Lecture 1 Introduction to Accounting Theory PDF

Lecture 1 Introduction to Accounting Theory 1 Recommended Textbooks Deegan, C. and Unerman, J. (2011). Financial Accounting Theory. European edition. 2nd ed. McGraw-Hill. (D&U) [Main text I] Rankin, M., Stanton, P., McGowan, S., Ferauto, K., Tilling, M. (2022)....

Lecture 1 Introduction to Accounting Theory 1 Recommended Textbooks Deegan, C. and Unerman, J. (2011). Financial Accounting Theory. European edition. 2nd ed. McGraw-Hill. (D&U) [Main text I] Rankin, M., Stanton, P., McGowan, S., Ferauto, K., Tilling, M. (2022). Contemporary Issues in Accounting. 3rd ed. Wiley. (R) [Main text II] Godfrey, J., Hodgson, A., Holmes, S. and Tarca, A. (2010). Accounting Theory. 7th ed. Wiley. (GHHT) [additional reading] Additional journal articles will be posted on blackboard for you to download. 1.2 Background reading for Lecture 1 D&U Chapter 1 Rankin et al. Chapter 1; Chapter 5, pp. 131- 134 GHHT Chapts. 1&3 1.3 Overview of Lecture 1 Definition of accounting theory Types of accounting theories Accounting theory development over time Relationship between theory and research Evaluation of theories 1.4 What is a theory? An organized way of thinking about a subject A set of ideas that explains something ‘a scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’ (Oxford English Dictionary) “theory is a statement of concepts and their interrelationships that shows how and/or why a phenomenon occurs” (Corley & Gioia, 2011: 12) 1.5 What is the purpose of theories? To make sense of the world (physical, social, psychological phenomena) and communicate that understanding to others To make sense of (financial) accounting information Financial statements, corporate annual reports Accounting info is compiled and interpreted by people 1.6  Types of theory Type of theory Users Example Common-sense Lay people It is not what http:// www.telegraph.co.uk/ theory (personal you know, but news/politics/ experience) who you know 10137928/Its-still- who-you-know-not- what-you-know-that- matters-say-two- thirds-of-Britons.html Working Managers, Crisis http:// www.bernsteincrisism theory investors, communication anagement.com/ auditors should articles/10-steps-of- (Generalisatio prioritise key crisis- ns made in stakeholders communications.html particular professions) Scholarly Academics Accounting Positive theory choice is Accounting driven by Theory 1.7  Scholarly theory Has undergone systematic research Provide more thorough, accurate, and abstract explanations for financial accounting than common-sense or working theories 1.8 What is the purpose of theories?  Theories are used to 1. Describe what people do = Descriptive theories 2. Suggest the best way (i.e., prescribe) to deal with specific types of human behaviour = prescriptive or normative theories 3. Explain and predict what people do = predictive or positive theories 1.9 1. Descriptive theories Describe what people do Based on common practice Describe  Common ways of avoiding high COVID-19 infection rates in various countries Describe accounting practice  Common practise of accounting for fixed assets Future accountants are trained by practising accountants 1.10 Descriptive theories Advantage: Tends to be accepted by majority Disadvantage: Does not entail critical evaluation Does not allow for change 1.11 2. Prescriptive (= normative) theories Also called normative theories What people should do Suggest best way to  Avoid high COVID-19 infection rates Prescribe particular accounting practices  Account for fixed assets, i.e., historical cost, current cost, exit price, etc. Advantage  Can improve accounting practises Disadvantage  Assumes that there is one ‘best way’ 1.12 3. Predictive (= positive) theories  Also called positive theories  Concerned with explaining reasons for outcomes and predicting future outcomes  Explain characteristics of people most likely to die of COVID-19, i.e., age, gender, ethnicity  Predict what effect a change in social behaviour will have on infection rates  Explain and predict accounting method choice  Characteristics of companies most likely to revalue their assets  What effect a change in accounting standards on leases will have on the way firms finance their assets 1.13 Comparison of descriptive, prescriptive and predictive theories Descriptive theories Prescriptive (normative) Predictive (positive) theories theories Descriptive “what is” Prescriptive Explanatory, predictive “what should be” “why it is” “what will happen” Non-value laden Value-laden Non-value laden* No empirical methodology No empirical methodology Empirically based * PAT Assumes specific human characteristics 1.14 Examples of uses of accounting theories Theories might: prescribe how assets should be valued predict why managers will choose particular accounting methods explain how an individual’s cultural background affects accounting information provided prescribe what accounting information should be provided to particular classes of stakeholders predict that the relative power of a stakeholder group will affect the accounting information it receives predict that accounting information is used to present organisations as legitimate 1.15 Accounting theories Accounting is a human activity Explain the behaviour of people within and outside of organisations with respect to accounting information Theories of accounting consider: Why people within organisations elect to provide particular information (preparer perspective) People’s behaviour with respect to accounting information (user-perspective) People’s needs for accounting information (user- perspective) 1.16 Accounting theories Accounting is a social phenomenon Accounting theories are theories about human behaviour Borrow from disciplines dealing with human behaviour  Psychology, sociology 1.17 Why do we need accounting theories? Accounting is viewed as a ‘practical’ discipline  Learning how to apply accounting rules Theories are necessary to understand the (social) world we live in  They provide a basis for the decisions we make, e.g. whether to include an item in the financial statements or not (materiality and recognition criteria) 1.18 Why do we need accounting theories? We can make better predictions and decisions if we get the contradictions out of our thinking, if we consider what is known on the many sides of the issue i.e., the various theories which exist on:  The regulation of accounting  e.g., whether we need accounting regulation or not  The provision of financial accounting information  e.g., why accountants choose particular accounting methods  The way financial information is received  e.g., how people react to particular accounting numbers 1.19 Why study accounting theories – to understand: Motivation for individuals to support or lobby regulators for some accounting methods in preference to others ( Regulatory theories) How and why the capital markets react to particular information ( Positive accounting theory) Whether there is a ‘true measure’ of income ( Asset valuation theories) 1.20 Overview of theories of accounting Many theories of financial accounting exist No universally accepted theory of accounting  Different perspectives about the central objective, role and scope of financial accounting No universally accepted perspective about the role of accounting theory  Different researchers have different perspectives of the role of accounting theory 1.21 Accounting Theory Timeline 1.22 Early development of accounting theory Descriptive theories Relied upon the process of induction Development of ideas or theories through observation 1920s to 1960s theories developed from observing what accountants did in practice Codified as doctrines or conventions of accounting 1.23 Criticisms of inductive method … ‘concentrates on the status-quo, is reactionary in attitude, and cannot provide a basis upon which current practice may be evaluated or from which future improvements may be deduced.’ (Gray, Owen and Maunders 1987, p. 66) Assumes what is done by the majority is the most appropriate practice Perspective of accounting Darwinism 1.24 Example of inductive approach to theory development Grady (1965) undertook research commissioned by the AICPA (American Institute of CPAs) Formed the basis of APB Statement No. 4 ‘Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises’ Reflected generally accepted accounting principles at the time 1.25 Theory development - 1960s and 1970s Sought to prescribe particular accounting practices Known as normative theories Not driven by existing practices Theories critical of historical cost accounting Sought to provide improved approaches to asset valuation in a time of widespread inflation 1.26 Example of prescriptive theory 1961 and 1962 studies by Moonitz, and Sprouse and Moonitz commissioned by the Accounting Research Division of the AICPA Authors proposed that accounting measurement systems be changed from historical cost to a system based on current values Not supported by AICPA as too radically different from current practice 1.27  Theory development - mid to late 1970s Research aimed at explaining and predicting accounting practice rather than prescribing particular practices Known as positive theories 1.28 Positive theories Seek to predict and explain particular phenomena Begins with assumption(s), and through logical deduction enables prediction(s) to be made If predictions are sufficiently accurate when tested against observations of reality, they are regarded as having provided explanation of why things are as they are 1.29 Testing a Theory in Research Theory plane 3. State 2. Develop 4. Construct research theoretical research design question/ framework hypothesis 1. Identify 5. Observe research problem 8. Assess 6. Analyse 7. Evaluate limitations and constraints Observation plane 30 Relationship between theory and research "... all research emanates from the researcher’ s implicit or explicit theory of the phenomenon under investigation" (Rocco & Plakhotnik, 2009: 121). 1.31 Evaluation of theories Theories of accounting are only abstractions of reality The choice of one theory in preference to another is based on value judgements Cannot expect to provide perfect explanations or predictions of human behaviour or assess what types on information users actually need 1.32 The role of assumptions Even though an argument is logical we might only accept the argument if we accept any critical assumptions being made  If we reject any central assumptions we may reject the prediction  E.g., people make rational decisions and are driven by money  Maybe people doe not always make rational decisions?  Maybe people are driven by the desire to help others? 1.33 Evidence Is there enough evidence to support the theory? Is there conflicting evidence? 1.34  Any questions? Engage in the discussion on the discussion board on blackboard Why do we need accounting theories? 1.35