ACCOUNTING THEORY (Hendriksen): a set of broad-principles that (1) provides a general frame of reference by which accounting practice can be evaluated and (2) guides the development of new practices and procedures. In other words, the main objective of an accounting theory would be to provide a coherent set of logically derived principles that serve as a frame of reference for evaluating and developing accounting practices

McDonald argues that a theory must have three elements: (1) encoding of phenomena to symbolic representation, (2) manipulation or combination according to rules and (3) translation back to real world phenomena.

Our symbols are debit, credit and other terms. The encoding involves putting transactions in terms of our symbols using translation rules. Techniques for determining profit may be considered rules of manipulation of accounting symbols. Mapping back to real world phenomena is perhaps done by users making economic decisions based on accounting numbers.

Main Characteristics of a Theory

Composed of a body of knowledge

Internally consistent

Explains and/or predicts

Represents the ideal

Ideal reference to guide practice

Addresses problems and provides solutions

Two contrasting philosophies:
Rationalism vs. Empiricism

Rationalism has classical Greek origins. Starting with Ionian speculation on the nature of matter and the universe (Thales, c 634-546 B.C.) and including mathematical speculation (Pythagoras, c 580-c 500 B.C.), culminated in Athens in the rationalist idealism of Plato (c 428-347 B.C.), a disciple of Socrates (c 469-399 B.C.); the latter was sentenced to death for alleged impiety. Aristotle (384-322 B.C.) united all fields of study in his system.[1]
ra·tion·al·ism (ràsh¹e-ne-lîz´em) noun

1. Reliance on reason as the best guide for belief and action.

2. Philosophy. The theory that the exercise of reason, rather than the acceptance of empiricism, authority, or spiritual revelation, provides the only valid basis for action or belief and that reason is the prime source of knowledge and of spiritual truth.

Rationalism is associated with “analytic”

an·a·lyt·ic (àn´e-lît¹îk) or an·a·lyt·i·cal (-î-kel) adjective

1. Of or relating to analysis or analytics.

2. Dividing into elemental parts or basic principles.

3. Reasoning or acting from a perception of the parts and interrelations of a subject: “Many of the most serious pianists have turned toward more analytic playing, with a renewed focus on the architecture and ideas of music” (Annalyn Swan).

5. Logic. Following necessarily; tautologous: an analytic truth.

6. Mathematics. a. Using, subjected to, or capable of being subjected to a methodology involving algebra and calculus. b. Proving a known truth by reasoning from that which is to be proved.

Empiricism

empiricism, (èm-pîr¹î-sîz´em) philosophical doctrine holding that all knowledge is derived from experience, whether of the mind or of the senses. Thus it opposes the rationalist belief in the existence of innate ideas. A doctrine basic to the scientific method, empiricism is associated with the rise of experimental science after the 17th cent. It has been a dominant tradition in British philosophy, as in the works at Locke, Hume, and George Berkeley. Most empiricists acknowledge certain a priori truths (e.g., principles of mathematics and logic), but John Stuart Mill and others have treated even these as generalizations deduced from experience.

em·pir·i·cism (èm-pîr¹î-sîz´em) noun

1. The view that experience, especially of the senses, is the only source of knowledge.

2. a. Employment of empirical methods, as in science. b. An empirical conclusion.

3. The practice of medicine that disregards scientific theory and relies solely on practical experience.

— em·pir¹i·cist noun[2] em·pir·i·cal (èm-pîr¹î-kel) adjective— em·pir¹i·cal·ly adverb

1. a. Relying on or derived from observation or experiment: empirical results that supported the hypothesis. b. Verifiable or provable by means of observation or experiment: empirical laws.

2. Guided by practical experience and not theory, especially in medicine.

Accounting Theory – Some Other Definitions

Hypothesis

A supposition or conjecture put forward to account for certain facts and used as a basis for further investigation by which it may be proved or disproved

Proposition

Any declarative statement that may be believed, doubted or denied as either true or false

A priori propositions (also called analytic propositions)

Statements whose truth value can be known by pure reason or by analyzing the meaning of the words used

A posteriori propositions (also called synthetic or empirical propositions)

Statements whose truth value can be determined only after facts or by virtue of the way the world is. The truth value of these statements cannot be established by pure reason or on the basis of the meaning of the words.

