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Chapter 1 Financial Accounting Theory

a. What is a Theory?
Henderiksen (1970) Theory is defined as :
A coherent set of hypothetical, conceptual and pragmatic principles forming
the general framework of reference for a field of inquiry
Financial Accounting Standards Board (FASB) a coherent system of interrelated
objectives and fundamentals that can lead to consistent standards.
theories of financial accounting
Accounting is a human activity and will consider such thing as peoples behavior
and/or peoples needs as regards financial information, or the reason why people
within organizations might select to supply particular information to particular
stakeholder group.
Theories will include consideration of:
Prescribe how, asset should be valued for external reporting purpose
(normative theories Current cost accounting), based on a particular
perspective of the role of accounting.

Predict that managers paid bonus on the basis of measures such as profits
will seek to adopt those accounting method that lead to an increase in
reported profit (i.e. Positive Accounting theory)

Predict that the relative power of a particular stakeholder group.

Seek to explain how an individuals cultural background will impact on the


types of accounting information to provide to people outside the organization.

Predict that organization seeks to be perceived by the community as


legitimate and that accounting information can be used as a means of gaining,
maintaining or regaining the legitimacy to the organization (i.e. Legitimacy
Theory)

b. A brief overview of theories of accounting


Different researchers have different perspectives of the role of accounting theory.
a. Some researchers believe that the principal role of accounting theory should
be to explain and predict particular accounting-related phenomena.
b.

Other researchers believe that the role of accounting theory is to prescribe


particular approaches to accounting based on a perspective of the role of
accounting. E.g. a theory that prescribes the assets should be valued on the
basis of market values rather than historical costs.

Early development of accounting theory relied on the process of induction, that is,
the development of ideas or theories through observation.
Period 1 (1920s to early 1960s)
From the 1920s to the 1960s, theories of accounting were predominantly
developed on the basis of observation of what accountant actually did in practice.
That is, they were developed by the process referred to as induction. This can be
contrasted with a process wherein theories are developed by deductive reasoning,
which is based more upon the use of logic rather than observation.
Period 2 (1960s and 1970s)
While some accounting researchers continued to adopt an inductive approach, a
different approach becomes popular in the 1960s and 1970s. This approach
sought to prescribe particular accounting procedures, and as such was not driven
by existing practices. I.e. theories being developed based on development of
arguments about what the researchers considered accountant should do.
Rather than being developed on the basis of inductive reasoning, these theories
were being developed on the basis of deductive reasoning.
Period 3 (Late 1970s)
In the mid to late 1970s, there were further changes in the focus of accounting
research and development and a great deal of accounting research had the major
aim of explaining and predicting accounting practice, rather than prescribing
particular approach.

c. Positive research
Research that seeks to predict and explain particular phenomena is classified as
positive research and the associated theories are referred to as positive theory.
A positive theory begins with some assumption(s) and, through logical deduction,
enables some prediction(s) to be made about the way things will be.
If the prediction is sufficiently accurate when tested against observations of reality,
then the story is regarded as having provided an explanation of why things are as
they are. E.g. A positive theory of accounting may yield a prediction that, if certain
conditions are met, then particular accounting practice will be observed.
Positive theories can initially be developed through some form of deductive
(logical) reasoning. Their success in explaining or predicting particular phenomena
will then typically be assessed based on observation that is, observing how the
theorys predictions corresponded with the observed facts.
Positive Accounting Theory is developed by Watts and Zimmerman, which seeks
to predict and explain why managers elect to adopt particular accounting methods
in preference to others. The theory relied in great part of work undertaken in the
fields of economics, and central to the development of Positive Accounting Theory
was the acceptance of economics based rational economic person assumption.
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That is the assumption that an accountant are primarily motivated by self-interest,


and that the particular accounting method selected will be dependent on certain
conditions.
Factors - FAT
1. Assumption : self-interest
2. Premises :
a. The accountant is rewarded in terms of accounting-based bonus;
b. The organization they work for is close to breaching negotiated accounting
based debt covenants.
However, PAT does not seek to tell us that what is being done in practice is the
most efficient or equitable process.

