chapter 2 godfrey
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CHAPTER 2 ACCOUNTING THEORY
CONSTRUCTION
Godfrey, J., Hodgson, A., Tarca, A., Hamilton, J. and
Holmes, S.
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I. THEORY FORMULATION
A. What is a theory
In the simplest form: theory is a statement of a belief
expressed in a language.
Theories are logical arguments; their concludingstatements of belief are hypotheses.
Such theories comprise a set of premises (statements)
that are logically connected to give rise to thehypothesis.
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Two different approaches to theory development:
1. Deductive reasoning:
From general premises to develop predictions,
prescriptions or explanations of specific
matters.
2. Inductive reasoning:
From specific observations to develop a general
implication of those observations.
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PANEL B: The nature of the Plant and Machinery account
DEDUCTION
P1 All assets accounts have debit balances.
P2 The Plant and Machinery account is an asset account.
_______________________________________________________
C The Plant and Machinery account has a debit balance.
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 account is an asset account and has a debit
balance.
______________________________________________________
C All asset accounts have debit balances.4
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B. Parts of a theory
A theory must be expressed in a language, which canbe either verbal or mathematical.
Theory development begins in the ‘unreal’ world ofabstraction – that is, in the human mind. But for it
to be useful, theory must eventually relate to the‘real’ world, the world of experience.
Note that the impetus (driving force) for a theory islikely to derive from the real world but the start of a
theory is the intellectual reasoning in ‘the abstractworld’.
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PARTS OF A
THEORY
Syntactic Semantic Pragmatic
Three types of relationship in the theoreticalstructure that should be noted are the syntactic,semantic and pragmatic relations.
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Parts of a Theory(a) Syntactic relationship
The first relationship is the syntactic orlogical relationship, linking together thebasic concepts.
This relation has to do with the rules of thelanguage employed. For example, if thetheory is expressed in English, then this
relation refers to the rule of grammar; if thetheory is mathematical, then this relationrefers to the rules of mathematics.
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Evaluating the syntactic relation of atheory involves evaluating the validity (i.e.the logic) of the argument that constitutesthe theory. It does not involve establishing
the truth of an argument.
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For example, take the following argument:
Premise 1: All accounts relating to assets have debitbalances.
Premise 2: The accumulated depreciation account
relates to assets.
_____________________________________________
Conclusion: The accumulated depreciation account has
a debit balance.
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The conclusion, or hypothesis, that the accumulated
depreciation account has a debit balance is clearlyincorrect. However, the logic (syntactic relationship) is
valid because if the premises were both true, the
conclusion would also be true.
(Premise 1 is incorrect because contra assets have
credit balances.)
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(b) Semantic relationship
Semantics = branch of linguistics concerned withmeaning.
The second relationship is the semantic
relationship, which link the basic concepts of atheory to objects in the real world.
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For example, consider the following argument:
Premise 1: All asset accounts have debitbalances.
Premise 2:The sales returns account is not an
asset account.________________________________________Conclusion: The sales returns account has a
debit balance.
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The conclusion that is reached is true because inthe real world sales returns accounts have adebit balance. However, if we look at the logicflowing from premises 1 and 2, then thestatement is not true. Hence, in this case truthis inductively derived from the observation.
If we have semantic rules for linkingpropositions to objects or events and analyticrules for linking basic concepts, we can thenform hypotheses or theories, which have bothempirical and syntactic content.
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(c) Pragmatic relationship
The third relation is the pragmatic relation. Manytheories do not have a pragmatic aspect. This relation
pertains to the effect of words or symbols on people.
The nature of accounting is such that an overall theoryof accounting must have a pragmatic orientation. We
are interested in how accounting concepts and their
real-world corresponding events or objects affect
people’s behaviour.
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Accounting information must satisfy the informationneeds of users.
Observe that people react to the same message indifferent ways. For example, the release of anaccounting standard may motivate some managers tosupport that standard while others will lobby for its
withdrawal.
Investors or other users of accounting reports who basetheir actions on the same information might either buy
or sell on the stock market.
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THE MAIN PURPOSE OF THIS CHAPTER IS TO PROVIDE
SOME INSIGHT INTO HOW ACCOUNTING THEORIES
HAVE BEEN HISTORICALLY FORMULATED.
