GODFREYHODGSON

HOLMESTARCA

CHAPTER 1 INTRODUCTION

Overview of Accounting Theory

What is a theory? Hendriksen’s definition: …the coherent set of hypothetical, conceptual and

pragmatic principles forming the general framework of reference for a field of inquiry.

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What is an accounting theory? Hendriksen’s definition: …logical reasoning in the form of a set of broad

principles that

• provide a general framework of reference by which accounting practice can be evaluated and • guide the development of new practices and

procedures.

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Overview of Accounting Theory

Overview of Accounting Theory

• Whether a theory is accepted depends on how:– well it explains and predicts reality– well it is constructed both theoretically and

empirically– acceptable its implications are

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Overview of Accounting Theory

The development of accountingtheory has been mostly unstructured

Chambers:Accounting has frequently been described as a body of practices which have been developed in response to practical needs rather than by deliberate and systematic thinking.

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Pre-theory (1400s – 1800)

Goldberg:No theory of accounting was devised from the time of Pacioli down to the opening of the nineteenth century.

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Greek in 5th Century BC

• In 1915, scientist discovered “Zenon Papyri”• Contains information about the construction

projects, agricultural activities and business operations of the private estate of Apollonius for a period of about 30 years during the 3rd century BC

• A written record of all transactions, a personal account for wages paid to employees, inventory records and a record of asset acquisitions and disposals

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Italy

• The Romans kept elaborate records but since they expressed numbers through letters of the alphabet, they were not able to develop any structured system of accounting

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Italy (Renaissance 1300- 1500)

• The Italians were vigorously pursuing trade and commerce, and the need to keep accurate records arose

• Italian merchants borrowed the arabic numeral system and the basis of arithmetic and an evolving trend toward the double-entry bookkeeping system

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Italy, 1494

• An Italian monk, Fra Luca Pacioli, “Summa de Arithmetica Geometria Proportioniet Proportionalita”, a book on arithmetic

• Desribed doube-entry bookkeeping• Formalized the practices and ideas that had

been evolving over the years

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1600

• Statement of profit & loss and statement of balances

• The primary motive for separate financial statements was to obtain information regarding capital

• Balance sheet data were stressed while income and expense date were viewed as incidental

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1800

• Evolution of joint ventures into business corporations in England

• Bookkeeping expanded into accounting • The concept of net worth (owner’s original

contribution +/- profits/losses) emerged• Periodic reporting for owners and prospective

owners

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1800

• Companies Acts in England stimulated the development of accounting standards and laws to safeguard shareholders against improper actions by corporate officers

• Dividends were required to be paid from profits and accounts were required to be kept and audited by persons other than the directors

• Industrial revolution

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Later part of 1800

• Industrial revolution arrived in the US• Railroad industries created the need for

supporting industries, led to increases in the market for corporate securities and an increased need for trained accountants

• Accountants were initially trained through an apprenticeship system , later private commercial college emerged

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1900- 1915

• The concept of income determination was not well developed

• Debate over which financial statement should be viewed as more important

• 1904 : international congress of accountants in US which formed American Associaton of Public Accountants. In 1916

• Many universities began offering accounting courses

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After the Great Depression

• 1933 : Securities Act• 1934 : Securities Exchange Act which

established SEC • 1935 : American Association of University

Instructors in Accounting changed into American Accounting Association

• 1936 : AICPA

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Pragmatic accounting (1800– 1955)

• The ‘general scientific period’– based on empirical observation of practice– provided an explanation of accounting practice– focused on the existing ‘viewpoint’ of accounting

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Normative accounting (1956-1970)

• Sought to establish ‘norms’ for the best accounting practice

• Focused on what should be (the ideal) v. what is

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Normative accounting (1956-1970)

• Degenerated into battles between competing viewpoints

• Two groups dominated:– conceptual framework proponents– critics of historical cost

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Normative accounting (1956-1970)

• Factors prompting the demise of the normative period include:– the unlikelihood of one particular normative

theory being generally accepted– the application of financial economic principles– the availability of empirical data and new testing

methods

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Normative accounting (1956-1970)

• The major criticisms of normative theories were:– they do not necessarily involve empirical

hypothesis testing– they are based on value judgements

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Positive accounting (1950 to the present day)

• A shift to a new form of empiricism called ‘positive theory’

• Had its origins in the ‘general scientific period’• It seeks to explain the accounting practices

being observed

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Positive accounting (1950 to the present day)

• Its objective is to explain and predict accounting practice

e.g. the bonus plan hypothesis

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Positive accounting (1950 to the present day)

• It helps predict the reactions of ‘players’, such as shareholders, to the actions of managers and to reported accounting information

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Positive accounting (1950 to the present day)

• Major deficiencies are:– ‘wealth maximisation’ has become the answer to

explain all accounting practices and reported information

– it relies excessively on agency theory and dubious assumptions about the efficiency of markets

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Positive accounting (1950 to the present day)

• Behavioural research:– concerned with the sociological implications

of accounting numbers and the associated actions of ‘key players’

– emerged in the 1950s

– despite growing acceptance since the 1980s, positive accounting theory still dominates

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Recent developments

• Academic and professional developments in accounting theory have tended to take different approaches

• Academic research focuses on capital markets, agency theory and behavioural aspects

• The profession has sought a more normative approach – what accounting practices should be adopted

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Recent developments

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Recent developments

• Conceptual framework – resurrected in 1980s– states the nature and purpose of financial

reporting– Establishes criteria for deciding between

alternative accounting practices– SACs 1–4

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Recent developments

• Conceptual framework – Recent Developments– Joint project between IASB & FASB– International harmonisation of accounting

practices through a single consistent set of international financial reporting standards (IFRS)

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Recent developments

• The conceptual framework underpinning the IFRS favours a move toward – accounting practices that provide information for

enhancing decision making by investors and others

– recognising all gains and losses in the accounting periods in which they occur

– measurement using exit values

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Content outline

• Part 1: Accounting theory (chapters 1 – 3)• Part 2: Theory contributing to practice

(chapters 4 – 10)• Part 3: Accounting and research (chapters 11

– 14)

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Summary

• Accounting theory• Major periods of accounting theory

development• Normative accounting• Positive accounting• Conceptual framework• IFRS

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Key terms and concepts

• Theory• Accounting theory• Normative theory• Positive theory• Behavioural theory• Conceptual framework• IFRS

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