accounting theory revision

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Lecture 1

Introduction to

Accounting Theory

1







Doris Merkl-Davies

Division: Financial Studies

Location: Room 1.08, Hen Goleg

Telephone: 01248 38 2120

Email: [email protected]

Reader in Accounting

MA, PGCE (Vienna University), MBA, PhD (Bangor University)

Office hours: Mon. 9.00-10.00; Wed. 2.00-3.00 (Hen Goleg, Room 1.08)

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Doris Merkl-Davies

  • Research interests
  • Corporate narrative reporting
  • Impression management
  • CSR reporting
  • Accounting theory

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Doris Merkl-Davies

  • Can’t live without

  • Motto

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BBS film club

  • Venue: Alun A0.01, 3.00-5.00pm
  • WEEK 3 (WEDNESDAY 15 OCTOBER):
    Wall Street (discussant: Doris Merkl-Davies)
  • WEEK 5 (WEDNESDAY 29 OCTOBER):
    Office Space (discussant: Tony Dobbins)
  • WEEK 9 (WEDNESDAY 26 NOVEMBER):
    Citizen Kane (discussant: Bernardo Batiz-Lazo)

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Module format

  • Lectures: Mon. 10-12 in Drama Rehearsal Room
  • Tutorials:
  • Group A: Mon, 13.00-14.00 LR5
  • Group B: Tue, 9.00-10.00 LR1

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Recommended Textbooks

  • Deegan, C. and Unerman, J. (2011). Financial Accounting Theory. European edition. 2nd ed. McGraw-Hill. (D&U) [Main text I]
  • Rankin, M., Stanton, P., McGowan, S., Ferauto, K., Tilling, M. (2012). Contemporary Issues in Accounting. 2nd ed. Wiley. (R) [Main text II]
  • Godfrey, J., Hodgson, A., Holmes, S. and Tarca, A. (2010). Accounting Theory. 7th ed. Wiley. (GHHT) [additional reading]
  • Additional journal articles will be posted on blackboard for you to download.

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Background reading for Lecture 1

  • D&U Chapter 1
  • Rankin et al. Chapter 1; Chapter 5, pp. 131-134
  • GHHT Chapts. 1&3

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Overview of Lecture 1

  • Definition of accounting theory
  • Types of accounting theories
  • Accounting theory development over time
  • Relationship between theory and research
  • Evaluation of theories

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Exercise 1: What is a theory?

  • In groups of 6 find an example of a famous theory
  • Discuss the main features of the theory
  • What does this theory do?
  • What do we use it for?
  • Nominate a group member to report back to the class

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What is a theory?

  • An organized way of thinking about a subject
  • A set of ideas that explains something
  • ‘a scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’ (Oxford English Dictionary)
  • “theory is a statement of concepts and their interrelationships that shows how and/or why a phenomenon occurs” (Corley & Gioia, 2011: 12)

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What is the purpose of theories?

  • To make sense of the world (physical, social, psychological phenomena) and communicate that understanding to others
  • To make sense of (financial) accounting information
  • Financial statements, corporate annual reports
  • Accounting info is compiled and interpreted by people

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Types of theory

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Type of theory Users Example
Common-sense theory Lay people (personal experience) It is not what you know, but who you know http://www.telegraph.co.uk/news/politics/10137928/Its-still-who-you-know-not-what-you-know-that-matters-say-two-thirds-of-Britons.html
Working theory Managers, investors, auditors (Generalisations made in particular professions) Crisis communication should prioritise key stakeholders http://www.bernsteincrisismanagement.com/articles/10-steps-of-crisis-communications.html
Scholarly theory Academics Accounting choice is driven by managerial self-interest Positive Accounting Theory

Scholarly theory

  • Has undergone systematic research
  • Provide more thorough, accurate, and abstract explanations for financial accounting than common-sense or working theories

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What is the purpose of theories?

  • Theories are used to

Describe what people do = Descriptive theories

Suggest the best way (i.e., prescribe) to deal with specific types of human behaviour = prescriptive or normative theories

Explain and predict what people do = predictive or positive theories

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1. Descriptive theories

  • Describe what people do
  • Based on common practice
  • Describe
  • Common practise of bringing up children
  • Common practises for dealing with underage binge drinking in various countries
  • Describe accounting practice
  • Common practise of accounting for fixed assets
  • Future accountants are trained by practising accountants

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Descriptive theories

  • Advantage:
  • Tends to be accepted by majority
  • Disadvantage:
  • Does not entail critical evaluation
  • Does not allow for change

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2. Prescriptive (= normative) theories

