Accounting Theory

Structure of Accounting Theory

ACCOUNTING THEORY STRUCTURE

 Acctg theory is based on several elements

(Belkoui, 2000):
1. Financial Statements objective statements
2. Postulates and accounting theoritical concepts
3. Accounting principles statements
4. Accounting techniques
 1.2 ACCOUNTING THEORY
STRUCTURE
1. Objective of Financial Statements

2a. The postulates of 2b The theoretical concepts

Accounting of accounting

3. The principles of Accounting

4. The Accounting Techniques

 Objectives of Financial
Statement
 The objective as state in CF example; APB No 4
 Particular and general objectives in preparing
financial statement.
 General objectives are as follow:
 Provide reliable information about economic
resources
 Provide relevant information to statement’s user need
 Provide information about future planning of an
organization
 Objective of Financial
Statement

 The qualitative objective of financial

statement are as follow;
 Relevant
 Understandability
 Verifiability
 Neutrality
 Timeliness
 Comparability
 Completeness
 Accounting Postulate

 There are 4 main postulates for accounting

convention:
1. Entity postulate
2. Going-concern postulate
3. Unit of measure postulate
4. Accounting period postulate
 Entity Postulate

 Holds that each accounting unit separate and

distinct from its owner and other firms
 Distinguish between business and personal
transactions
 One way to define economic unit responsible
for economic activities and control of the unit
Going Concern Postulate

 Holds the business activity will continue its

operation long enough to realize its projects,
commitments and ongoing activities.
 Not expect entity to liquidated in foreseeable
future or the continuum for indefinite period of
time.
 Provide financial statement as a series of
continuous report
 Going Concern Postulate

 Justifies the valuation of assets on a non liquidation

basis and provide the basis for depreciation or
impairment of asset.
 Fixed assets are depreciated over their useful life
rather than shorter period of liquidation.
 Support benefit theory that encourage the manager
to forward looking and motivate investors to commit
capital to an enterprise.
Going Concern Postulate
 All accounting theorist not share the same
interpretation on this postulate;
 Paton and Littleton state ‘the possibility of abrupt
cessation of activity cannot afford a foundation of
accounting’
 Chamber views as continuous state of orderly
liquidation, rather than in forced liquidation
Unit of Measure Postulate
 Necessary to account for the transaction of the firm in
the uniform manner by using monetary unit
 Accounting can be a measurement and communication
process that are measurable in monetary terms
 Resulted in two principal limitation of accounting;
 Accounting information are quantified and limit the
prediction of non monetary information
 Purchasing power of money cannot be determined
accurately and stable.
The accounting period
postulate

 Holds that financial reports depicting changes in

the wealth of the firm should be disclosed
periodically.
 Duration period may vary but income tax require
income determination on annual basis, or normal
business practice period.
 More companies issue interim report for more
update and reliable information.
 The accounting period
postulate

 Imposes accruals and deferrals, required the

preparation of financial position in term of
prepaid exp. , uncollected rev., unpaid wages and
depreciation exp.
 Accountant may have to rely on experience and
judgment to determine necessity for accruals and
deferrals.
Theoretical concepts of
accounting
 Three main theoretical concepts of
accounting that always been practice:
 propriety theory
 entity theory
 fund theory
The proprietary theory
 Entity is agent, representative or
arrangement through which the individual
entrepreneurs or shareholders operate.
 Proprietor group as the center of interest
which accounting records are kept and
financial statement are prepared.
 Focus on the determination and analysis of
the proprietor’s net worth
 The proprietary theory

