Financial Accounting Theory Craig Deegan, 3 rd edition Prepared by: Dewan Mahboob Hossain, Assistant Professor; Department of Accounting & Information Systems; University of Dhaka; Dhaka; Bangladesh
Chapter 1: Introduction to financial accounting theory
Why is accounting theory important?
Overview of theories of accounting.
Can we prove a theory?
Logic and evidence.
A coherent group of general propositions used as principles of explanation for a class of phenomena.
Theories impose cohesion and stability.
Whenever life is ambiguous people will work at confronting these ambiguity through theorizing.
Theories of accounting
Prescribes how assets should be valued for external reporting purposes?
Predicts that managers paid bonuses on the basis of profit will adopt those accounting methods that lead to an increase in reported profits.
Seeks to explain how an individual cultural background will impact on the types of accounting information that the individual seeks to provide to people outside the organization.
Exposure to issues like:
How the various elements of accounting should be measured?
What motivates managers to provide certain types of accounting information?
What motivates managers to select particular accounting methods in preference to others?
What motivates individuals to support and perhaps lobby regulators for some accounting methods in preference to others?
How and why capital market reacts to particular kind of information?
Theories of accounting: overview
Many theories of financial accounting.
No universally accepted theory.
*Explain and predict
*Prescribe (as opposed to describe)
Early theories used induction.
Development of ideas or theories through observation.
-large number of observations.
-observations repeated under wide variety of conditions.
-no accepted observation should conflict with the derived universal law.
1920s to 1960s: based on observations
Theories of accounting were developed on the basis of observation of what accountants actually did in practice induction.
Accounting Darwinism: ‘accounting practice has evolved, and the fittest, or perhaps ‘the best’ practices have survived.
No prescription because, rarely have regulatory bodies accepted suggestions.
1960s and 1970s
Prescribe particular accounting procedure not driven by existing practices.
Normative period what accountants should do?
Mid to late 1970s
Major aim shifted to explaining and predicting accounting practices.
Positive Accounting Theory (PAT) was developed by Watts and Zimmerman. It seeks to predict and explain why managers/accountants elect to adopt particular accounting methods in preference to others.
PAT embraced the assumption of self interest.
PAT is concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular accounting method…but it says nothing about which method a firm should use.
Can we prove a theory?
An acceptable theory might admit exceptions.
While we might use observations to support a theory, it would generally be inadvisable to state that we have proved a theory on the basis of observations.
Karl Popper falsification knowledge develops through trial and error.
Knowledge develops as a result of continual refinement of a theory.
Logic and evidence
All surfers over the age of 35 ride long boards.
Jack is a surfer over the age of 35.
Jack therefore rides a long board.
If we accept the above premises, we might accept the conclusion. It is logical.
A lot of surfers over 35 ride long boards.
Jack is a surfer over 35.
Therefore, Jack rides a long board.
Not logical .
Self-interest tied to wealth maximization motivates all decisions by individuals.
Manager X is paid on the basis of reported profit.
Accounting method Y is an available method of accounting that will increase reported profits relative to other methods.
Manager X will adopt accounting method Y.
Logical. If the premises are both logical and true, then the conclusion will be true.