Deegan & Wolk - Accounting Theory

1. CHAPTER 1
Introduction to Financial Accounting Theory
and Accounting Research
DR. MD TAPAN MAHMUD
AIS, FBS, BUP

2. Chapter Contents
 Meaning of Theory – General and life-based
 Developing process of theories – inductive/deductive
 Accounting theory – human activity/behavior alignment and its role/utilities
 Why it is important for the students and accounting professionals to study
accounting theory and related critical perspectives?
 Why there is no universally-accepted accounting theories?
 Development (era) of accounting theory – inductive/perspective/predictive
 Precautions and rule of thumbs in evaluating (accounting) theories?
 Can we prove a theory?
 How to evaluate a theory in a structured way – logic/assumption/generalizability?
 Key factors impacting the (accounting) research process?
 Directions in accounting research

3. What is a Theory…
 Misconception:
 Numbers / number crunching are real stuff! Texts are theory!
 Theory is not:
 A guess - A hunch - A hypothesis - A speculation – Ad hoc - A random unstructured
idea
 Ex: If the first day of your new year is bad, the whole year will be bad!
 Theory is:
 Based on logical reasoning– Structured – Evidenced (not proven!) (Evidence = Quant or Qual)
 There must be framework of reference to base other ideas/decisions

4. What is a Theory…
 Hendriksen (1970): Theory is…
 A coherent (components of a theory should logically combine together ) set of
 Hypothetical – suggested and backed by evidence (later)
 Conceptual – thought/notion
 Pragmatic principles – fundamental conde of conduct
 Forming the general framework of reference:
 Principle + Assumption+ Constraints = FASB conceptual framework
 For a field of inquiry
 Accounting standards
 Features to have for Theory:
 Clear – Precise – Accurate – Consistent – Logical – Complete – Fair - Objective

5. What is a Theory… (Nice features to have, but not necessary!)
 Theories could be accurate but not useful (applied) in daily life:
 Mathematical theory
 Theory of the origin of the universe
 Theories might not always support a moral position:
 A scientific theory may go against a moral code
 Theories might be narrow in scope but true
 Theories might not be orthodox /traditional/ conservative/ generally accepted
 It doesn’t have to explain an exact scenario/ doesn’t have to be realistic
 No person walks with a supply-demand curve to buy coke!

6. What is a Theory(Developing Process and types)
 Inductive reasoning-based theories:
 Based on empirical observations
 Claimed to be ‘scientific’
 Without real-world observation its impossible to form such theories
 It tends to provide explanation/description/interpretation of a real-world phenomena
 Deductive reasoning-based theories:
 Based on logical deduction
 Is not based on real world data
 Tends to prescribe/guide

7. What is a Theory (a comprehensive notion – Life!)
 Llewelyn (2003):
 Theories impose cohesion and stability.
 So that whenever ‘life’ is ambiguous (which is most of the time!) people will
work at confronting this ambiguity through ‘theorizing’.
 Also, because ‘life’ and situations commonly have multiple meanings and
give rise to different assessments of significance, everyone has a need for
‘theory’ to go about their everyday affairs.
 ‘Theories’ do not just reside in libraries, waiting for academics to ‘dust them
down’; they are used whenever people address ambiguity, contradiction or
paradox so that they can decide what to do (and think) next.
 Theories generate expectations about the world.

8. Accounting Theory (human-motivation-behavior)
 Accounting is a human activity(accountants, users of accounting information;
no human, no accounting!)
 Therefore, there is no point in studying Financial Accounting without having an
idea regarding Accounting Theory
 Financial Accounting Theories have to consider:
 People’s behavior and needs regarding the financial accounting information
 Why people within the organization might elect to supply particular information to
particular stakeholder group?
 Why particular accounting rules are mandated by regulators?

