Accounting Theory Formulation & Verification - PDF

TOPIC 2: FORMULATION AND VERIFICATION OF ACCOUNTING THEORY PART 1- SMA/UITM/PA  …………………recall: Theory formulation /construction A theory is defined as a set of interrelated...

TOPIC 2: FORMULATION AND VERIFICATION OF ACCOUNTING THEORY PART 1- SMA/UITM/PA  …………………recall: Theory formulation /construction A theory is defined as a set of interrelated constructs (concepts), definitions, and propositions that present a systematic view of phenomena by specifying relations among variables with the purposed of explaining and predicting the phenomena (Kerlinger, 1964). SMA/UITM/PA  should have descriptive approach in general and a normative (prescriptive) approach in particular. having the quality of authenticity and also authoritative. Must be wide acceptance. Characteristics The ability to evaluating and explaining the current events correctly. of ideal theory The ability analysing past events and forecast future events the potentiality of solving the problems created by the happening of an event. verifiable through testing of hypothesis. SMA/UITM/PA  ►How a particular accounting theory is useful? –The underlying assumptions ► Classify the theories according to the (1)assumptions they rely on, how they are (2) formulated and their approaches to explaining and predicting actual events. ► ► Pragmatic, ► Normative, ► Positive, and ► Behavioural SMA/UITM/PA  Pragmatic theories Descriptive pragmatic approach Criticisms of descriptive pragmatic approach: based on observed behavior of does not consider the quality of an accountants accountant’s action theory developed from how does not provide for accounting practices to accountants act in certain situations be challenged tested by observing whether focuses on accountants’ behaviour not on accountants do act in the way the measuring the attributes of the firm theory suggests is an inductive approach SMA/UITM/PA  Pragmatic theories Psychological pragmatic approach: Criticisms of descriptive pragmatic approach: theory depends on observations of the reactions Criticisms of the psychological pragmatic approach: of users to the accountants’ outputs – some users may react in an illogical manner a reaction is taken as evidence that the outputs – some users might have a preconditioned response are useful and contain relevant information – some users may not react when they should Theories are therefore tested using large samples of people SMA/UITM/PA  This relation pertains to the effect of words or symbols on people Pragmatic How accounting concept and their real world corresponding events or object theories affect people’s behavior Example Release of accounting standard may Users of accounting report who base motivate some managers to support their action on the same information the standard or lobby to withdraw it SMA/UITM/PA  Normative theories ► 1950s and 1960s ‘golden age’ ► policy recommendations ► what should be ► concentrated on deriving: ► true income (profit) ► practices that enhance decision-usefulness ► based on analytic and empirical propositions Financial statements should mean what they say SMA/UITM/PA  ►Features: ► Market-based theories which use methods other than historical cost method. ► Respective concepts of true income and financial position. Normative ► Assume profit maximisation is the primary goal Theories of management. ► Constructed on the basis of deductive reasoning. ► Regard the provision of information for decision making as the main function of financial statements. ► SMA/UITM/PA  Normative Theories True income: Decision usefulness: a single measure for assets the basic objective of accounting is to a unique and correct profit figure aid the decision-making process of certain ‘users’ of accounting reports by providing useful accounting data SMA/UITM/PA  Normative theories ► Normative approach is based on value judgments or personal opinion; and these value judgments cannot be verified or tested. SMA/UITM/PA  Positive theories Positivism or empiricism means testing or Expanded during the relating accounting Explain the reasons for 1970s hypothesis or based on current practice ‘experiences’ or ‘facts’ of the real world Test theories that Predicting the role of assume that People act in their own accounting information accounting information self interest in decision-making is an economic and political commodity SMA/UITM/PA  Positive theories Test theories that assume that accounting Why firms likely use SLM The theories of people act information is an rather than diminishing in their own self interest economic and political balance depreciation? commodity Look at costs and benefits of alternative accounting Managers incentives to methods and which choose accounting valuation models give the method best prediction of future returns, share prices, etc. SMA/UITM/PA  Main differences between normative and positive theories: ► Normative theories are prescriptive ❖ Describe how accountant should behave to achieve an outcome that is judged to Normative vs be right and good income ► Positive theories are descriptive, Positive explanatory or predictive ❖ Describe how people do behave regardless whether it is right, explain why people behave in certain manner or predict how people will react/ do? SMA/UITM/PA  Behavioural THEORIES Derived from discipline such as psychology, sociology and organisational theories. Objectives is to discover why people behave as they do. According to Hofstedt and Kinard (1970), behavioural accounting research is defined as: “The study of the behaviour of accountants or the behaviour of non-accountants as they are influenced by accounting functions and reports” Encompasses: ▪ Judgement and decision making of accountants and auditors; and ▪ Influence of the output on users’ judgements and decisions making. SMA/UITM/PA  Behavioural Approach Important of Behavioural accounting research : ▪ Identifies how people use and process accounting information. Specifically, it examines the decision-making activities of the preparers, users and auditors of accounting information. ▪ Provides valuable insight into the ways of how different decisions are produced, processed and how people react to particular items of accounting information and communication methods. By improving