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Accounting TheoryFifth Edition

Eldon S. HendriksenMichaelf. Van Breda

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Chapter 1:Introduction and Methodology of Accounting

Approach to Accounting Theory

A Tax Approach

A Legal Approach

An Ethical Approach

Economic Approaches

A Behavioral Approach

A Structural Approach

Classifying Accounting Theories

Theory as a Language

Theory as Reasoning

Theory as Script

Theory Verification

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What is a theory?

…the coherent set of hypothetical, conceptual andpragmatic principles forming the generalframework of reference for a field of inquiry.

Chapter 1: Introduction and Methodology of Accounting

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What is an accounting theory?…logical reasoning in the form of a set of broad

principles that Provides a better understanding of existing

practices to practitioners, investors, managers,and students

provide a general framework of reference bywhich accounting practice can be evaluatedand

guide the development of new practices andprocedures.

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Whether a theory is accepted depends onhow: well it explains and predicts reality. well it is constructed both theoretically and

empirically. Its implications are acceptable.

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Approaches to Accounting Theory

1. A Tax Approach:The objectives of tax accounting are very different from those of

financial reporting

Tax is not interested in measuring the income of a company, asestablishing a base for tax purposes

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Chapter 1: Introduction and Methodology of Accounting

Positive influence of tax accounting on financialreporting:

-The provision of depreciation gave rise to depreciationmethods, concepts & calculating depreciation costs.

-Appropriate methods for inventory valuation (Lower of Costor market)

- Court cases had considerable influence on development ofaccounting concepts

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Negative influence of tax accounting on financialreporting:

The tendency to accept income tax provisions as acceptedaccounting principles and practices. Like following thedepreciation method acceptable for tax purposes regardlessof whether or not it follows good accounting theory in thesituation

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2. A Legal Approach:In many situations there are economic as well as legal issues.

Lawyers & Accountant look at property and related concepts thesame way, but they don’t always arrive at the same conclusion.

Lawyers interested in income available for tax or income availablefor dividends.

Accountant interested in increment in value or a measure ofoperational efficiency

While Law certainty provides numerous examples that can stimulatethinking on accounting theory, it is seldom the deciding factor.

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3. An Ethical ApproachFundamental ethical questions are at the heart of all modern theorybuilding.

The ethical approach to accounting theory places emphasis on theconcepts of justice, truth, and fairness

Neutrality, absence of bias and representational faithfulness are bothconsidered necessary characteristics of a reliable accountingsystem.

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The term truth means “in accordance with the fact” – not all whorefer to truth in accounting have in mind the same definition of facts

Many associate the term truth with statements that they believe tobe established principles

This makes the truthfulness of the financial reports depend on thefundamental validity of the accepted rules and principles on whichthe statements are based.

This is an inadequate foundation for measuring truthfulness.

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4. Economic Approaches:Accountants have long attempted to interpret accounting concept in

terms of economic concepts

There are 3 different avenues in taking an economic approach toaccounting: macroeconomic, microeconomic, and the corporatesocial.

a. Macroeconomicsb. Microeconomicsc. Corporate Social

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Chapter 1: Introduction and Methodology of Accounting

a. Macroeconomic Approach:Attempts to explain the effect of alternative reporting procedureson economic measurements and economic activities at a levelboarder than the firm, such as an industry or the nationaleconomy. (What is the effect on the economy?)

b. Microeconomic Approach:Attempts to explain the effect of alternative reporting procedureson economic measurements and economic activities at the levelof the firm. (What is the effect on the stockholders?)

c. Corporate Social Accounting:Attempts to explain the effect of alternative reporting procedureson the society – The cost of the environmental pollution,unemployment, unhealthful working conditions, …. (What is theeffect on other stakeholders)

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Chapter 1: Introduction and Methodology of Accounting

5. A Behavioral Approach:Attempt to measure and evaluate the economic, psychological, andsociological effects of alternative accounting procedures andreporting media, on the users of accounting reports.

6. A Structural Approach:A classical approach, focuses on the structure of the accountingsystem itself. The accountants attempt to classify similar transactionsimilarly, to seek consistency in recording and reporting transactions.

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Chapter 1: Introduction and Methodology of Accounting

Classifying Accounting Theories

1. Theory as a Language:Relies on the notion that the accounting is a language.

* What effect will the words have on listeners?* What meaning, if any, do the words have?* Do the words make logical sense?

How to study language?Pragmatic is the study of the effect of languageSemantics is the study of the meaning of languageSyntactics is the study of the logic or grammar of the language

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Chapter 1: Introduction and Methodology of Accounting

Behavioral & Economic approaches are primarily pragmatic in style.

Structural approach is primarily syntactic.

Many accounting concepts still have no semantic content

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Chapter 1: Introduction and Methodology of Accounting

2. Theory as a Reasoning:In accounting: The generalizations are often termed postulate.

The Principles are the basis for practical application.

a. Deductive Reasoning:The arguments flow from generalization to specifics.Practical applications and rules (principles) are deduced from thepostulates.Objectives are an important part of the deductive process, becausedifferent objectives can require entirely different structures andresult in different principles.

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Chapter 1: Introduction and Methodology of Accounting

b. Inductive Reasoning:The arguments flow from specifics to generalizations.Principles are induced from best current practice, based uponpractical experience, and generalized as whole.

…………………………..

If we restricting ourselves to the financial data of a firm for example,we are drawing on certain postulates regarding the environment ofaccounting.If we restrict ourselves to observing only financial transactions, wewill only confirm existing practice.Induction & deduction, are complementary, almost all theories willinclude some elements of both deductive and inductive reasoning.

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Chapter 1: Introduction and Methodology of Accounting

3. Theory as Script:

a. Descriptive (Positive) theory:Explain what & how financial information is presented.Attempts to discover how management and others decide whichis the best way for them.Inductive theory by their nature are usually positive.

b. Prescriptive (Normative) theory:What data ought to be communicated and how they ought to bepresented.Attempts to discover the best way of accounting for atransaction.Deductive theories are not necessarily normative.

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Chapter 1: Introduction and Methodology of Accounting

Theory VerificationVerification may be defined as establishing the acceptability, or thetruth, of a theory.

Different theories are judged in different ways.

Normative theories are judged by the reasonableness of theirassumptions.

Positive theories are judged in two different way depending onwhether they have empirical content or not.

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Chapter 1: Introduction and Methodology of Accounting

Syntactic theories are positive theories which have no empiricalcontent. They are confirmed by logic alone.

Semantic theories are positive theories that do have empiricalcontent. They are confirmed by research studies. (whether usersunderstand the information procedures’ intended meaning)

Pragmatic theories are also positive theories with empirical content(emphasize the usefulness of accounting to investors and others)