9. Accounting Theory (various Utilities/Roles)
 Accounting theories are here to:
 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
 Explain or predict how accounting disclosures might be used as part of a
strategy to legitimize the operations of an organization

10. Why it is important for us to study Accounting
(financial) Theory?
 To compliment the learning of constructing and reading a financial statements
 To understand thoroughly and to be able to critique the accounting practices of
the large companies
 To clarify the vital role that an accountant plays in the society as regards to
wealth channeling
 To compliment the analysis of financial statements for the purpose of taking
particular decision (for both Accounting and non-accounting individuals)
And also, learning the rules of financial accounting without considering the
implications of accounting information is not recommended.

11. Studying Accounting theories exposes the students to various issues:
 How elements of accounting should be measured
 The motivations driving organizations to provide certain types of accounting
information
 The motivations driving individuals to support or lobby regulators for some
accounting methods in preference to others
 The implications for organizations and their stakeholders if one accounting
method is chosen or mandated in preference to others
 How and why the capital markets react to particular information
 Whether there is a ‘true measure’ of income
Why it is important for us to study Accounting
(financial) Theory?

12. How may Accounting theories aid the
Accounting profession(als)?
 High-profile accounting failures (Enron/WorldCom) have raised the level of
awareness among non-accountants and has significantly decreased the trust-
level of professional Accounting practices
 Before these failures, there were evidences that financial accounting was used to
create benefits for the managers (self-interest-based behavior)
 Enron: https://www.youtube.com/watch?v=SMT5v5zT5KQ

13. How may Accounting theories aid the
Accounting profession(als)?
 Therefore, insights from a varied range of Accounting theories would help
us to:
 Evaluate the suitability of current accounting practices
 Develop improved accounting practices where current practices are
unsuitable for changed business circumstances
 Defend the reputation of accounting when accounting practices are
blamed for causing companies to fail (USA financial crisis of 2008)
 2008 USA Financial Crisis:
https://www.youtube.com/watch?v=GPOv72Awo68&t=117s

14. A brief overview of Accounting theories
(No Universally-accepted Accounting Theory)
 Because, different researchers have different perspectives of the role of
Accounting theory, and/or what the central objective, role and scope of
financial Accounting should be (ex: Positive Vs Normative)
 A researcher’s own values will influence which theory he or she elects to
embrace
 Practice of financial Accounting theory is evolving due to the changes in
technical capabilities of AIS, size and influence of corporation and so on
 Refinement in well-established theories are always knocking on the door for
burning issues of different eras (ex: climate change and CSR practice, Global
Financial Crisis and accounting regulation/professionalism, IASB’s fit to local
requirements)

15. Throwback to the development of Accounting
Theories…
 1920 to 1960s: Inductive Accounting Theories
 1960 to 1970s: Prescriptive (Normative) Accounting Theories
 Mid to late 1970s: Predictive (Positive) Accounting Theories

16. Throwback to the development of Accounting
Theories (1920 to 1960s: Inductive)
 Induction: Development of ideas or theories based on observations
 Reflecting what accountants did in practice; common practices were then
codified in the form of doctrine or conventions
 Ex: conservatism
 Ex: ignoring inflation-impact in financial reporting

17. Throwback to the development of Accounting
Theories (1920 to 1960s: Inductive)
 Criticisms:
 Study of ‘what is’; not ‘what is not’ or ‘what should be’(future directions)
 Concentrates only on the ‘status quo’ and only reactionary
 Can’t provide a basis upon which current practices can be evaluated
 Assumes that common practice by majority of accountants are right
practice
 Avoids ‘radical’ or ‘controversial’ research-ideas, preferring ‘idea-
acceptability’ (GAAP) of regulatory bodies
 Supports Accounting Darwinism: accounting practices has evolved and the
‘fittest’ or perhaps the ‘best’ practices only have survived

18. Throwback to the development of Accounting
Theories (1960 to 1970s: Normative)
 Sought to Prescribe (as opposed to describe) and not driven by existing practices
 Based on norms/values
 Many theories were developed in this era which were based on the development
of arguments (deductive reasoning) regarding what the researchers considered
accountants should do