 Accounting equation:
ASSETS – LIABILITIES = PROPRIETOR’S EQUITY
 More assets center and balance sheet oriented.
 Revenues and expenses  increase or decrease
respectively in proprietorship not result from
investment or withdrawal.
 Corporate income tax are expenses and dividends are
withdrawal of capital
The entity theory
 Entity is separate and distinct from those who
provide capital
 Business unit owns the resources of the
enterprise and is legally responsible to claim
of the owner and the creditors.
 Accounting equation:
 ASSETS = EQUITIES
 ASSETS = LIABILITIES + STOCKHOLDER’S
EQUITY
 The Entity theory
 Assets are rights to the entity, so as liabilities are
the obligation of the entity.
 Income is the right of the entity until it is
distributed as dividends
 More “income centered” and concentrate more to
Income Statement
 Income is increase in stockholder’s equity
 The Entity theory
 Undistributed profits will remain the right of entity.
 Income tax is distribution of income rather than expenses
 Impact ,
 Favors the adoption of LIFO rather than FIFO as a better income
determination. Why?
 Revenues are product to company and expenses are goods and
services consumed to obtained these revenues.
 Preparation of consolidated statement and recognition of
minority interest.
The fund theory
 Basis of accounting on group of assets and
related obligations and restrictions.
 Business unit as consisting of economic
resources (funds) and related
obligations/restrictions regarding the use of
the resources.
 Accounting equation:
ASSETS = RESTRICTION OF ASSETS
The fund theory
 The accounting unit is terms of assets and the
uses which it committed. Liabilities is series
of legal and economic restriction on use of
the assets.
 More asset center and consider statement of
sources and uses of funds as the main
statement.
 Primarily applied to government and
nonprofit organizations
The accounting principles

 8 accounting principles that supposed to be

understood:
 Cost principle
 Revenue Principle
 Matching Principle
 Objectivity Principle
 Consistency Principle
 Full disclosure principle
 Conservatism Principle
 Materiality Principle
The cost principle

 Acquisition cost or historical cost is the

appropriate valuation basis for recognition of the
acquisition of all goods and services, expenses
costs, and equities.
 APB no. 4;
“cost is the amount, measured in money, of cash
expended or other property transferred, capital
stock issued, services performed, or a liability,
incurred, in consideration of goods or services
received or to be received. Costs can be be
classified as unexpired or expired.”
The cost principle

 Cost = exchange price of or the monetary

consideration given for the acquisition of goods
or services.
 Justified with objectivity and going-concern
postulate
 Precarious validity of unit-of measure postulate,
that assumes purchasing power of the dollar is
stable. (disadvantage)
The revenue principle
 Revenue principle specifies:
 The nature and components of revenue
 The measurement of revenue
 The timing of revenue recognition
 The nature and component of
revenue
 Revenue can be interpreted as:
 An inflow of net assets from sale of goods @ services
 An outflow of goods @ services to customers
 A product of the firm from mere creation of goods and
services during a given period.
 Product concept regarding measurement and timing
 2 view for component of revenue:
 Broad/ comprehensive- all proceeds from business ,
disposal of assets and investment activities.
 Narrow –includes only the rev.-producing activities
Measurement of revenue

 Value of exchange in an “arm’s-length”

transaction
 2 primary interpretation;
 Cash discount and any reductions in fixed assets
are adjustment necessary
 Non cash transaction is equal to fair market value
of consideration or received, whichever easier to
compute.
The timing of revenue
recognition
 Employ realization principle to select a ‘critical event’
 Earned ,distributable form, result of conversion, results of legal scale,
severed from capital, form of liquid assets
 Accrual basis for rev. recognition reported for
production
 Critical events basis,
 Time of sale-price, exchangeable good, realization of transaction
 Completion of production-stable market and stable price
 Receipt of payment subsequent to sale-resonably accurate valuation
 The matching principle
 Expenses recognized at the same period of association
revenues
 Association between rev. and exp. depends on criteria:
 Direct matching expired cost with rev.
 Direct matching expired cost with period
 Allocation of cost over period benefited
 Expensing all other cost in the period incurred
 Cost of producing finished good for sale; 2 categories
 Inv. valuation & income determination
 Depreciable and non depreciable operating assets
 Cost of selling and administrations
Objectivity Principle

 Depends heavily on the reliability of

measurement procedure used
 Subject to different interpretation;
 Free from personal bias of measure
 Objective measurement based on evidence
 Depends on the given group of measurers
 Size of dispersion as degree of objectivity.
The consistency principle

