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CIA 3003
ACCOUNTING
THEORY AND
PRACTICE

The Scope and Role of

Accounting Theory
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Outline
2

Introduction:

• What is accounting theory’?

• How accounting theories relate to accounting practices?

Formulation of accounting theory: Inductive vs Deductive

Development of accounting theory

• Pre-theory period
• General Scientific Period
• Normative Period
• Specific Scientific theory

Construction of accounting theory

+ Introduction: 3

The Nature of Accounting

Accounting is not like the ‘hard’ sciences, nor is it a simple

mechanical exercise.

Accounting is viewed as a practical discipline:

Accounting rules are the primary focus. There may seem to be little use for
theory.

However, THEORY is necessary to:

Provide a basis for decisions we make.
The accounting researcher Henclriksen (1970, p. l) clefines a theory as A coherent set of
hypothetical, conceptual and pragmatic principles forming the general framework of reference for a
field of inquiry.
+ We are studying Financial Accounting 4

Theory but…
What is a THEORY?

A coherent set of A scheme or system of A theory could be based on

hypothetical, ideas or statements held numerous observations
conceptual and as an explanation or (inductive reasoning) or
pragmatic principles account of a group of developed on the basis of
forming the general facts or phenomena logic (deductive
framework of reference (The Oxford English reasoning)
for a field of inquiry Dictionary)
(Hendriksen 1970, p.1)

Based on logical Could be

Different to a (coherent) reasoning, ‘positive’ or
‘hunch’
and not ad hoc in ‘normative’
nature
+ Why is theory needed? 5

Two different ways in which theories are useful:

• provide an explanation and predict of a particular
accounting related phenomenon
• Prescribe particular approaches to accounting.

Just because there is a theory about something, it

does not mean that the theory is correct.

An important issue when learning about or using

theory (including accounting theory) is to consider
how the appropriateness of any particular theory can
be assessed.
Theory construction
Glautier et al 2011
 6
What is Accounting Theory?

provide a general
framework of reference by
Logical which accounting practice
reasoning in the can be evaluated
form of a set of
broad principles guide the development of
that: new practices and
procedures

(Hendriksen, 1970)
+ Examples of uses of accounting theories
7

◼ Theories might:
◼ prescribe how assets should be valued – what an accountant shoud do
◼ predict why managers will choose particular accounting
methods Revaluation, depreciation
◼ explain how an individual’s cultural background affects
accounting information provided. Technical terms and financial
jargon may not have direct translations, leading to potential
miscommunications or misunderstandings. Cultures with higher risk
tolerance may be more willing to take on debt or invest in speculative
projects, while those with lower risk tolerance may prioritize more
conservative financial strategies.
 Extra points
◼ prescribe what accounting information should be provided to particular
classes of stakeholders
Accounting information should be tailored to meet the needs of various classes of
stakeholders
◼ predict that the relative power of a stakeholder group will affect the
accounting information it receives
Power in this context refers to the influence and control a stakeholder group has over
the organization, which can be based on factors such as financial investment, market
position. Powerful stakeholders may demand greater transparency and disclosure,
pushing organizations to provide more detailed accounting information to maintain
their trust and support.

◼ explain or predict how accounting disclosures might be used as part of a

strategy to legitimise the operations of an organization
In conclusion, accounting theory, particularly institutional theory, can help explain how
organizations strategically use accounting disclosures to legitimize their operations. By
aligning their financial reporting practices with societal norms and expectations,
organizations can enhance their credibility, trustworthiness, and overall legitimacy in
the eyes of their stakeholder
+ 8

How can accounting theories

help the accounting profession?
◼ Without a theoretically informed understanding, it is difficult
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
◼ Eg: In the case of Enron, it is not that failure of accounting
information to signal financial catastrophes, but auditors
colluded with management to mislead external stakeholders
◼ Can be argued to support positive accounting theory, one
party was acting to maximise wealth at the expense of others.
+ 9

Accounting Theory:
Objectives & Acceptance

Main objectives of accounting The acceptance of a theory will

theory: depend on:

Explain why & Provide the How well it

how current basis for explains and How well it is
accounting development of predicts reality constructed
practice evolved such practice

How acceptable
Suggest are the
improvements implications of
the theory

(Godfrey et al., 2010)

 10

Accounting Theory: Formulation

2 APPROACHES

Inductive: Deductive:
Specific to General to
general specific
+ Accounting Theory Formulation
11

(Inductive/ Bottom-up Approach)

• The inductive approach begins with observations and
measurements and moves toward generalised conclusions.