19. Throwback to the development of Accounting
Theories (1960 to 1970s: Normative)
 Researchers were critical of ‘historical cost accounting’ (due to inflation) and
vouched for other alternatives (replacement cost, net realizable value, present
value).
 However, since it was difficult to resolve the differences in opinion (subjectivity)
‘historical cost accounting’ continued to be used
 It should not be evaluated on whether they reflect actual accounting practice
or not
 Rather the prescriptions might reflect radical departure from existing practices

20. Throwback to the development of Accounting
Theories (1960 to 1970s: Normative)
Examples:
 Continuously Contemporary Accounting (CoCoA): most useful information
about an organization's asset is ‘current cash equivalents’ (Raymond Chambers)
 https://bizfluent.com/info-8610950-benefits-disadvantages-fairvalue-accounting.html
 In recent years the use of ‘market values’ (more specifically fair value) for asset
valuation has gained popularity with the IASB
 Conceptual Framework of Accounting / Financial Reporting: It provide
guidance on:
 How the elements of financial statements should be defined
 When they should be recognized
 How they should be measured

21. Throwback to the development of Accounting
Theories (1960 to 1970s: Normative)
 Further subdivision of normative theories: True Income Theories and Decision
Usefulness Theories
 True Income Theories make certain assumptions regarding the role of
accounting and then seek to provide a single best measure of profits
 Decision Usefulness Theories are again subdivided into:
 Decision-makers’ emphasis: asks what the stakeholders want, and the prescribe
design of the accounting information to be offered to the stakeholders
 Decision-model emphasis: doesn’t care what the stakeholders want, delivers
information based on usefulness of decision making

22. Throwback to the development of Accounting
Theories (1960 to 1970s: Normative)
Criticism:
 It is not based on observation, rather on personal opinion, hence it is not
scientific
 Normative theorists impose their personal opinions on others

23. Throwback to the development of Accounting Theories
(Mid to late 1970s: Predictive /Positive/Explanatory)
 Aim of ‘explaining’ and ‘predicting’ rather than ‘prescribing’
 It tries to ‘make sense’ of what is currently happening in the real-world
 Positive theory is mostly ‘If…Then…’ phrasing based (ex: if certain conditions are
met, then particular accounting practices will be observed)

24. Throwback to the development of Accounting Theories
(Mid to late 1970s: Predictive /Positive/Explanatory)
 Through logical argument, make predictions (Hypothesis)
 Test the predictions/hypothesis through actual ‘real-world’ observations
 Modify the theory, if necessary, based upon the real-world observations
Developing Process of Positive Theories:
 Researchers might firstly identify a number of key assumptions
 Ex: that individuals are driven by self-interest
 Ex: capital markets are efficient

25. Throwback to the development of Accounting Theories
(Mid to late 1970s: Predictive /Positive/Explanatory)
Example of Positive Accounting Theory:
 Developed by Watts and Zimmerman
 It seeks to predict and explain why accountants elect to adopt particular
accounting methods in preference to others
 It is based on ‘rational economic person’ assumption
 Individuals motivated by self-interest tied to wealth-maximization
 Challenges the view that accountants will be ‘objective’

26. Throwback to the development of Accounting Theories
(Mid to late 1970s: Predictive /Positive/Explanatory)
Criticisms:
 When there is no data, there is no way of building a theory
 Do not seek to tell us regarding the evaluation (i.e., what is the most efficient or
equitable process)
 Do not tell us what we should do (i.e., which method a firm should use); no
prescriptions available
 No prescription means there is nothing (almost) to offer for the professional
accountants, which is a dilution of academic responsibility

27. Evaluating Accounting Theories
 There are lots of Accounting theories available in the open
 Many researchers prefer one theory of accounting and then condemn
alternative theories to establish his/her position
 To evaluate, students should consider the merit of the argument offered by a
researcher and the research-method employed
 Researchers that adopt a given ‘paradigm’ often challenge the views of
people researching from a different paradigm
 A ‘paradigm’ can be described as an approach to knowledge advancement
that adopts particular theoretical assumptions, research goals and research
methods (Kuhn, 1962)