  • Also called normative theories
  • What people should do
  • Suggest best way to
  • Bring up children, i.e., authoritarian, laissez-faire style, etc.
  • Prescribe particular accounting practices
  • Account for fixed assets, i.e., historical cost, current cost, exit price, etc.
  • Advantage
  • Can improve accounting practises
  • Disadvantage
  • Assumes that there is one “best way”

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3. Predictive (= positive) theories

  • Also called positive theories
  • Concerned with explaining reasons for behaviour and predicting future behaviour
  • Explain characteristics of children are most likely to engage in binge drinking, i.e., social class, gender, parenting style
  • Predict what effect a change in licensing laws will have on underage teenage drinking

Explain and predict accounting method choice

Characteristics of companies most likely to revalue their assets

What effect a change in accounting standards on leases will have on the way firms finance their assets

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Comparison of descriptive, prescriptive and predictive theories

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Descriptive theories

Prescriptive (normative) theories

Predictive (positive) theories

Descriptive “what is”

Prescriptive

“what should be”

Explanatory, predictive “why it is” “what will happen”

Non-value laden

Value-laden

Non-value laden*

No empirical methodology

No empirical methodology

Empirically based

* PAT Assumes specific human characteristics

Examples of uses of accounting theories

  • Theories might:
  • 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
  • predict that accounting information is used to present organisations as legitimate

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Accounting theories

  • Accounting is a human activity
  • Explain the behaviour of people within and outside of organisations with respect to accounting information
  • Theories of accounting consider:
  • Why people within organisations elect to provide particular information (preparer perspective)
  • People’s behaviour with respect to accounting information (user-perspective)
  • People’s needs for accounting information (user-perspective)

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Accounting theories

  • Accounting is a social phenomenon
  • Accounting theories are theories about human behaviour
  • Borrow from disciplines dealing with human behaviour
  • Psychology, sociology

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Exercise 2

  • Which of the following is NOT an assumption used in normative theory construction?
  • A. Profit and value can be measured precisely
  • B. Financial accounting is useful for making economic decisions
  • C. There are multiple available profit measures
  • D. Markets are inefficient and can be fooled by 'creative accountants‘
  • E. All of the above

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Why do we need accounting theories?

  • Accounting is viewed as a ‘practical’ discipline
  • Learning how to apply accounting rules
  • Theories are necessary to understand the (social) world we live in
  • They provide a basis for the decisions we make, e.g. whether to include an item in the financial statements or not (materiality and recognition criteria)

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Why do we need accounting theories?

  • We can make better predictions and decisions if we get the contradictions out of our thinking, if we consider what is known on the many sides of the issue
  • i.e. the various theories which exist on:
  • The regulation of accounting, e.g. whether we need regulation or not
  • The provision of financial information, e.g. Why accountants choose particular accounting methods
  • The way financial information is received, e.g. How people react to particular accounting numbers

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Why study accounting theories –
to understand:

  • Motivation for individuals to support or lobby regulators for some accounting methods in preference to others ( Regulatory theories)
  • How and why the capital markets react to particular information ( Positive accounting theory)
  • Whether there is a ‘true measure’ of income ( Asset valuation theories)

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Overview of theories of accounting

  • Many theories of financial accounting exist
  • No universally accepted theory of accounting
  • Different perspectives about the central objective, role and scope of financial accounting
  • No universally accepted perspective about the role of accounting theory
  • Different researchers have different perspectives of the role of accounting theory

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Accounting Theory Timeline

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Early development of accounting theory

  • Descriptive theories
  • Relied upon the process of induction
  • Development of ideas or theories through observation
  • 1920s to 1960s theories developed from observing what accountants did in practice
  • Codified as doctrines or conventions of accounting

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Criticisms of inductive method

  • … ‘concentrates on the status-quo, is reactionary in attitude, and cannot provide a basis upon which current practice may be evaluated or from which future improvements may be deduced.’ (Gray, Owen and Maunders 1987, p. 66)
  • Assumes what is done by the majority is the most appropriate practice
  • Perspective of accounting Darwinism

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Example of inductive approach to theory development

  • Grady (1965) undertook research commissioned by the AICPA
  • Formed the basis of APB Statement No. 4 ‘Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises’
  • Reflected generally accepted accounting principles at the time

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Theory development - 1960s and 1970s

  • Sought to prescribe particular accounting practices
  • Known as normative theories
  • Not driven by existing practices
  • Theories critical of historical cost accounting
  • Sought to provide improved approaches to asset valuation in a time of widespread inflation

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Example of prescriptive theory

  • 1961 and 1962 studies by Moonitz, and Sprouse and Moonitz commissioned by the Accounting Research Division of the AICPA
  • Authors proposed that accounting measurement systems be changed from historical cost to a system based on current values
  • Not supported by AICPA as too radically different from current practice

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Theory development - mid to late 1970s

  • Research aimed at explaining and predicting accounting practice rather than prescribing particular practices
  • Known as positive theories

