ACC00106 -Contemporary Issues in Accounting Session 2, 2013 Topic 1 Theories of Accounting Lecturer:- Dr. Lynn Barkess
Theories of Accounting Session 2, 2013 Overall unit objectives:1. Explain the main concepts inherent in selected theories of accounting 6. Critically evaluate contemporary financial reporting practice.
Theories of Accounting Session 2, 2013 On completion of this topic you should be able to: 1. explain the difference between normative and positive accounting theories 2. explain the difference between theories based on induction and deduction and apply these to accounting theories and practice 3. apply agency theory to financial accounting 4. provide two examples of how agency theory has been empirically tested 5. critically evaluate Positive Accounting Theory 6. explain the purpose and overall limitations of the IAS Framework for the Preparation and Presentation of Financial Statements
Lecture OutlineTopic 1 Theories of Accounting Session 2, 2013 • In this lecture I will address the following issues : • What is theory? • The development of accounting theories, including • Induction V. deduction • Normative Accounting Theories • Positive Accounting Theory (PAT) • Theories and the Conceptual framework • Criticisms of the Conceptual Framework
One Definition of A Theory Session 2, 2013 ‘A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry’ (Hendriksen 1970, p. 1) Theories are generally based on logical reasoning, and not ad hoc in nature
Overview of theories of accounting Session 2, 2013 - there are many theories of accounting -with different researchers having different perspectives on the role of accounting in society, ie they operate from different paradigms
Overview of theories of accounting Session 2, 2013 -theories may explainand/or predictthe choice of accounting policies (these theories may be classified as being Positive Accounting Theories) -theories may prescribe how accounting should be practiced (may be classified as Normative Accounting Theories) - most early accounting theories were based on observation of accounting practice or induction
Development of accounting theories- Induction Session 2, 2013 Accounting theories based oninductionare derived by observing what is happening in practice. From the1920s to 1960s, theories of accounting were developed from careful observation of what accountants did in practice and then codifying that practice into regulation -to make valid generalisations from observation, the sample size must be large, -the observations must be able to be repeated under a wide range of conditions and -no observation should conflict with the derived theory
Development of accounting theories- Induction Session 2, 2013 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 & Maunders 1987, p. 66) Perspective of accounting Darwinism
Development of accounting theories- Deduction Session 2, 2013 The deductive method Deductive or logical reasoning starts with a general case and deduces specific instances. This example from wikipedia: All men are mortal Socrates is a man Socrates is mortal Acceptance of the argument must be based on the accuracy of the premise that all men are mortal and the correct classification of Socrates as a man.
Development of accounting theories- Deduction Session 2, 2013 • Two examples of deductive theories used in accounting • Normative Theory- prescribes what should be donenot what is observed • Positive Accounting Theory- may be used to explain and/ or predict what motivates people and their choices of accounting policies
Development of accounting theories- Normative accounting theories – 60s & 70s Session 2, 2013 Accounting researchers began to question the status quo. They began to develop theories of accounting using deductivereasoning and to provide prescriptions about how accounting should be practiced.
Development of accounting theories- Normative accounting theories – 60s & 70s Session 2, 2013 During this time Professor Chambers argued that information most useful to investors was the adaptive capacity of a business. He argued that exit prices- the price that could be obtained from the sale of the assets should be used to derive the net market value of an entity. To replacehistoric cost a valuation method that has been used for centuries. Other theories of measurement developed around this time include CCA and CPPA (Topic 2).
Development of accounting theories Session 2, 2013 Historical Cost survives due to a general lack of agreement between researchers and regulators on the best way to measure assets.
Development of accounting theories Session 2, 2013 Positive Theories of Accounting Have been developed to explain and predict particular phenomena Watts and Zimmerman’s - Positive Accounting Theory (PAT) is examined in this course
Development of accounting theories- PAT Session 2, 2013 • Is based in agency theory and is a deductive theory that can be tested by observation • PAT focuses on explaining and predicting agency relationshipsin the accounting environment • Agency relationships arise with the delegation of decision making from principal to the agent– separation of ownership and control • Owners and managers • Managers and creditors
Development of accounting theories-PAT Session 2, 2013 Is based on economic assumptions All individuals are rational and driven by self-interest Will act in an opportunistic manner to increase their own wealth
Development of accounting theories- PAT Session 2, 2013 Organisations will use mechanisms (contracts) to align the interests of the of principals and agents These contracts take account of bonding costs and monitoring costs
Development of accounting theories- PAT Session 2, 2013 Bondingcosts arise when agents arepenalised for acting in ways that violate the interests of principals. Based on the notion that the agent will act in their own self-interest the agent will accept a lower salary to compensate (price protect) the principal. Monitoring costs are cost born by the principal. Anexample is the costs of auditing the financial statements prepared by the agent. These costs arise as a result of Information Asymmetry
Development of accounting theories Session 2, 2013 Why study accounting theories? PAT • predict why managers will choose particular accounting methods • predict how the relative power of a stakeholder group will affect the accounting information it receives • PAT researchers include • Bell and Brown (1968): Examined the stock market reaction to accounting earnings announcements. (Deegan p 262) • Jensen and Meckling (1976) considered the relationships and conflicts between principals and agents. (Deegan p 265)
Development of accounting theories Session 2, 2013 • How are accounting theories useful? • Normative Theories • prescribe how assets should be valued • prescribewhat accounting information should be provided to particular classes of stakeholders • The Conceptual Framework is another example of Normative Accounting Theory
Conceptual framework theory Session 2, 2013 • IASB – Conceptual framework is adopted in Australia and Hong Kong and parts of the Framework have also been incorporated in the Accounting standard for business enterprise: basic standard in China ( p. 28 Rankin et al 2012).
Conceptual framework theory Session 2, 2013 How does theory inform the conceptual framework? As mentioned the Conceptual Framework is an example of Normative Theory Prescribes basic principles relating to financial statements. Includes: • Purpose -General purpose FS • Users- Range of users who may provide resources • Why- to meet common information needs of the users for decision making • Underlying assumptions • going concern
Conceptual framework theory Session 2, 2013 • How does theory inform the conceptual framework? • Type of information to be included- relevant and faithful representation • Desired enhancing characteristics- comparability, verifiability, timeliness, understandability (all on a cost benefit constraint) • Elements - essential features of assets, liabilities, equity, income and expenses • Measurement basis - • Concept of capital To be discussed in greater detail in Topic 2.
Criticisms of the Conceptual Framework Session 2, 2013 • Can be ambiguous • Principles are often vague and leaving room for alternative interpretations • Eg., Do share options meet the definition of an expense? Lack of guidance no definitive answers to measurement issues Conceptual Framework simply reflects existing accounting principles and practices (descriptive) rather than being prescriptive (normative) to improve accounting practices.
Criticisms of the Conceptual Framework Session 2, 2013 • Disagreement with principles • Eg., Should main objective of FS be stewardship and accountability instead of providing information useful for decision making • Concept of Faithful representation • Assumes there is one ‘correct and objective’ view. As we know there are many different and legitimate accounting policy choices that can be used in the preparation of the FS. • No guidance is provided as to how to choose among legitimate alternatives.
Evaluating Theory Session 2, 2013 Is the argument logical What are the central assumptions Does the evidence support the story
Topic 2- Measurement Session 2, 2013 Will examine normative theories of measurement and capital maintenance And Creative Accounting