28. Evaluating Accounting Theories
Scientific Progress (views of Kuhn)
 Scientific progress is not evolutionary, rather revolutionary
 Knowledge advances when one theory is replaced by another as particular
researchers attack the credibility of an existing paradigm and advance an
alternative
 Researchers attack the credibility of an existing paradigm and advance an
alternative, which is promoted as being superior (Religious Conversion)
 Idea of Religious Conversion could be a Possible explanation of why researchers
try to denigrate the credibility of alternative theories
 But no accounting theory has, to date, overthrown all other alternatives

29. Evaluating Accounting Theories
What are the precautions before adopting a theory?
 Researchers see what they want to see and regardless of the type (normative or
positive) of Accounting theory and his/her choice is related to a certain value-
judgement
 If there are Big-name(s) behind the developments of a theory, it is more likely to
be chosen; doesn’t mean it is bullet-proof!
 Extent of acceptance of a certain theory in a given research community may
also influence the adoption; majority is not always right!
 Legitimacy Theory is the ‘legitimate’ theory for Social and Environmental Accounting
(SEA) research. However, Institutional Theory may overdrive Legitimacy Theory, soon!

30. Evaluating Accounting Theories
What are the precautions before adopting a theory?
 Remember the properties and limitations of Normative and Positive Accounting
theories and criticize a given theory before adopting it
 Question the merit of the logic/ assumption/ premise of an explanation /
prediction / prescription
 A Parsimonious (output of a simple, yet, tight logical economic explanation)
theory is preferred
 Rule of thumb:
 Prescription: If it is logically weaved; you may accept it
 Prediction: If it is an output of a valid research method; you may accept it

31. Can we prove a Theory?
 There are often alternative theories for a specific phenomena offering opposite
explanation or prescriptions. Opposite alternatives can’t be right simultaneously
(generally speaking); so, is there any way to prove a theory?
 Since financial accounting is a human activity, it is not going to provide perfect
predictions in all cases.
 If there is a reasonable amount of correspondence between the prediction and
reality; a positive theory should be accepted as valid; perfect prediction is
impossible!
 We might have observations to ‘support’ a theory; it is not recommended to
state that we have ‘proved’ theory on the basis of observations.

32. Can we prove a Theory?
Is the theory Falsifiable?
 There is a group of theorists, known as ‘falsificationists’ (lead by Karl Popper)
 They believe that knowledge develops through trial-and-error
 To develop scientific knowledge, hypothesis should be designed in such a way,
that it allows rejection if the evidence is unsupportive of the hypothesis
 Knowledge develops through continual refinement of theory; therefore, what is
accepted today, may not be accepted tomorrow
 The refined theories will be accepted until a related hypothesis is deemed to be
falsified

33. Can we prove a Theory?
Is the theory Falsifiable?
 Researcher should not seek for observations to confirm a hypothesis, rather they
should be trying to find evidences to reject (or falsify) a given hypothesis
 You would see cases of reverse hypothesis and rejection to reach to an intended
(pre-determined) conclusion by a many researchers
 It is better to stay open, claiming that evidence ‘supports’ a theory; so that, we
can accept an alternative (better explained) theory in future
 This view again supports the concept of ‘Accounting Darwinism’

34. Evaluating Theories–Considerations of Logic and
Evidence
These are the evaluation criteria:
1. Evaluation through logical deduction
2. Evaluating the underlying assumptions
3. Universal applicability of theories
4. Generalizing theories from the testing of samples

35. Evaluating Theories–Considerations of Logic and
Evidence (Evaluation through logical deduction)
1. Break-down the hypothesis in premise(s)
2. Consider the logic of the premise(s) and its relationship to the conclusion
3. If the conclusion follows the logic of the premise, test it with real-world
observation (if it doesn’t, drop the hypothesis)
4. Understand whether the logic holds against evidence or not and accept
/reject the hypothesis, thereby
*In Deductive / Normative research only logic is enough; empirical testing is not required