d. Normative research
While positive theories tend to be based on empirical observation, there are other
theories based not on observation but rather on what the researcher believes
should occur in particular circumstances. Theories that prescribe particular
actions are called normative theory.
For example, Chambers Continuously contemporary accounting describes how
financial accounting should be undertaken. It is prescriptive and central to this
theory is a view that most useful information about an organizations assets for the
purpose of economic decision is information about their current cash equivalent.
Normative theories of accounting are not necessarily based on observation and
therefore cannot (or should not) be evaluated on whether they reflect actual
accounting practice.
The conceptual framework of accounting is an example of a normative theory of
accounting. Relying on various assumptions about the types or attributes of
information useful for decision making, The CFA provides guidance on how assets,
liabilities, expenses, income and equity should be defined, when they should be
recognized, and ultimately how they should be measured.
e. Evaluating theories of accounting
The Positive Accounting theorist and the normative theorist would be considered
to be working from different paradigms which provided greatly different
perspectives about the role of accounting research.
Argument between PAT and Normative Theorist:
Proponents of PAT have at different times, tried to undermine normative research
because it was not based on observation (observation-based research was
deemed to be scientific and scientific research was considered to be akin to good
research, but rather was based on personal opinion about what should happen.
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Rationale
PAT theorist often argue that in undertaking research they do not want to impose
their own views on others as this is unscientific, but rather they prefer to provide
information about the expected implications of particular actions and thereafter let
people decide for themselves what they should do.
However, as a number of accounting academics have quite rightly pointed out,
selecting a theory to adopt for research such as public theory or PAT is based on a
value judgment; what to research is based on value judgment, believing that all
individual action is driven by self-interest as the PAT do is a value judgment, and
so on.
Positive theories are value laden
Tinker et al.(1982) argue that all research is value laden and not socially neutral.
Competition among theories to meet users demand constraints the extent to
which researcher values influence research design. Positive theories are if..then
propositions that are both predictive and explanatory. Researchers choose the
topics to investigate, the method to use, and the assumptions to make.
Researchers preferences and expected payoffs affect the choice of topics,
methods and assumptions, In this sense, all research, including positive research
is value laden.
f. Can we prove a Theory?
In relation to the issue of whether we can prove a theory or not, it is useful to refer
to insights provided by a group of theorist knows as falsification(ists) the major
leader of which is considered to be Karp Popper.
Popper, and the falsification(ists), considers that knowledge develops through
trial and errors. To develop hypotheses from a theory of a researcher, the
falsification(ist)s believe that these hypotheses must be of a form that allows them
to be rejected if the evidence is not supportive of the hypotheses.
According to Popper and other falsificationists, knowledge develops as a result
of continual refinement of a theory. When particular hypotheses are deemed to be
false through lack of empirical support, the pre-existing theories will be refined (or
abandoned).
Chambers provides a useful overview of falsificationisem. He states:
The falsification freely admits that observation is guided by and presupposes
theory. He is also happy to abandon any claims implying that theories can be
established as true or probably true in the light of observational evidence.
It is always safer to say that our evidence supports a theory but that it is also
possible that we might embrace an alternative theoretical perspective at a future
time should better explanation for a particular phenomenon become available.
g. Evaluating theories consideration of logic and evidence
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Logical deduction
Acceptance of a theory and its associated hypotheses must be tied to whether we
accept the logic of the argument, the underlying assumptions and any supporting
evidence provided.
An argument is logical to the extent that if the premises on which it is based
are true, then the conclusion will be true. That is, the argument (even if
logical) will only provide a true account of the real world if the premises on
which it is based are true.
The positive theories of accounting has a number of central assumptions,
including an assumption that all people are opportunistic and will adopt particular
strategies to the extent that such strategies lead to an increase in the personal
wealth of those parties making the decision.
That is self-interest is a core belief about what motivates individual action.
Central Premises
For Conceptual Framework of Accounting model, it is based on a central premise
that the objective of financial accounting is to provide information that allows users
of general purpose financial reports to make and evaluate decision about the
allocation of scarce resources. If we were not accepted this central premises then
we could reject the guidance provided by the framework even if it could be
considered to be logically structured.
Human factor
While we must always consider the logic of an argument and the various
assumptions that have been made, what we also must remember is that theories,
as particularly those in the social science by nature are abstractions of reality. We
cannot really expect particular theories about human factor to apply all the time.

