TOPIC 2:

FORMULATION AND
VERIFICATION OF
ACCOUNTING
THEORY
PART 1-

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 …………………recall:
Theory
formulation
/construction A theory is defined as a set of interrelated constructs
(concepts), definitions, and propositions that present a
systematic view of phenomena by specifying relations
among variables with the purposed of explaining and
predicting the phenomena (Kerlinger, 1964).

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 should have descriptive approach in general and a normative
(prescriptive) approach in particular.

having the quality of authenticity and also authoritative.

Must be wide acceptance.

Characteristics The ability to evaluating and explaining the current events correctly.
of ideal theory
The ability analysing past events and forecast future events

the potentiality of solving the problems created by the happening of an

event.

verifiable through testing of hypothesis.

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  How a particular accounting theory is useful? –The underlying assumptions
 Classify the theories according to the (1)assumptions they rely on, how they are
(2) formulated and their approaches to explaining and predicting actual events.


 Pragmatic,
 Normative,
 Positive, and
 Behavioural

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 Pragmatic theories

Descriptive pragmatic approach Criticisms of descriptive pragmatic

approach

• based on observed behavior of • does not consider the quality of an

accountants accountant’s action
• theory developed from how accountants • does not provide for accounting practices
act in certain situations to be challenged
• tested by observing whether accountants • focuses on accountants’ behaviour not on
do act in the way the theory suggests measuring the attributes of the firm
• is an inductive approach

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 Pragmatic theories

Psychological pragmatic approach: Criticisms of descriptive pragmatic

approach:
• theory depends on observations of the reactions • Criticisms of the psychological pragmatic
of users to the accountants’ outputs approach:
• a reaction is taken as evidence that the outputs – some users may react in an illogical manner
are useful and contain relevant information – some users might have a preconditioned
response
– some users may not react when they should
• Theories are therefore tested using large samples
of people

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 This relation pertains to the effect of words or
symbols on people

Pragmatic How accounting concept and their real world

corresponding events or object affect people’s
theories behavior

Example
Release of accounting standard may motivate
Users of accounting report who base their
some managers to support the standard or
action on the same information
lobby to withdraw it

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 Normative theories

 1950s and 1960s ‘golden age’

 policy recommendations
 what should be
 concentrated on deriving:
 true income (profit)
 practices that enhance decision-usefulness
 based on analytic and empirical propositions

Financial statements should mean what

they say
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 Normative Theories

Features:
 Market-based theories which use methods other than historical cost method.
 Respective concepts of true income and financial position.
 Assume profit maximisation is the primary goal of management.
 Constructed on the basis of deductive reasoning.
 Regard the provision of information for decision making as the main function
of financial statements.

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 Normative Theories

True income: Decision usefulness:

a single measure for assets the basic objective of accounting is to aid the
a unique and correct profit figure decision-making process of certain ‘users’ of
accounting reports by providing useful
accounting data

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 Normative
theories

 Normative approach is based on

value judgments or personal
opinion; and these value judgments
cannot be verified or tested.

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 Positive theories

Positivism or empiricism
means testing or relating
Explain the reasons for
Expanded during the 1970s accounting hypothesis or
current practice
based on ‘experiences’ or
‘facts’ of the real world

Test theories that assume

Predicting the role of
that accounting information People act in their own self
accounting information in
is an economic and political interest
decision-making
commodity

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 Positive theories

Test theories that assume that

Why firms likely use SLM
accounting information is an The theories of people act in
rather than diminishing balance
economic and political their own self interest
depreciation?
commodity

Look at costs and benefits of

alternative accounting methods
Managers incentives to choose
and which valuation models
accounting method
give the best prediction of future
returns, share prices, etc.

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Normative vs Positive

Main differences between normative and positive theories:

 Normative theories are prescriptive
 Describe how accountant should behave to achieve an outcome
that is judged to be right and good income
 Positive theories are descriptive, explanatory or predictive
 Describe how people do behave regardless whether it is right,
explain why people behave in certain manner or predict how
people will react/ do?

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 Behavioural THEORIES

Derived from discipline such as psychology, sociology and organisational theories. Objectives is
to discover why people behave as they do.
According to Hofstedt and Kinard (1970), behavioural accounting research is defined as:
“The study of the behaviour of accountants or the behaviour of non-accountants as they are
influenced by accounting functions and reports”

Encompasses:
 Judgement and decision making of accountants and auditors; and
 Influence of the output on users’ judgements and decisions making.

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 Behavioural Approach

Important of Behavioural accounting research :

 Identifies how people use and process accounting information.

Specifically, it examines the decision-making activities of the preparers, users and auditors
of accounting information.

