Accounting Theory: Questions and Answers
Chapter 1: Fundamental Concepts of Accounting Theory
1. What is meant by accounting theory?
Accounting theory refers to the framework of assumptions, methodologies, and principles
that govern the study and application of financial reporting and accounting practices. It
aims to explain and predict accounting behaviors and practices, ensuring relevance and
reliability in financial reporting.
2. Discuss the double-entry system.
The double-entry system records each transaction as a debit in one account and a credit in
another, maintaining the accounting equation: Assets = Liabilities + Equity. This system
ensures the accuracy of financial records and facilitates error detection.
3. What is the importance of accounting history?
Understanding accounting history reveals how financial systems evolved to meet business
and societal needs. It highlights key developments, such as the introduction of the double-
entry system and the establishment of limited liability companies, shaping modern financial
reporting standards.
4. Compare deductive and inductive approaches to the formulation of accounting theory.
- Deductive Approach: Begins with a general theory or premise and applies logical
reasoning to arrive at specific conclusions or predictions.
- Inductive Approach: Starts with observations and specific instances to develop broader
generalizations and theories.
5. How to verify a theory?
A theory can be verified through empirical testing and validation. This involves gathering
data, conducting experiments or studies, and comparing the results with the theory's
predictions to determine its accuracy and reliability.
Chapter 2: Decision-Usefulness Approach to Accounting Theory
1. Explain the decision-usefulness approach to theory development.
This approach emphasizes providing financial information that is useful for decision-
making, particularly for investors and creditors. It focuses on relevance, reliability, and
comparability in financial statements.
2. How can the decision-usefulness approach relate to accounting theory formulation?
Accounting theory is structured to align with decision-usefulness by ensuring the
information supports rational decision-making, helping users assess past performance and
predict future outcomes.
3. Examples of decisions requiring accounting reports:
- Investment decisions (e.g., buying stocks based on earnings reports).
- Lending decisions (e.g., evaluating a firm's solvency for a loan application).
4. How could researchers evaluate the decision-usefulness of adopting IFRS?
Researchers evaluate decision-usefulness by assessing whether IFRS adoption improves
transparency, comparability, and investor decision-making effectiveness through empirical
studies and user feedback.
5. Who are the primary financial statement users?
Investors, creditors, managers, and regulatory bodies are the primary users, relying on
financial statements for economic decisions.
6. What information do users need according to the conceptual framework?
Users need information on the entity's financial position, performance, and cash flows to
assess its profitability, liquidity, and risk.
7. Qualitative characteristics of useful financial accounting information:
- Fundamental: Relevance and faithful representation.
- Enhancing: Comparability, verifiability, timeliness, and understandability.
8. Why is information about securities’ riskiness useful to investors?
It helps investors assess potential returns relative to the associated risks, enabling informed
portfolio management and investment choices.
Chapter 3: Normative Accounting Theory and Fair Value
1. What is normative accounting theory?
Normative accounting theory prescribes how accounting should be conducted based on
objectives like efficiency and fairness, rather than describing current practices.
2. Qualitative characteristics of useful financial information:
- Relevance: Pertains to decision-making.
- Reliability: Free from material errors.
- Comparability: Allows evaluation across entities.
3. Arguments against historical cost accounting:
- Ignores inflation and market value changes.
- Does not reflect current asset values.
- Can mislead users during economic volatility.
4. Fair value and its benefits:
Fair value reflects current market conditions, providing a more realistic appraisal of assets
and liabilities. Benefits include better predictive value, improved transparency, and
enhanced comparability.
5. Three main types of economic decisions:
- Investment Decisions: Allocating resources to maximize returns.
- Financing Decisions: Determining optimal funding methods.
- Operating Decisions: Managing day-to-day business operations.
Chapter 4: Agency Theory and Reporting Practices
1. Briefly explain the concept of agency theory and its costs.
Agency theory examines conflicts between principals (owners) and agents (managers).
Agency costs arise from monitoring, incentivizing, and resolving these conflicts.
2. Explain efficiency and opportunistic perspectives of Positive Accounting Theory:
- Efficiency Perspective: Managers choose accounting policies to improve contracts and
economic outcomes.
- Opportunistic Perspective: Managers manipulate accounting choices for personal gain.
3. Discuss hypotheses of Positive Accounting Theory:
- Bonus plan hypothesis.
- Debt covenant hypothesis.
- Political cost hypothesis.
4. Describe criticisms of Positive Accounting Theory:
- Focuses on predicting behavior rather than prescribing better practices.
- Neglects ethical considerations.
5. Define earnings management:
Earnings management refers to using judgment in financial reporting to manipulate
earnings, influencing perceptions about a firm’s financial health.
6. Ways management can exercise judgments in financial reporting to manage earnings:
- Adjusting accruals.
- Income smoothing.
- Using big bath accounting.
7. Patterns/strategies of earnings management and their relation to Positive Accounting
Theory hypotheses:
- Income Smoothing: Relates to bonus plan hypothesis.
- Big Bath Accounting: Aligns with political cost hypothesis.
- Manipulating Accruals: Connected to debt covenant hypothesis.
8. Motivations to manage earnings:
- Meeting investor expectations.
- Enhancing stock performance.
- Securing management bonuses.