Chapter 2 The Financial Report Environment


1. Introduction
1 Financial Accounting is a process involving the collection and processing of
financial information to assist in the making of various decisions by many
parties external to the organiation.
2 It is not possible to generate reports that will satsify each partys needs. As
such, the process of financial accounting leads to the generation of reports
deemed to be general purpose financial reports.
3 Ideally, users of financial reports should hava a sound working knowledge of
the various accounting standards because, arguably, without such knowledge
it can be difficult to interpret what the reports are actually reflecting.
4 The accounting results will be heavily dependent upon the particular
accounting methods chosen, as well as upon various professional judgements
made. Depending upon who complies the accounting reports, measures of
profits and net assets vary greatly.
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2. An Overview of the development and regulation of accounting practice


One of the first to document the practice of double entry accounting was a
Franciscan monk by the name of Pacioli. A revoew of this work indicates that our
current system of double entry accounting is very similar to that developed many
hundreds of years ago. There were debits and credits, with debits going on the
left, credit on the right. There were also jounrals and ledgers.
There is an increasing trend towards the view that financial accounting should
reflect the various social and environmental consequences of a reporting entrys
existence. Unfortunately, however, our dated double enty system has a general
inability to take such consequences into account.
While accounting and accountants have existed for hundreds of years, it was not
until the nineteenth century that accountants within the UK and the US banded
together to form profesional association.
In the early part of the twentieth century, there was limited work undertaken to
codify particular accounting principles or rules. There was limited work undretaken
to codigy particular accounting principles or rules. There was also very limited
uniformity between the accounting methods adopted by different organizations
thereby creating obvious comparability problems.
The development of mandatory accounting standards is a relatively recent
phenomenon.
3. The rationale for regulating financial accounting practice.
Most developed countries, there is a multitude of accounting standards covering a
broad cross-section of issues but do we need all this regulation?
There are two broad schools of thought on this issue.
a. Regulation is not necessay
- accounting information will be prepared to pay for it to the extend that it
has use;
- capital markets require information and any organ that fails to provide
information will be punished by the market;
- Regulation will lead to over-supply of information as users will tend to
overstate the need for the information;
- Regulation typically restricts the accounting methods that may be used in
order to reflect their particular performance and position.
b. Regulation is required
- Markets for information is not efficient
- Free market ignore the right of individual investors
- Parties with limited power will generally be unable to secure information
about an organisation
- Regulation leads to uniform methods being adopted by different entities
thus enhancing comparability
- Investors need protection from fradulent organisation that may produce
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misleading information.
Theories available to describe who benefit from such regulation
A. Public Interest theory of regulation
The theory proposes that regulation be introduced to protect the public.
This theory assumes that the regulatory body is a neutral arbiter of the public
interest and does not let its own self-interest impact on its rule-making
processes.
Rationale: The protection may be required as a result of inefficient market.
B. Capture theory of regulation
A contrary perspective of regulations is provided by captured theory which
argues that although regulation is often introduced to protect the public, the
regulatory mechanisms are often subsequently controlled (captured) so as to
protect the interests of particular self-interested groups within society.
Rationale: The regulated tend to capture the regulator. Posner argues
that the original purposes of the regulatory program are later thwarted
through the efforts of the interest group.
C. Economic interest theories of regulation
The theory assumes that everybody acts in their own self-interest, including
regulators and those people that are regulated.
Rationale: Regulators will only propose and support regulation which leads
to favorable outcomes for themselves, perhaps in terms of their re-election.

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