On Theory Construction and Verification

1. On Theory Construction and Verification Author: Robert R. Sterling Source: The Accounting Review, Vol. 45, No. 3 (Jul., 1970). Pp.444-457 Published by: American Accounting Association

2. Article broken up into 4 parts: • I. Introduction • II. The Nature of Theories • III. Some Accounting Interpretations • IV. A Program for Constructing a Theory of Relevant Measurements

3. Introduction Isaac Newton, Theory of Gravity Albert Einstein, Theory of Relativity “Intuitive Flashes” by genius mathematicians have been viewed at times as how those theories came about. Even though, it is very rare that theories arise this way.

4. Theory is defined as follows: a coherent group of tested general propositions, commonly regarded as correct, that can be used as principles of explanation and prediction for a class of phenomena: Einstein's theory of relativity. • When a new theory is proposed it is because the old theory had deviations in it, referred to as “anomalies” • With a theory come predictions and expectations and if those occur then the theory is believed to be correct.

5. II. The Nature of Theories • It is very important to study language, since theories are put into words. • There are three main areas in the study of language: • Syntactics is the study of the relations of signs to signs (p445). For example, If TNT knows drama and CBS does not know drama, then CBS is not TNT. Syntactic is analytical and says nothing about the real world. They are logically true and carry no standalone empirical content. • Semantics is the study of the relation of signs to objects (p445). Semantics are empirical (based on observation) rather than analytical. They are either true or false. For example, Dr. Ward is the head of the graduate school. The statement is either completely true or false. • Pragmatics is the study of the relation of signs to the users of those signs (p446). The same sign can be interpreted in different ways. • Two part division in science, which are empirical or non empirical, come from the three areas of language stated above. • Theory of empirical science is made of combinations between analytical and empirical statements. • Two part division when it comes to a theory of empirical science: (1). A Formal System, which uses syntactical rules and (2). An Interpretations of the formal system using semantical rules.

6. III. Some Accounting Interpretations • An Anthropological Interpretation • The oldest from of theory construction is to watch what an accountant would do and then reason under rules that would apply to all. • If this was adopted it would show a theory of what an accountant would do under certain conditions. • Key challenges: Will this person act in a way that is expected? Changes will not occur because accountants will act with principles set forth by previous generations. The process will be never ending. The cycle will be observe actions teach how to act observe actions. Accounting theory should deal with phenomena, not with practicing accountants. • Sterling goes on to say that interpretation is not appropriate because it gives a theory of accountants’ behavior and not a theory of accounting.

7. III. Some Accounting Interpretations • A Model-of-the-Firm Interpretation • This interpretation implies that individual balances or financial statements speak about the state of the firm • Verification occurs through audits, which say that theory has been confirmed. • The key challenge arises from the audit verification process. Outputs of the system are not verified by auditing. The articles lists cost allocation and depreciation methods as the primary issues. Since present accounting theory states that outputs are not separately verifiable, which speaks of net income and total assets as a grouping rather than individual account. Sterling thinks that it is not appropriate to use this interpretation.

8. III. Some Accounting Interpretations • A Psychological Interpretation • Same as previous interpretation except for verification of the outputs. The output now is the how the receiver reacts, while the inputs are the financial statements given to the reader. • If the reader reacts then it is evident that the financial statements are useful. • A challenge could exist if the reader is conditioned to react by the environment to those financial statements. • Sterling agrees with this interpretation the most because he feels the reaction should be valued when constructing a theory of accounting.

9. IV. A Program for Constructing a Theory of Relevant Measurement • Sterling says, “Accounting ought to be a measurement-communication process” (p454). What he means is that an accountant should do the measurement and communicate the finding to a decision maker. This way decision theories are more practical. • It is very important that accounting theory construction and measurement development go hand in hand. Sterling says, “ The theory specifies what is to be measured, how the measurements are to be manipulated and what measurable outcomes one can expect”(p456) • Sterling concludes by saying, “that Accounting theory can be constructed from the specifications of the broader theories of economic decision” (p457)