36. Evaluating Theories–Considerations of Logic and
Evidence(Evaluation through logical deduction)
 Case-1: Premise with logic and relation with conclusion (valid for real-world test)
 All surfers over the age of 35 ride longboards
Jack is a surfer over the age of 35
Jack therefore rides a longboard
 Case-2: Premise with no logic and no relation with conclusion (invalid for real-
world test)
 A lot of surfers over 35 ride longboards
Jack is a surfer over 35
Therefore Jack rides a longboard

37. Evaluating Theories–Considerations of Logic and
Evidence(Evaluating the underlying assumptions)
 Positive Theory (Watts and Zimmerman) assume:
 Self-interest tied to wealth-maximization motivates all decisions by individuals
 Case:
 manager X is paid based on reported profits (bonus = 5% of profit)
 accounting method Y is an available method of accounting that will increase
reported profits relative to other methods
 Then we might accept the prediction (all other things being equal)based on the
assumption that manager X will adopt accounting method Y

38. Evaluating Theories–Considerations of Logic and
Evidence(Evaluating the underlying assumptions)
 However, if you don’t accept the assumption(s), you may reject the prediction
 Gray, Owen and Adams reject the central assumption of Positive Accounting
(self-interest-based behavior of the managers) and therefore any prediction /
explanation drawn from the said theory would be also rejected by them
 They will not use it as a means of explaining or describing the practice of
Corporate Social Reporting (CSR)/ Social and Environmental Accounting (SEA)

39. Evaluating Theories–Considerations of Logic and
Evidence(Evaluating the underlying assumptions)
 If we believe (assume) that the central objective of financial accounting is to
provide information to a broad cross-section of stakeholders, We may reject the
prescriptions of conceptual framework of IASB, despite the fact that it is logically
constructed (sound)
 Additional considerations: While evaluating the merit of the premise /logic/
assumption/ argument, beware of these followings:
 colorful / emotive language; and/or appeal to mere analogy / authority
 Statements where ‘all’ is implied, but ‘some’ is true
 Conceptual framework prescribes qualitative characteristics for financial
information and recognition criterion for the elements of financial statements
(normative in nature)

40. Evaluating Theories–Considerations of Logic and
Evidence(Universal applicability of theories)
 Theories of social sciences (e.g., Accounting theories) are by nature abstraction
of reality. These deal with human behavior (which is not structured). Therefore, it
would be naïve to think that social science theories would be able to predict
reality perfectly
 Here, considering more than one theory may provide a more rounded
perspectives
 However, there are cases where alternative theories may provide polar-opposite
predictions; in such cases choice of one theory must be made

41. Evaluating Theories–Considerations of Logic and
Evidence(Universal applicability of theories)
 Positive theories are empirically tested for acceptance. However, such theories
still give rise to the following questions:
 What if a theory doesn’t fit in all settings?
 Should the theory then be rejected?
 Or, can we accept a theory that admits exception?
 If a theory fails to provide for universality or if data is unsupportive of the
hypothesis, maybe the following happened:
 Maybe the data were inappropriately collected Or
 Data is not providing a sound correspondence with the theoretical variables involved
 Therefore, we may accept a theory with exception; however, continuous misfit
or unsupportive cases should lead to rejection of a theory

42. Evaluating Theories–Considerations of Logic and
Evidence(Generalizing theories from the testing of samples)
 Many Accounting researchers borrow research methods used in pure science
and assume that phenomena being studied will behave in the same way in all
similar situations. They think that it is possible to develop generalizable
Accounting theories and consider generalizability a key determinant to accept
or reject a theory
 Opposite-view: Accounting is a social science is applicable only for specific
localized situation and hence generalizability can’t be a key element
 Middle-view: It is possible to make some very broad generalizations in social
sciences; however, the applicability to specific scenario may call for specific
individual factors befitting for a given scenario