 Provides valuable insight into the ways of how different decisions are produced, processed
and how people react to particular items of accounting information and communication
methods. By improving the decision making process, users of financial information can
avoid making bad decisions that lead to losses, and preparers and auditors of financial
information can avoid being sued.

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• It can lead to training and increase in knowledge for accountants to improve their skills in
information gathering, processing and communication.
• It can provide useful information to accounting regulators, particularly in the aspect of
providing decision-useful information to the users of financial statements. Can directly
study specific accounting options and then report to standard setters on which methods
or disclosures improve users’ decision.
• It can lead to efficiencies in the work practices of accountants and other professionals.
For example, a computerised expert system for decision making can be developed
through the harnessing and recording of the expertise and skills of experienced
accountants using the behavioural research methods. This system will then be used to
train inexperienced practitioners. Some auditors have also used behavioural research
methods to develop an expert system to conduct risk assessment of potential audit
clients.
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 FORMULATION OF
ACCOUNTING THEORY

Deductive Approach Inductive Approach Ethical Approach

Economic
Sociological
Approach Eclectic Approach
Approach

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 Formulation of Accounting Theory under deductive and inductive

Two approaches to theory formulation

 Deductive Approach
The approach moves from the general (basic propositions or premise) to derive
logical conclusion. Reasoning from general statements to specific statements
Eg:
All humans are opportunistic
Managers are human
Managers are opportunistic

Based on normative theory

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 Formulation of Accounting Theory under inductive approach

Two approaches to The construction of a theory

theory formulation begins with observation and
moves toward generalized Eg: self interest -> wealth
• Inductive Approach Based on positive theory
conclusion. Reasoning from maximization
particular statements to general
statements

PREDICTION: Manager A is
Manager A- bonus ->reported Accounting method A – increases Accounting method B- decreases
more likely to opt for Accounting
profits: reported profit reported profit
method A

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 The deductive approach-what should be

Steps used to derive the deductive approach

Specifying the objectives of Selecting the postulates of Deriving the principles of Developing the techniques of
financial statements. accounting (assumption) accounting. accounting.

(Theories developed from general statement to specific statement/ to develop

predictions, prescription or explanation on specific matters)

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 Premise 1: All asset accounts have
debit balances.

Premise 2: The land and building

Example account is an asset account.

Conclusion: The land and building

account has a debit balance.

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 The inductive approach
 Steps used to derive the inductive approach
1. Recording all observations observation (i.e. phenomena, event of things),
2. Analyzing and classifying and explain these observations to detect recurring
relationships.
3. Inductive derivation of generalizations and principles of accounting from
observations that depict recurring relationships (making conclusion).
4. Testing the generalizations.
(Theories developed from specific statement/observation to develop general
statement / implication of those observation )

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 Premise 1: The Land and Buildings account is an
asset account and has a debit balance.

Premise 2: The motor vehicle account is an asset

account and has a debit balance.
Example
Premise 3: The plant and machinery account is an
asset account and has a debit balance.

Conclusion: All assets accounts have debit balances.

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 In the deductive approach, the truth or falsity of the
propositions does not depend on other propositions, but
must be empirically verified.

Comparing In the inductive approach, the truth of the propositions

depends on the observation of sufficient instances of
recurring relationships.
deductive and
inductive Accounting propositions that result from inductive

approach inference imply special accounting techniques only with

high probability.

Accounting propositions that result from deductive

inference lead, on the other hand, to specific accounting
techniques with certainty.

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 The basis core consists of the concepts of
fairness, justice, equity and truth

The ethical In general, the concepts of fairness implies that

accounting statements have not been subject to
approach undue influence or bias.

The committee on auditing procedures refers to

fairness of presentation as conformity with
GAAP, disclosure, consistency and comparability.

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 The sociological approach

 Emphasizes the social effects of accounting techniques.

 According to this approach, a given accounting principle or technique is
evaluated for acceptance on the basis of its reporting effects on all
groups in society.
 Implies that accounting data will be useful in making social welfare
judgments.

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 Emphasizes controlling the behavior of
macroeconomic indicators that result from the
adoption of various accounting techniques.

The economic The choice of different accounting techniques

depends on their impact on the national economic
approach good.

Accounting policies and techniques should reflect

‘economic reality’ and the choice of accounting
techniques should depend on ‘economic
consequences’.

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 SMA/UITM/PA
 In general, the formulation of accounting theory
and the development of accounting principles
have followed an eclectic approach (a
combination of approaches), rather than just
The eclectic one school of thought.
approach  This approach is mainly the results of various
attempt by professionals and government to
participate in establishment of concepts and
principles in accounting.