the decision making process, users of financial information can avoid making bad decisions that lead to losses, and preparers and auditors of financial information can avoid being sued. SMA/UITM/PA  It can lead to training and increase in knowledge for accountants to improve their skills in information gathering, processing and communication. It can provide useful information to accounting regulators, particularly in the aspect of providing decision-useful information to the users of financial statements. Can directly study specific accounting options and then report to standard setters on which methods or disclosures improve users’ decision. It can lead to efficiencies in the work practices of accountants and other professionals. For example, a computerised expert system for decision making can be developed through the harnessing and recording of the expertise and skills of experienced accountants using the behavioural research methods. This system will then be used to train inexperienced practitioners. Some auditors have also used behavioural research methods to develop an expert system to conduct risk assessment of potential audit clients. SMA/UITM/PA  Formulation of Accounting Theory Deductive Inductive Ethical Approach Approach Approach Economic Sociological Approach Eclectic Approach Approach SMA/UITM/PA  Formulation of Accounting Theory under deductive and inductive Two approaches to theory formulation ❑ Deductive Approach The approach moves from the general (basic propositions or premise) to derive logical conclusion. Reasoning from general statements to specific statements Eg: All humans are opportunistic Managers are human Managers are opportunistic Based on normative theory SMA/UITM/PA  Formulation of Accounting Theory under deductive and inductive The construction of a Two approaches to theory begins with theory formulation observation and moves Inductive Approach toward generalized Eg: self interest -> wealth Based on positive theory conclusion. Reasoning maximization from particular statements to general statements PREDICTION: Manager A Manager A- bonus - Acc method A – Acc method B- decreases is more likely to opt for >reported profits: increases reported profit reported profit Acc method A SMA/UITM/PA  The deductive approach-what should be Steps used to derive the deductive approach Specifying the objectives Selecting the postulates of Deriving the principles of Developing the techniques of financial statements. accounting (assumption) accounting. of accounting. (Theories developed from general statement to specific statement/ to develop predictions, prescription or explanation on specific matters) SMA/UITM/PA  Premise 1: All asset accounts have debit balances. Premise 2: The land and building Example account is an asset account. Conclusion: The land and building account has a debit balance. SMA/UITM/PA  The inductive approach Steps used to derive the inductive approach 1. Recording all observations observation (i.e. phenomena, event of things), 2. Analyzing and classifying and explain these observations to detect recurring relationships. 3. Inductive derivation of generalizations and principles of accounting from observations that depict recurring relationships (making conclusion). 4. Testing the generalizations. (Theories developed from specific statement/observation to develop general statement / implication of those observation ) SMA/UITM/PA  Premise 1: The Land and Buildings account is an asset account and has a debit balance. Premise 2: The motor vehicle account is an asset account and has a debit balance. Example Premise 3: The plant and machinery account is an asset account and has a debit balance. Conclusion: All assets accounts have debit balances. SMA/UITM/PA  In the deductive approach, the truth or falsity of the propositions does not depend on other propositions, but must be empirically verified. Comparing In the inductive approach, the truth of the deductive propositions depends on the observation of sufficient instances of recurring relationships. and inductive Accounting propositions that result from inductive inference imply special accounting techniques only with high probability. approach Accounting propositions that result from deductive inference lead, on the other hand, to specific accounting techniques with certainty. SMA/UITM/PA  The basis core consists of the concepts of fairness, justice, equity and truth The ethical In general, the concepts of fairness implies that accounting statements have approach not been subject to undue influence or bias. The committee on auditing procedures refers to fairness of presentation as conformity with GAAP, disclosure, consistency and comparability. SMA/UITM/PA  The sociological approach ► Emphasizes the social effects of accounting techniques. ► According to this approach, a given accounting principle or technique is evaluated for acceptance on the basis of its reporting effects on all groups in society. ► Implies that accounting data will be useful in making social welfare judgments. SMA/UITM/PA  Emphasizes controlling the behavior of macroeconomic indicators that result from the adoption of various accounting techniques. The The choice of different accounting economic techniques depends on their impact on the national economic good. approach Accounting policies and techniques should reflect ‘economic reality’ and the choice of accounting techniques should depend on ‘economic consequences’. SMA/UITM/PA  SMA/UITM/PA ► In general, the formulation of accounting theory and the development of accounting principles have followed an eclectic approach ( a combination of The eclectic approaches), rather than just one school of thought. approach ► This approach is mainly the results of various attempt by professionals and government to participate in establishment of concepts and principles in accounting.  What is the purpose of accounting theory? How did accounting theory develop? REVISION What roles can theory play in relation to accounting? Give an example Using an accounting context, give an example of using induction to develop a theory. How can you evaluate the theory and its hypothesis? What is the scientific method? Describe two accounting issues that the scientific method can be used to resolve SMA/UITM/PA