Theory

Tentative
Hypothesis

Pattern
• From specific observations to
a general conclusion. Observation

Example:
P1: The plant and machinery account is an asset account and has a debit
balance.
P2: The motor vehicle account is an asset account and has a debit balance.
P3: The land is an asset account and has a debit balance.
Conclusion: All asset accounts have debit balance.
Premise 1: Firm A made a public announcement
of its losses, then its share price fell
Premise 2: Firm B made a public announcement
of its losses, then its share price fell
Conclusion: ?? All firms that made a public
announcement of its losses, experienced falls in
their share price
+ Accounting Theory Formulation
12

(Deductive/ Top-down Approach)

Theory

Hypothesis

Observation
• The deductive approach begins with
basic accounting propositions and
Confirmation
proceeds to derive logical conclusions
about the subject under consideration.

Example:
Premise 1: Asset accounts have debit balance.
Premise 2: The plant & machinery account is an asset account.
Conclusion: The plant & machinery account has a debit balance
Premise 1: All asset accounts have
debit balance
Premise 2: Account Receivable
has a debit balance
Conclusion: ?? Account
Receivable must be an asset
account
 Development of Accounting Theory 13

1400-1800 1970-present
1800-1960
Pre-theory 1960-1970 Specific
period General Scientific
Scientific Normative
No theory of Period theory
accounting was Period
devised

Positive
Pragmatic accounting
accounting
+ Early Development of Accounting Theory 14

(1920-1960)
◼ Relied upon induction approach.
◼ Development of ideas or theories through observation of ‘real world’
phenomena/
◼ Based on empirical analysis (relying on real-world observations not simply
on logic).
◼ Theories developed from observing what accountants did in practice
(observe what actually happened).
◼ Common practices were codified as doctrines or conventions of accounting.

◼ Example:
◼ It was observed that where judgements were necessary, accountants
usually underestimated revenues and overstated expenses – resulted
in hypothesis that where judgement is needed, a conservative
procedure is adopted.
◼ Tested by observing whether accountants do act in the way that theory
suggests.
+ 15

Example of Inductive Approach

to Theory Development
◼ Grady (1965) undertook research commissioned by the
American Institute of Certified Public Accountants (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 (GAAP) at the
time.
◼ It did not seek to evaluate logic/merit of accounting practises being
used.
◼ Not controversial and had a high probability of bring accepted.
+ 16

Criticisms of Inductive Approach

◼ ‘… 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 &
Maunders 1987, p.66)

◼ Assumes what is done by the majority is the most

appropriate practice.
+ 17

Development of Accounting Theory

(1960-1970)

◼ There was a shift in research focus, became known as the

‘normative period’ of accounting research.
◼ The normative research sought to prescribe what should
happen.
◼ Known as normative theories (normative theories provide prescription).
◼ Accounting theorist attempt to establish ‘norms’ for ‘best accounting
practice’.
◼ The research was not driven by existing practices, and hence not
typically inductive in nature (that is, not based on observation).
◼ Rather, were deductive in nature (based on logical argument)
sought to develop new methods of accounting.
+ 18

Example of Normative Theory

Studies by Moonitz (1961) and Sprouse and Moonitz

(1962) 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
◼ Sought to provide improved approaches to asset valuation
in a time of widespread inflation
◼ Not supported by AICPA as too radically different from
current practice
+ They are based on personal
opinion about what should
happen.

Criticism of
Normative Lack of empirical observation.

Theories

Positive theorists argue that they

would prefer to provide information
about expected implications of
actions and let others decide
themselves what they should do.
In detail, the three basic reasons for the shift in the normative approach
towards the positive (Januarti, 2004) are:

• The inability of the normative approach to empirical testing of theories is

due to the foundation of false assumptions or premises that cannot be
tested for validity.

• The normative approach focuses more on the prosperity of individual

investors rather than the prosperity of society at large.

• The normative approach provides neither motivation nor possibility for the
optimal allocation of economic resources in the capital market. It is
meaningful of an economic system based on market mechanisms,
accounting information that can be a control tool for society on the efficient
allocation of economic resources
Development of Accounting Theory (mid to
late 1970s): Positive Theories
Godfrey et al. (1997) stated that the accounting
theory Positive accounting attempts to answer, the
following questions from an economic point of
view, namely
1) what are the costs and benefits of alternative
accounting methods?
2) What are the costs and benefits of regulation and
the process of determining accounting
standards?
3) What is the impact of published financial
statements on stock prices?
+ 20

Development of Accounting Theory (mid to

late 1970s): Positive Theories
2 major development:

◼ Move from normative to positive accounting.