II. PRAGMATIC THEORIES A. Descriptive pragmatic approach
An inductive approach to accounting theory
development – it is based on continual observation of
the behaviour of accountants in order to copy theiraccounting procedures and principles. Accountants
were trained by being apprenticed or articled to a
practicing accountant for a number of years.
Descriptive pragmatic is probably the oldest and most
universal method of accounting theory construction.
Sterling refers to this method as the anthropological
approach.
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Criticisms:
1.The descriptive pragmatic approach does not include
an analytical judgement of the quality of anaccountant’s actions; there is no assessment ofwhether the accountants report in the way in which heor she should.
2.This approach does not provide for accountingtechniques to be challenged, hence it does not allow forchange. For example, we observe practicingaccountant’s methods and techniques and teach those
methods and techniques to students. But thosestudents will become practicing accountants whom wewill observe in the future to learn what to teach, andso on.
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3.The descriptive pragmatic approach focuses attention
on accountants’ behaviour, not on measuring the
attributes of the firm such as assets, liabilities andprofit. In taking a descriptive pragmatic approach, we
are not concerning ourselves with the semantics of
accounting phenomena.
Sterling comments:
‘……………..it is my value judgement that the theory
of accounting ought to be concerned with accounting
phenomena, not practicing accountants, in the sameway that theories of physics are concerned with
physical phenomena, not practicing physicists.”18
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B. Psychological pragmatic approach
Psychological pragmatic approaches observe users’responses to the accountants’ outputs (such as the
financial reports). A reaction by the user is taken as
evidence that the financial statements are useful and
contain relevant information.
One problem that will arise is that each individual will
react differently to the financial information.
Therefore, we have to rely on decision theories, whichis a refinement of the psychological approach.
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II. SYNTACTIC AND SEMANTICTHEORIES
Traditional historical cost accounting has beentheoretically interpreted as almost completely asyntactic theory.
This interpretation of accounting theory may bedescribed as follows:
the semantic inputs of the system are thetransactions and exchanges recorded in thevouchers, journals and ledgers of the business.
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All these steps were accomplished on the basis
of the premises and assumptions of historical
cost accounting; inflation is not to be recorded
and market values of assets and liabilities are
ignored.
Use double-entry accounting and the principlesof historical cost accounting to calculate profit
and loss and the financial position.
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The individual propositions are verified every
time the statements are audited by checking the
calculations and manipulations.
However, the accounts are rarely audited
specifically in terms of whether and how people
will use them (a pragmatic test).
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Criticism:
1. The theory has semantic content only on the basis of
its inputs.
2.There is no independent empirical operation to verify
the calculated outputs, for example ‘income’ or ‘total
assets’.
These figures are not observed; they are simple
summations of account balances and the auditing
process is, in essence, simply a recalculation.
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Sterling comments:
If one were to confirm a theory of astronomy, as
illustrated by a particular planetarium, one will
check on the accuracy of the observational inputs,
and check for errors in computation. However, atsome point, the outputs of the system would be
verified by looking at the sky to see if the stars
were in fact in the position indicated by the
planetarium.
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3. Traditional historical cost accounting has also
been criticised on the basis of its syntactic, for
example, with respect to the practice of summingseveral different money amounts assigned to
specific assets (i.e. summing of cash held today
with cash paid for land 20 years ago, which the
company still holds today).
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4.Further criticism by Chambers:
The internal inconsistency of historical cost accountingis similar to the philosophy of doublethink.
Doublethink means the power of holding two
contradicting beliefs in one’s mind simultaneously, and
accepting both of them.
For example, valuations are incorporated in balance
sheets… but the balance sheet is not a valuation
statement. Fixed assets should be carried at cost … inhistorical accounts, unless such cost is no longer
meaningful.
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5.There are many imprecision of definitions in
accounting. In terms of Popperian approach to
science, many of the propositions of conventionalaccounting are not falsifiable.
Popperian approach of verifying theory:
All hypotheses proposed must be capable of
falsification. If a hypothesis is not proposed or worded
so that it is falsifiable, then it is not informative and
does not add to scientific progress. Once proposed, ahypothesis needs to be tested rigorously and ruthlessly
by both analytical and empirical analysis.27
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In defence of the historical cost system:
Historical cost accountants however, argue that there is no
requirement that accounting outputs should have anysemantic content or be subjected to falsification rules
because the purpose of accounting is to allocate the
historic cost of resource usage against revenue, which is
the matching concept.
Hence, assets, liabilities and owner’s equity are residuals
from this process; they are not meant to measure or say
anything about value or the financial state of affairs.
