Accounting Principles & Theories

• Accounting theory involves formulation and verification
• A theory is defined as a set of interrelated constructs, definitions, and propositions that present a systematic view of phenomena by specifying relations among variables to explain and predict phenomena

Characteristics of an Ideal Theory

• It should have a descriptive approach in general and a normative approach in particular

• It should be authentic, authoritative, and widely accepted

• It should explain current events correctly, analyze past events, and forecast future events

• It can potentially solve problems created by an event

• It is verifiable through hypothesis testing

• Underlying assumptions determine the usefulness of an accounting theory

• Theories are classified by the assumptions they rely on and their approaches to explaining and predicting actual events

• Classifications include pragmatic, normative, positive, and behavioral theories

Pragmatic Theories

• Based on observed behavior of accountants and reactions of users to accountants' outputs
• Descriptive pragmatic approach based on observation, test, and inductive reasoning
• Psychological pragmatic approach depends on observations of the reactions of users to the accountants' outputs
• Reactions are taken as evidence of usefulness and relevant

Criticisms of Pragmatic Theories

• Descriptive pragmatic approach does not consider quality of action nor provide for challenging accounting practices

• It focuses on accountants' behavior rather than attributes of the firm

• Psychological pragmatic approach can be illogical, preconditioned, or muted

• Theories require large samples of people for testing

• Pragmatic theories involve the effect of words or symbols on people

• The accounting concept and real-world events affect people's behavior

• Example: The release of an accounting standard may motivate some managers to lobby to withdraw it, and users of an accounting report may act on the same information

Normative Theories

• The 1950s and 1960s was its "golden age"
• Focuses on policy recommendations, what should be, and deriving true income and practices that enhance decision usefulness
• Based on analytic and empirical propositions
• Financial statements should mean what they say
• It is a market-based theories which use methods other than historical cost
• Respective concepts of true income and financial position
• Profit maximization is a main goal for management
• Constructed on the basis of deductive reasoning
• Regard the provision of information for decision making as the main function of financial statements
• A normative approach is based on value judgments or personal opinion that cannot be verified or tested

True Income

• A single measure for assets and a unique, correct profit figure

Decision Usefulness

• The basic accounting objective is to aid decision-making by providing useful data

Positive Theories

• Expanded in the 1970s
• Positivism or empiricism is based on testing, relating to accounting hypotheses or experiences
• Explain the reasons for current practice and predict the role of accounting information in decision-making
• Test theories that assume accounting information is an economic and political commodity
• People act in their own self-interest
• Asks why firms use SLM rather than diminishing balance depreciation?
• Considers incentives to encourage accounting method choice, costs, benefits of accounting methods, and valuation models for future returns and share prices

Normative vs. Positive Theories

• Normative theories are prescriptive and describe ideal accountant behavior
• Positive theories are descriptive, explanatory, or predictive of how people actually behave

Behavioral Theories

• Derived from psychology, sociology, and organizational theories
• Objectives: discover why people behave as they do
• It is the study of the behavior of accountants or non-accountants influenced by accounting and reports
• Focuses on judgement and decision making of accountants and auditors and influence of outputs on users' decisions
• It identifies how people use and process accounting information, and examines the decision-making activities of accounting information preparers, users and auditors
• Provides insight into how different decisions are produced, processed, and how people react to items of accounting information and communication methods
• It can lead to training and increased knowledge for accountants and provide useful information to accounting regulators

Formulation of Accounting Theory

• Can be approached through deductive, inductive, ethical, sociological, economic, or eclectic methods

Deductive Approach

• Moves from general propositions to logical conclusions
• Reasoning is from general statements to specific statements and is based on normative theory
• It begins by specifying objectives of financial statements, postulates of accounting, derives principles of accounting, then develops techniques of accounting
• Theories are derived from general to specific statements

Inductive Approach

• Theory construction begins with observation and moves toward general conclusion
• Reasoning is from particular statements to general statements
• Involves recording observations, analyzing and classifying observations to detect relationships, inducing generalizations and principles of accounting from these observations, then testing generalizations
• Theories are developed from specific to general statement to develop implication of observation

Key Differences in Approach

• In the deductive approach, the truth or falsity of the propositions are empirically proved
• In the inductive approach, the truth of the propositions depends on observation of sufficient instances of recurring relationships
• Accounting propositions that are derived from inductive inference only has high probability

Ethical Approach

• Revolves around fairness, justice, equity, and truth
• Concepts of fairness implies that accounting statements not subject to undue influence or bias
• Fairness of presentation means conformity with GAAP, disclosure, consistency, and comparability

Sociological Approach

• Emphasizes social effects of accounting techniques
• Accounting is evaluated on its reporting effects on all groups in society
• Accounting data should be useful in judgments on social welfare

Economic Approach

• Emphasizes controlling behavior of macroeconomic indicators from adoption of accounting techniques
• Choice of accounting techniques depends on impact on the national economic good
• Accounting policies and techniques should reflect "economic reality" and the choice of accounting techniques should depend on "economic consequences"

Eclectic Approach

• Formulation of accounting theory and development of accounting principles have followed an eclectic approach, combining approaches from different schools of thought
• The result of various attempts by professionals and governments to establish concepts and principles in accounting