 Economic events should be recorded and

reported in a consistent manner from period to
period
 Financial statement is more comparable and
more useful, reduce manipulation
 Conformity with GAAP
 Changes has to justify are:
 Reporting entity –retroactive
 Accounting estimates -prospective
 Accounting principle –general and current
The full disclosure
principle
 Disclosure of accounting data should be “full”, “fair”, and
“adequate”
 Should contains sufficient information for average
investor making decision.
 Full disclosure should include;
 Details of accounting policies and methods.
 Additional information to aid in investment analysis pr various
claims party
 Changes from preceding years in accounting policies or methods
 Assets, liabilities, costs & rev. with party that have controlling
interest.
 Contingent assets, liabilities and commitments.
 Financial or non operating transaction after balance sheet date
The conservatism principle

 Choose among two or more acceptable

accounting techniques for the option that has
the least favorable impact on stockholder’s
equity
 Accountant be more pessimistic that
constitute a departure from acceptable
approaches.
 Example adoption of LCM conflicts with
historical principle.
 Materiality Principle
 Transaction and events having insignificant economic
effects may be handle in most expeditious manner
 Implicit guide for accountant of what should be
disclosed
 APB 4, financial reporting is only concerned with
information that is significant enough to affect
evaluation or decisions
 2 criteria recommended
 Size approach (Bernstein-10-15%Niafter tax)
 Change criterion approach- impact of item on trends or
changes between accounting periods.
 The uniformity and comparability
principles
 Use of the same procedures by different firm to
achieve comparability of financial statements to
reduce diversity of using different accounting
procedures.
 To protect the user and present user with
meaningful data
 Principal support;
 Reduce diverse use of acctg procedures and inadequacies
acctg practices
 Allow meaningful comparison
 Restore confidence of users
 Lead governmental intervention and regulation

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1.3 Usage of theory :Theory
Acceptance

 Theory is accepted depends upon:

 How well it explains and predicts reality
 How well it is constructed
 How acceptable are the implications of the theory.
Nature of acctg theory:

 Provide a basis for the prediction and

explanation of accounting behaviour and events.
 Many theories arise from different approaches to
construction of acctg theory.
 Acctg theory as middle range from researchers
percieve both ‘users’ of acctg data and
“environment” where users and preparers
behave.
Nature of acctg theory:
 AAA Committee on Concepts and Standard
conclude;
 No single governance theory is rich enough to
encompass the full range of user-environment
specification
 There exist fa literature not theory of fa but
collection of theories can be arrayed over the
differences in user-environment specification
The nature of accounting:
various images
Accounting as:
 language
 historical record
 current economic reality
 information system
 commodity
 ideology
Accounting as an ideology
Accounting has been perceived as:
 a means of sustaining and legitimising the
current social, economic and political
arrangements:
 Karl Marx maintained that accounting perpetuates a
form of false consciousness and mystifies rather than
reveals the true nature of social relationships
 accounting has been perceived as a myth, symbol
and ritual that permits the creation of a symbolic
order within which social agents can interact
 an instrument of economic rationality and a
tool of the capitalistic system
Accounting as a language
 Accounting is perceived as the language of
business
 According to Hawes, a language has two
components, being symbols and grammatical
rules:
 numerals and words and debits and credits are
examples of the symbols unique to accounting
 in accounting, grammatical rules refer to the
general set of procedures used
Accounting as a historical
record
 Accounting records provide a history of the
manager’s stewardship of the owner’s
resources
 Measurement of the stewardship concept has
evolved over time, in the following periods:
 pure custodial period
 traditional custodial period
 asset-utilisation period
 open-ended period
 Accounting as a current
economic reality
 Balance sheets and income statements should
both be based on economic reality rather than
on historical costs
 The main objective of this image of accounting is
the determination of true income
Accounting as an information
system
 Accounting links an information source or
transmitter (usually the accountant), a channel
of communication and a set of receivers
(external users)
 This view of accounting:
 assumes that the accounting system is the only
formal measurement system in the organisation
 raises the possibility of designing an optimal
accounting system capable of providing useful
information
Accounting as a commodity