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Positive theories

  • Seek to predict and explain particular phenomena
  • Begins with assumption(s), and through logical deduction enables prediction(s) to be made
  • If predictions are sufficiently accurate when tested against observations of reality, they are regarded as having provided explanation of why things are as they are

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Positive theories - continued

  • Positive Accounting Theory
  • Developed by Watts and Zimmerman
  • Seeks to predict and explain why accountants elect to adopt particular accounting methods in preference to others
  • Based upon ‘rational economic person’ assumption
  • Individuals motivated by self-interest tied to wealth maximisation

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Relationship between theory and research

  • Theories are used to understand accounting practice better
  • Accounting researchers use theories
  • Theories are used in empirical research (i.e., research based on data, such as financial statements, annual reports, share prices) to explain phenomena and make predictions
  • Theories help us to critically evaluate a phenomenon (i.e., accounting method choice)

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Relationship between theory and research

  • "... all research emanates from the researcher’ s implicit or explicit theory of the phenomenon under investigation" (Rocco & Plakhotnik, 2009: 121).

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Testing a Theory in Research

1. Identify

research problem

Theory plane

Observation plane

2. Develop

theoretical framework

3. State research question/

hypothesis

4. Construct

research design

5. Observe

6. Analyse

7. Evaluate

8. Assess limitations

and constraints

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Testing a Theory in Research

Identify research problem

  • Bias in corporate narrative documents

Develop theoretical framework

  • Agency theory assumptions
  • Information asymmetry between managers and investors; managers are self-interested (want to maximise their compensation); managers manipulate presentation of information in corporate narrative documents (e.g., annual report)

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Testing a Theory in Research

State research question/hypothesis

  • Managers in firms with negative financial performance are more likely to introduce reporting bias (in the form of pro-forma earnings number into corporate narrative documents than managers of firms with positive financial performance

Construct research design

  • Sample of firms; split into two groups based on positive/negative percentage change in earnings; chairmen’s statements (pro-forma earnings vs. GAAP earnings)

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Testing a Theory in Research

Observe/Analyse

  • Conduct statistical association tests

Evaluate

  • Do findings confirm/disconfirm hypothesis; compare with findings of prior research

Assess limitations/constraints

  • E.g., small sample size

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Criteria for evaluating theories

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Area of evaluation What to look for
Accuracy Has research supported that they theory works the way it says it does?
Practicality Have real-world applications been found for the theory?
Succinctness Has the theory been formulated with the appropriate number (fewest possible) of concepts or steps?
Consistency Does the theory demonstrate coherence within its own premises and with other theories?
Acuity To what extent does the theory make clear and otherwise complex experience?

Evaluation of theories

  • Theories of accounting are only abstractions of reality
  • The choice of one theory in preference to another is based on value judgements
  • Cannot expect to provide perfect explanations or predictions of human behaviour or assess what types on information users actually need

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Evaluating theories of accounting

  • When evaluating theories need to consider:

Assumptions: whether you agree with the central assumptions/premises of the theory

Logic: whether the argument supporting the theory is logical

Research methods: Whether the research methods are appropriate

Evidence: whether you accept any supporting evidence provided

Rhetoric: the use of rhetoric used for persuasion

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The role of assumptions

  • Even though an argument is logical we might only accept the argument if we accept any critical assumptions being made
  • If we reject any central assumptions we may reject the prediction

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Logical deduction

  • Acceptance of an argument must be based upon the accuracy of the premises
  • An argument is logical to the extent that if the premises on which it is based are true, then the conclusion will be true
  • To determine the logic of an argument we do not need to refer to ‘real world’ observations

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Research methods

  • Generalizing theories from the testing of samples
  • Methods borrowed from sciences  phenomena will behave the same in all situations
  • Not possible when dealing with human behaviour
  • Sample selection (firm size, industry, country of origin, listed/unlisted, etc.)
  • Keep in mind not only how the argument is developed, but also how it is tested!!!

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Evidence

  • Is there enough evidence to support the theory?
  • Is there conflicting evidence?

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Rhetoric

  • Thouless (1974) identifies 38 ‘dishonest tricks’ some writers use to support their argument including:
  • emotionally toned words
  • statements where ‘all’ is implied but ‘some’ is true
  • diversion to another question or to a side issue
  • use of speculative argument
  • prestige by false credentials
  • appeal to mere authority

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Any questions?

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Descriptive theories Prescriptive (normative)

theories

Predictive (positive)

theories

Descriptive “what is” Prescriptive

“what should be”

Explanatory, predictive

“why it is” “what will

happen”

Non-value laden Value-laden Non-value laden*

No empirical methodology No empirical methodology Empirically based

* PAT Assumes specific human characteristics