◼ Research began to aim at explaining and predicting accounting practice rather than
prescribing particular practices.
◼ Started to become popular, known as positive theories.

◼ Decision-usefulness orientation:
◼ Focuses shifted from the principles of accounting to the outcome of the accounting
process.
◼ Objective of Decision-Usefulness Theory of accounting: To provide
information that is useful in making investment decisions.
+ 21

Positive Theories
◼ Seek to predict and explain particular phenomena.

◼ Begin with assumption(s), and through logical deduction

enable prediction(s) to be made:
◼ an assumption might be that all individuals are self-interested
and are motivated by wealth maximisation.
◼ PAT has two main elements, namely assumptions and hypotheses.
Researchers use assumptions to organize, analyze, and understand
empirical phenomena related to the focus of research such as the use
of LIFO and FIFO methods to minimize tax liabilities. From these
assumptions, researchers can use hypotheses to be tested
empirically.

◼ If predictions are sufficiently accurate when tested against

observations of reality, they are regarded as having
provided an explanation of why things are as they are.
+ 22

Developing Positive Theories

◼ Researchers might firstly identify a number of key

assumptions:
◼ for example, that individuals are driven by self-interest, that
capital markets are efficient, and so forth.

◼ Through logical argument, make predictions and/or provide

explanations of actual phenomena based upon assumptions
(deduction).

◼ Test the predictions/explanations through actual ‘real world’

observations.

◼ Modify the theory, if necessary, based upon the real world

observations.
+ 23

Example of a Positive Theory

wealth
+ Management Compensation Hypothesis:
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Bonus Plan Hypothesis

◼ If managers’ remuneration is tied up with firm performance,

there is a higher possibility for the managers to manipulate
accounting methods/ figures to show the firm performance
is better than it should be.

◼ How? Inflating revenues or deflating expenses or liabilities.

◼ Use different depreciation method allowing lower profits at the
start and higher profits towards the end.
◼ Ignore any research and development costs, because it will
lower current year profits, thus affecting their income.
Management Compensation Hypothesis:
Hypothesis

Watts and Zimmermen in their paper entitled "Positive Accounting Theory: A

Ten Years Perspective" (1990) put forward three PAT hypotheses, namely:
1) Bonus Plan Hypothesis. This hypothesis states that managers will choose
accounting procedures that will shift future income to the current period
with the aim of earning bonuses.

2) Debt- Equity Hypothesis. This hypothesis states that for companies that will
violate debt covenants, managers will have the possibility of choosing
accounting procedures that shift future income to the current period so as to
increase net income and ultimately avoid technical errors.

3) Political Cost Hypothesis. This hypothesis states that companies that have
high profitability will tend to shift their income from this period to the next
period to avoid political costs. These three hypotheses are important
components of the PAT and will generate predictions that can be tested
empirically.
+ 25

Criticism of Positive Theories

◼ Positive accounting theories have been criticised for not

providing prescription.

◼ Wealth maximisation has become the answer to explain all

accounting practices and reported information.

◼ Relies excessively on agency theory and assumptions

about the efficiency of markets.
Summary
1400-1800 Goldberg:
No theory of accounting was devised from the time of Pacioli
Pre-theory
period down to the opening of the nineteenth century. Suggestions of
theory appear here and there, but not to the extent necessary
No theory of
accounting was to place accounting on a systematic basis
devised

1800-1960
explanations of accounting practice theory based on
General
Scientific observations of current practice empirical analysis
Period

1960-1970 what should be v. what is

Two dominant groups:
Normative conceptual framework proponents
Period
critics of historical cost

1970-present
positive accounting theory
Specific explain & predict
Scientific
theory e.g. bonus plan hypothesis, and political cost hypothesis
+ Development of Accounting Theory (1970-Present)
26

Behavioural Research Current Development

◼ Result from the narrow ◼ Corporate collapses e.g. Enron
approach of positive theorists. & WorldCom has triggered
question on whether a
◼ Concerned the broader comprehensive theory of the
sociological implications of impact of accounting on
accounting numbers and the behaviour had been developed.
associated actions of ‘key
players’. ◼ Increase in legislative reporting
requirements.
◼ e.g. The application of Theory
◼ Convergence of accounting
of Planned Behaviour (TPB); standards.
Technology Acceptance
Model (TAM) in accounting ◼ Use of technology.
research.
+ 27

Evaluating Theories of Accounting

◼ There are many accounting theories available.
◼ Why or how would we select one theory in preference to another?

◼ Choose a theory that support the research objectives as well as

research and theoretical perspective.