 Accounting exists because specialised

information is in demand and accountants are
willing and capable of producing it
 There is a market for accounting information
with its derived demand and supply
 Accounting development:
western ideas
 Babylon, Assyrian, Sumerian civilization- 3000BC
 Luca Pacioli-1494-double entry book
keeping-’Summa de Arithmetica Geometria,
Proportioni et Proportionalita”
 Italian Method –sixteenth and seventeenth
centuries
 19 centuries at US & Britain-MA
 1844-Auditing, ‘CA’-at Scotland (1854) & England
(1870)
 AA of PA (1887) & CPA on 1896 –New York
 Cost Acctg on 1900-industrial revolution
 Early development of
accounting theory
 Relied upon the process of induction
 development of ideas or theories through
observation
 1920s to 1960s theories developed from
observing what accountants did in practice
 codified as doctrines or conventions of accounting
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
and Maunders 1987, p. 66)
 assumes what is done by the majority is the
most appropriate practice
 perspective of accounting Darwinism
Example of inductive
approach to theory
 Grady (1965) undertook research
development
commissioned by the 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
at the time
Theory development - 1960s
and 1970s
 Sought to prescribe particular accounting
practices
 known as normative theories
 not driven by existing practices
 theories critical of historical cost accounting
 sought to provide improved approaches to
asset valuation in a time of widespread
inflation
Example of prescriptive
theory
 1961 and 1962 studies by Moonitz, and
Sprouse and Moonitz 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
 not supported by AICPA as too radically
different from current practice
Theory development - mid to
late 1970s
 Research aimed at explaining and predicting
accounting practice rather than prescribing
particular practices
 known as positive theories
Positive theories

 seek to predict and explain particular

phenomena
 begins with assumption(s), and through
logical deduction enables prediction(s) to be
made
 if predictions are sufficiently accurate when
tested against observations of reality, they
are regarded as having provided explanation
of why things are as they are
Positive theories -
continued
 Positive Accounting Theory
 developed by Watts and Zimmerman
 seeks to predict and explain why accountants
elect to adopt particular accounting methods in
preference to others
 based upon ‘rational economic person’
assumption
 individuals motivated by self-interest tied to wealth
maximisation
Normative theories

 Based on what the researcher believes should

occur in particular circumstances
 not based upon observation
 Example of normative theory:
 Continuously Contemporary Accounting (CoCoA)
by Raymond Chambers
 Should not be evaluated on whether they
reflect actual accounting practice
Classifications of
normative theories
 True income theories
 make assumptions about the role of accounting
then seed to provide a single ‘best measure’ of
profits
 Decision usefulness theories
 ascribe a particular type of information for
particular classes of users on the basis of assumed
decision making needs
Decision usefulness
theories
 Decision-makers emphasis
 undertaking research that seeks to ask decision
makers what information they want
 knowledge then used to make prescriptions about
what information should be supplied
 Decision-models emphasis
 develops models based upon the researchers’
perceptions about what is necessary for efficient
decision making
Evaluating theories of
accounting
 Students should consider the merit of the
argument and the research methods
employed
 some researchers may adopt strategies (such
as overt condemnation of alternative
theories) to support their own research and
theoretical perspective
 Revolutionary scientific
progress (Kuhn)
 Knowledge advances when one theory is
replaced by another as particular researchers
attack the credibility of an existing paradigm
and advance an alternative
 possible explanation of why researchers try to
denigrate the credibility of alternative theories
 but no accounting theory has to date overthrown
all other alternatives
 Pre-science

Crisis
Development of
competing schools of
thought

Anomalies

Dominance of one
paradigm

Khunian revolutions model

Criticism of positive
theories
- an example
 Positive theories of accounting have been
criticised for not providing prescription
 the decision not to provide prescription could
alienate academic accountants from their
counterparts within the profession
Criticism of normative
theories
- an example
 Normative theories have been criticised for lack
of empirical observation
 based on personal opinion about what should happen
 positive theorists argue that they would prefer to
provide information about expected implications of
actions and let others decide themselves what they
should do
 positive theorists also make value judgements