43. Evaluating Theories–Considerations of Logic and
Evidence(Generalizing theories from the testing of samples)
 If we want to generalize our findings from a sample, we must consider how the
original sample was chosen
 Prediction: ‘all’ companies will adopt a particular accounting method in times of
inflation
 If the prediction is tested against the ten ‘largest’ companies
 Then, such findings should not be considered generalizable
 You should consider not only how the argument is developed, but also how it is
tested (exception: normative theories-only argument testing is enough)
 We must evaluate whether the data-collected really represent valid measures of the
theoretical variables in question

44. Key Factors that Influence the Research Process
Positive Accounting Theory
1. All individuals (managers)
are motivated by self-
interest and tied to wealth-
maximization (objective
reality)
2. What accounting
methods managers will
choose, when the
respective area of
accounting is unregulated
3. Since all managers are
somewhat
interchangeable, large-
scale sampling and
statistical techniques can
be utilized
4. Results will be
generalizable across all
managers
Normative Accounting Theory
1. Its unrealistic that all
individuals are driven by
identical motivations; some are
motivated by wealth-
maximizations and others are by
societal/environmental well-
being
2. What accounting methods
managers will choose, when
respective area of accounting is
unregulated
3. Managers are not
interchangeable; small-scale
research (on limited managers/
specific type of firms); case-
study-style will be utilized
4. Results will not be
generalizable to all managers
Fig: Interdependence of various factors within the research process

45. Directions in Accounting Research
 Decision-Model
Approach
 Capital Market Research
 Behavioral Research
 Agency Theory
 Information Economics
 Critical Accounting

46. The Decision-Model Approach
 Asks what information is needed for making decisions; does not ask what
information users want
 Ex: Ijiri advocates for adjustments in the historical value based on purchasing power
 The decision makers may need to be taught how to use information
 Its orientation is normative and deductive
 Two major branches: a) enabling the user to better predict the future, b) analyzing
the efficiency and effectiveness of the management
 Aligned with the standard setting function – derivation of the conceptual
framework

47. Capital Market Research
 Efficient-Markets Hypothesis: market prices reflect fully all publicly available
information
 Since information is rapidly reflected in security prices, there has been demand for
increased accounting disclosure
 Researchers must specify the parameters (number, types of firms examined, sample
period) and research design carefully for it impacts the conclusion heavily!
 Significant body of research exists:
 Relationship between accounting-bases (financial statement ratios) and market-based
risk (VAR- value at risk) measures
 Impact of accounting policy choices on security price

48. Behavioral Research
 Focus is on how users of accounting information make decisions and what information
they need
 Is descriptive or positive in its approach
 Has shown gaps between the normative models and what is actually done by the
users
 Whether replacement cost information is more useful to the users than historical cost
 Two types:
 Behavioral: Individual judgements in a single person
 Experimental: Interactive – more than 1 person – effect of the decision of one person (or
group) on the decisions of others (or groups)
 Research subjects:
 How managers and auditors prepare accounting information?
 How users interpret financial statements/information?
 Effect of individual decision on the market

49. Agency Theory (also called Contracting Theory)
 Individuals act in their own best self-interest
 Enterprise is the intersection point for many contractual-type relationships among
 Management
 Owners
 Creditors
 Government
 Concerned with costs of monitoring and enforcing relations among the various
groups

50. Information Economics
 Focuses on the cost of producing accounting information
 Is analytical/deductive in nature
 It is recently been aligned with the agency theory assumptions:
 whether both sides have full information
 whether information asymmetry exists

51. Critical Accounting
 Conflict-based Perspective: Views accounting as having a key role in adjudicating
conflicts between the corporation and social constituencies (labor, consumers, public)
 Based on two areas of accounting developed in the 1960s
 Public interest accounting – Pro bono financial/tax services for entities who are unable to pay
 Social accounting – brining in the impact (cost) of externalities in the financial statements
 Positive researchers report on the reality and normative researchers opine on reality –
CA researchers aid in reshaping the reality!
 Attacks agency theory-based research; value-free data crunching-based research
 Less emphasis on mathematical/statistical models – more on historical explanation
 CA researchers believe that accounting should aid in solving broad social problems
 Ex: Equitable treatment for the less powerful stakeholders