The term accounting theory is actually quite mysterious. There are many definitions throughout the accounting literature *including+ the basic assumptions, definitions, principles and concepts and how we derive them that underlie accounting rule making by a legislative body. [It] also includes the reporting or accounting and financial information (pp. 2-3)

Most standard text-books, including the one we are using for this course, tend to use the term accounting theory exclusively for financial accounting (information used by investors, creditors, and other outside parties for analyzing management performance and decision-making purposes), thus excluding managerial or governmental accounting. Yet, even for financial accounting, there does not appear to exist a uniform theory. In its Statement of Accounting Theory and Theory Acceptance, the American Accounting Association concluded:
1. 2. No single governing theory of financial accounting is rich enough to encompass the full range of user-environment specifications effectively; hence, There exists in the financial accounting literature not a theory of financial accounting but a collection of theories which can be arrayed over the differences in user environment specifications.

In this course, we shall learn about some of these theories explaining financial accounting.

Lesson 1: Introduction to Accounting Theory 2012, Harjinder Deol

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2-1 Approaches to formulating an accounting theory

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Non-theoretical Pragmatic (practical) Authoritarian

Deductive Inductive Ethical Sociological Economic Eclectic

Based on Riahi-Belkaoui, A. (2004). Accounting Theory (5th ed.). London: Thomson Learning (p 110)

2.1 Classifications of accounting theories Of the various classifications that have been used, some important ones include classification based on: a) Research approaches: deductive versus inductive theories b) Use (or not) of value judgments: normative versus positive (descriptive) theories c) Scope of applicability: global versus particularistic theories

3. How does accounting research impact accounting theory? Prior to the 1970s, normative theories dominated in accounting. These theories tried to compete on their self-proclaimed merits. However, following the publication of seminal empirical studies in 1968, including Ball and Brown (1968) and Beaver (1968), normative theories began to cede status to positive (descriptive) research-based theories. The latter are heavily influenced by the financial-economics research tradition, and rely on underlying assumptions of market efficiency, rational decision making and the capital-asset-pricing-model (CAPM). Research in accounting falls under several major categories: i. Analytical: This includes: a. The decision-model approach b. Information economics c. Agency theory ii. Empirical a. Capital markets research iii. Experimental a. Behavioral research iv. Critical (or Alternative) Lesson 1: Introduction to Accounting Theory 2012, Harjinder Deol 7

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Analytical studies provided a mathematical proof of models which were usually built on a set of simplifying (often unrealistic) assumptions about human nature. Many of these studies were operationalized into empirical studies using archival accounting and securities market data. When some of the capital markets research began producing puzzling results, researchers started to draw upon theories from psychology, relaxing the assumption of rationality, giving birth to the traditional of behavioral experimental research. However, in spite of the growing body of literature from behavioral finance/accounting questioning the validity of assumptions of rational decision making, as well as less than compelling support for key assumptions such as market efficiency, capital markets research remains the dominant body of research in accounting. Starting in the 1980s, there has been a relatively smaller movement questioning the mainstream view of accounting. This highly fragmented body of literature is often called the Critical, or Alternative accounting literature. Studies in this tradition draw upon a variety of theories from sociology, including Marxism, Feminism, Post-Colonialism, Post-Modernist, etc.

Lesson 1: Introduction to Accounting Theory 2012, Harjinder Deol