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III. Normative Theories
The 1950s and 60s were described as the ‘goldenage’ of the normative theories. During this period
accounting researchers became more concerned
with policy recommendations and with what
should be done, rather than with analysing andexplaining current or accepted practice.
The focus in this period was either deriving the
‘true income’ or on discussing the type ofaccounting information, which would be useful in
making economic decisions.29
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III. Normative Theories
A. True income
True incometheorists concentrated on deriving a
single measure for assets and a unique (and correct)
income figure.
However, there was no agreement on what constituted
correct or true measure of value and income.
Much of the literature during this period consisted of
academic debate on the merits and demerits of each
system. 30
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III. Normative Theories
B. Decision-usefulness
This approach assumes that the basic objective of
accounting is to help the ‘users’ of accounting
reports in their decision-making process byproviding relevant and useful information.
For example, to help investors (current and
potential) decide whether to buy, hold or sell
shares. One test of usefulness already discussed
is the psychological pragmatic reaction to data.31
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In most cases, these theories were based on
classical economic concepts of profit and wealth
or rational decision-making.
They usually make adjustments to account for
inflation or the market value of assets. Theyare, in essence, measurement theories of
accounting.
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They are normative in nature because they make the
following assumptions:
1.accounting should be a measurement system;
2income and value can be measured precisely;
3.financial accounting is useful for making economic
decisions;
4.markets are inefficient or can be fooled by ‘creative
accountants’;
5.conventional accounting is inefficient (in information
sense);
6.there is one unique income measure.
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These assumptions were rarely subjected to
any empirical testing. Proponents usuallydescribed their derived accounting system
as ‘ideal’, recommend it replace historical
cost, and prescribed its use by all.
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IV. Positive Theories
During the 1970s, accounting theory saw a move
back to empirical or positive methodology.
Positivism or empiricism means testing or
relating accounting hypotheses or theories backto the ‘experiences’ or ‘facts’ of the real world.
At first, positive theories focused on empirical
testing of some of the assumptions made by the
normative accounting theorists.
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For example, in testing the usefulness of
different accounting techniques:
The researcher would survey the opinions of
financial analysts, bank officers or accountants
on the usefulness of different inflationaccounting methods in their decision-making
tasks (such as predicting bankruptcy, or deciding
whether to buy or sell shares.
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Today, positive theory is primarily concerned
with ‘explaining’ the reasons for current
practice and in ‘predicting’ the role ofaccounting and associated information in the
economic decisions of individuals, firms and
other parties that contribute to the operation of
the marketplace and the economy.
This research tests theories that assume that
accounting information is an economic and
political commodity, and that people act intheir own self-interest.
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Positive accounting theory (PAT) covers
questions such as:
Do firms substitute alternative ways of financing
assets when the rules governing the accounting
for leases change?
Which firms are more likely to use straight-line
depreciation rather than diminishing-balance
depreciation, and why?
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The theory used to answer these questions
generally revolves around
managers’ incentives to maximise bonuses basedon their companies’ profits,
their incentives to avoid breaching accounting-
based debt covenants and thereby reducing the
cost of debt,
or their incentives to use accounting techniques
to divert attention from their high profits if those
profits would attract public or government
scrutiny, and perhaps lead to higher taxes.
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Th idiff bt ti d iti th i
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Normative
Theories
Positive Theories
Prescriptive Descriptive, explanatory or predictive
Prescribe how
people such as
accountants
should behave toachieve an
outcome that is
judged to be right,
moral, just or a
‘good’ outcome.
Do not prescribe how people (e.g. accountants) should
behave to achieve an outcome that is judged to be
‘good’.
Rather, they avoid making value-laden prescriptions.
Instead, they describe how people do behave
(regardless of whether it is ‘right’;
they explain why people behave in a certain manner,
e.g. to maximise share values or their personal wealth
(regardless of whether that is ‘right’);
or they predict what people have done or will do
(again, regardless of whether that is ‘right’ or ‘best
behaviour’).
The main difference between normative and positive theories:
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Many positive theory researchers are largely
dismissive of normative viewpoints.
Similarly, many normative theorists do not accept the
value of positive accounting research.
In fact, the theories can coexist, and can complement
each other.
PAT can help provide an understanding of the role of
accounting which, in turn, can form the basis for
developing normative theories to improve the
practice of accounting.
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THANK YOU
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