Accounting theory 3

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Accounting theory 3

  1. 1. 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
  2. 2. Chapter 1: Introduction to financial accounting theory <ul><li>Theory </li></ul><ul><li>Why is accounting theory important? </li></ul><ul><li>Overview of theories of accounting. </li></ul><ul><li>Can we prove a theory? </li></ul><ul><li>Logic and evidence. </li></ul>
  3. 3. Theory <ul><li>A coherent group of general propositions used as principles of explanation for a class of phenomena. </li></ul><ul><li>Theories impose cohesion and stability. </li></ul><ul><li>Whenever life is ambiguous people will work at confronting these ambiguity through theorizing. </li></ul>
  4. 4. Theories of accounting <ul><li>Examples: </li></ul><ul><li>Prescribes how assets should be valued for external reporting purposes? </li></ul><ul><li>Predicts that managers paid bonuses on the basis of profit will adopt those accounting methods that lead to an increase in reported profits. </li></ul><ul><li>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. </li></ul>
  5. 5. Why important? <ul><li>Exposure to issues like: </li></ul><ul><li>How the various elements of accounting should be measured? </li></ul><ul><li>What motivates managers to provide certain types of accounting information? </li></ul><ul><li>What motivates managers to select particular accounting methods in preference to others? </li></ul><ul><li>What motivates individuals to support and perhaps lobby regulators for some accounting methods in preference to others? </li></ul><ul><li>How and why capital market reacts to particular kind of information? </li></ul>
  6. 6. Theories of accounting: overview <ul><li>Many theories of financial accounting. </li></ul><ul><li>No universally accepted theory. </li></ul><ul><li>*Explain and predict </li></ul><ul><li>*Prescribe (as opposed to describe) </li></ul>
  7. 7. Induction <ul><li>Early theories  used induction. </li></ul><ul><li>Development of ideas or theories through observation. </li></ul><ul><li>3 conditions: </li></ul><ul><li>-large number of observations. </li></ul><ul><li>-observations repeated under wide variety of conditions. </li></ul><ul><li>-no accepted observation should conflict with the derived universal law. </li></ul>
  8. 8. 1920s to 1960s: based on observations <ul><li>Theories of accounting were developed on the basis of observation of what accountants actually did in practice  induction. </li></ul><ul><li>Still popular. </li></ul><ul><li>Accounting Darwinism: ‘accounting practice has evolved, and the fittest, or perhaps ‘the best’ practices have survived. </li></ul><ul><li>No prescription because, rarely have regulatory bodies accepted suggestions. </li></ul>
  9. 9. 1960s and 1970s <ul><li>Prescribe particular accounting procedure  not driven by existing practices. </li></ul><ul><li>Normative period  what accountants should do? </li></ul><ul><li>Deductive reasoning. </li></ul>
  10. 10. Mid to late 1970s <ul><li>Major aim shifted to  explaining and predicting accounting practices. </li></ul><ul><li>Positive theories. </li></ul><ul><li>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. </li></ul><ul><li>PAT embraced the assumption of self interest. </li></ul>
  11. 11. PAT <ul><li>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. </li></ul>
  12. 12. Can we prove a theory? <ul><li>An acceptable theory might admit exceptions. </li></ul><ul><li>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. </li></ul><ul><li>Karl Popper  falsification  knowledge develops through trial and error. </li></ul><ul><li>Knowledge develops as a result of continual refinement of a theory. </li></ul>
  13. 13. Logic and evidence <ul><li>Logical deduction: </li></ul><ul><li>All surfers over the age of 35 ride long boards. </li></ul><ul><li>Jack is a surfer over the age of 35. </li></ul><ul><li>Jack therefore rides a long board. </li></ul><ul><li>If we accept the above premises, we might accept the conclusion. It is logical. </li></ul>
  14. 14. Logical deduction <ul><li>A lot of surfers over 35 ride long boards. </li></ul><ul><li>Jack is a surfer over 35. </li></ul><ul><li>Therefore, Jack rides a long board. </li></ul><ul><li>Not logical . </li></ul>
  15. 15. Logical deduction <ul><li>Self-interest tied to wealth maximization motivates all decisions by individuals. </li></ul><ul><li>Manager X is paid on the basis of reported profit. </li></ul><ul><li>Accounting method Y is an available method of accounting that will increase reported profits relative to other methods. </li></ul><ul><li>Manager X will adopt accounting method Y. </li></ul><ul><li>Logical. If the premises are both logical and true, then the conclusion will be true. </li></ul>

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