◼ Researchers that adopt a given ‘paradigm/ perspective’ 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). They are
positivistic, interpretive and critical paradigm.

◼ Theories can coexist and complement each other.

◼ Positive theories can help to understand the role of accounting and in turn
can form the basis for developing normative theories to improve the practice
of accounting.
+ 28

Accounting Theory Construction

APPROACH EXPLANATION
Pragmatic • Observe the behavior of accountants/ those who use the
information provided by the accountants.

Syntactic • Logical argument, based on a set of premises.

Semantic • Concern with the way theories correspond to real-world

events.
Normative • Based on syntactic and semantic.

Positive • Test hypotheses against actual events

Naturalistic • Individual cases and do not try to generalise.

PRAGMATIC THEORY

38

38
39

Pragmatic theory
Pragmatic approaches are based on
observing the behavior of accountants or
those who use the information generated
by accountants.
This approach can be mainly divided:
• Descriptive pragmatic approach
• Psychological pragmatic approach.
39
40

Pragmatic theory
The descriptive pragmatic The psychological pragmatic
approach approach
It is an inductive approach
• It requires theorists to
It is based on continual
observation of the behavior of observe users’ response to
accountants in order to copy the accountants’ outputs
their accounting procedures such as financial reports.
and principles. • A reaction by the user is
Hence, a theory can be taken as evidence that the
developed from observations financial statements are
of how accountants act in useful and contain
certain situations. information relevant to the
users. 40
41

CRITICISM OF Pragmatic theory

Criticism of the descriptive pragmatic approach:
• It does not consider the quality of an accountant’s
action
• Does not provide evidence for accounting practices to
be challenged
• Focuses on accountants’ behaviour not on measuring
the attributes of the firm

Criticism of the psychological pragmatic approach:

Some users may react in illogical manner
Some users might have a preconditioned responses
Some users may not react when they should
41
SYNTACTIC &
SEMANTIC THEORY

42

42
43

SYNTACTIC & SEMANTIC theory

relatively new approach in accounting theory that aims to provide a
more comprehensive understanding of accounting information by
incorporating linguistic and cognitive aspects.

43
44

CRITICISM OF SYNTACTIC & SEMANTIC

theory

• Such approach is criticised because of

lack of independent empirical verification
of the calculated outputs
• Historical cost accounting may produce
accurate (reliable) outputs but which
have little or no utility (relevant)
• They may not be useful for economic
decision making expected to verify
44

accounting entries.
+ 29

Summary of Theories of Accounting

◼ Many theories of financial accounting exist.

◼ No universally accepted perspective about the role of

accounting theory.
◼ different researchers have different perspectives of the
role of accounting theory (for example, to explain and
predict practice versus prescribing particular practice).
◼ a researcher’s own values will influence which theory
he or she elects to embrace.
 Summary 30

Accounting theory
Formulate:
Definition:
•Deductive:
Logical reasoning in the form of
General to
a set of broad principles to
specific
provide a general framework of
• Inductive:
reference by which accounting
Specific to
practice can be evaluated &
general
guide the development of new
practices and procedures.
Objective:
Explain current accounting
practice evolved, suggest Theory Construction:
improvements & provide the [Link] – behavior of
basis for development of such accountants & users of accounting
practice. information
[Link] – rely on logical
argument based on a set of
premise.
Development of Accounting
[Link] – how theories
Theory
correspond to real-world events.
1. Pre-theory period (1400-1800)
[Link] – rely both on semantic
2. General Scientific Period (1800
& syntactic approach.
– 1955)
5. Positive – test hypothesis against
[Link] Period (1956 –
actual events.
1970)
[Link] – consider individual
4. Specific scientific
cases & try not to generalize.
theory/Positive Era (1970 –
present)
+
DISCUSSION QUESTIONS
GROUP 1: Why is positive accounting theory argued to be superior than normative
accounting theory? Discuss

GROUP 2: Explain Extra Reading Material 1: Kabir (2005) Normative Accounting Theory File
page 1- 8, available in spectrum

GROUP 3:
Debate this: Accounting is not related to other disciplines. The use of, for example, financial
and economic theories in accounting research does not necessarily yield any outcome.

Group 4
Refer Reading Material 5 by Coetsee, explain Sec 2,3 and 4.1 page 2-5; available in
spectrum

Group 5
Refer Reading Material 5 by Coetsee, explain 5.2, and 6 page 10-13; available in spectrum

Group 6
Discuss how accounting theories relate to accounting practices? Give examples.

Group 7
Which formulation approach do you prefer, inductive or deductive and why? Relate to real life
examples (industry related examples)
+ 32

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