Premise

A statement on which reasoning is based

1. A proposition upon which an argument is based or from which a conclusion is drawn.

2. Logic. a. One of the propositions in a deductive argument. b. Either the major or the minor proposition of a syllogism, from which the conclusion is drawn.[3]

Theory

1. A set of ideas formulated (by reasoning from known facts) to explain something (Darwin's Theory of Evolution)

2. A statement of principles on which a subject is based (Theory of Music)

Deductive Theory

DEDUCTION = logical reasoning that something must be true because it is a particular case of a general law that is known to be true

Inductive Theory

INDUCTION = logical reasoning that a general law exists because particular cases that seem to be examples of it exist

The Scientific Method

Essentially a combination of deductive and inductive reasoning

Descriptive Theory (also called Positive Theory)

When an inductive theory is derived from factual, empirical observations, it is descriptive; it describes what reality is like

Normative Theory (also called Prescriptive Theory)

1. When a theory (especially deductive theory prescribes what the empirical world should be like (regardless of reality), it is called a normative theory

2. A theory which prescribes the behavior to be undertaken, or the rules to be followed in pursuit of specified objectives

Note: math and natural sciences do not usually make distinction between normative and descriptive. But terms are frequently used in social sciences like economics. You could have combinations: a positive theory of market price behavior may assume the use of profit-maximizing rules derived from normative theories of business managerial behavior

Syntactic Theory

Involves a formal structure of relationships which is logically consistent

Semantic Theory

A descriptive structure of relationships which is empirically valid

Pragmatic Theory

A relational structure between a descriptive theory and its environment (users, for example)

APPROACHES TO THE DEVELOPMENT OF ACCOUNTING THEORIES

DEDUCTIVE APPROACH

1. Specifying the objectives of financial statements

2. Selecting the postulates of accounting

3. Deriving the principles of accounting

4. Developing the techniques of accounting

Examples: Edwards and Bell, Moonitz, and Sprouse and Moonitz, APB Statement No. 4, FASB conceptual framework

INDUCTIVE APPROACH

1. Observations, and recording of all observations

2. Analysis and classification of these observations to detect recurring relationships, "likes" and "similarities"

3. Inductive derivation of generalizations and principles of accounting from those observations that depict recurring relationships

4. Testing of the generalizations

Examples: Paton and Littleton, Ijiri

PRAGMATIC APPROACH

The object is to find a ‘workable’ solution to a problem, not necessarily an optimum solution

Quote from Chambers (1966): “What is generally understood by the study of accounting is the study of accounting methods and rules. That a knowledge of methods and rules is useful is obvious. But statements of methods and rules are not statements about accounting. They are part of accounting as it is practiced or as it is recommended to be practiced. As such, they give no understanding of the nature and function of accounting.”

ETHICAL APPROACH

Concepts like fairness, justice, equity and truth are the criteria for formulating accounting theory

SOCIOLOGICAL APPROACH

Similar to an ethical approach because it is concerned with the social effects of accounting techniques. A given accounting principle is evaluated for acceptance based on its reporting effects on all groups in society.

ECONOMIC APPROACH

Emphasizes controlling the behavior of macroeconomic indicators that result from the adoption of various accounting techniques. The choice of different accounting techniques depends on their impact on the national economic good. Criteria:

(1) accounting policies and techniques should reflect "economic reality"

(2) the choice of accounting techniques should depend on "economic consequences"

EVENTS APPROACH

The purpose of accounting is to provide information about relevant economic events that might be useful in a variety of possible decision models. It is up to the accountant to provide the information and it is up to the user to fit the events into their decision models.

BEHAVIORAL APPROACH

Emphasizes the relevance to decision making of the information communicated. Accounting is assumed to be action oriented -- its purpose is to influence action or behavior directly through the information content. The choice of an accounting technique would be evaluated with reference to the objectives and behavior of the users of financial information.

Behavioral effects of accounting information

Human information processing

PREDICTIVE APPROACH

Uses criterion of predictive ability. The choice among accounting options should depend on the particular method's ability to predict events of interest to users. For example, predictions of earnings, bond ratings, takeovers, market reactions, etc.

ECLECTIC APPROACH

What has generally happened in accounting so far. Eclectic approach means a combination of approaches, generally as a result of numerous attempts by individuals, professionals and government organizations involved in the process of setting accounting standards.

Aspects of Accounting Theory Construction

	Propositions
Distinguishing Features	Analytic (a priori)	Synthetic (a posteriori)
Type of science	Analytical	Empirical
Source of propositions	Assumptions	Specific observations
Theory type	Normative (prescriptive)	Positive (descriptive)
Reasoning	Deductive	Inductive
Language system	Syntactic	Syntactic, semantic (pragmatic)
Epistemological Basis	Rationalism	Empiricism
Verification	Logical	Logical, empirical

THE PARADIGMS OF ACCOUNTING

par·a·digm (pàr¹e-dìm´, -dîm´) noun

1. An example that serves as pattern or model.[4]

A paradigm is a fundamental image of the subject matter within a science. It serves to define what should be studied, what questions should be asked, how they should be asked, and what rules should be followed in interpreting the answer obtained. The paradigm is the broadest unit of consensus within a science and serves to differentiate one scientific community (or subcommunity) from another. It subsumes, defines and interrelates the exemplars, theories, methods, and instruments that exist within it.

ANTROPOLOGICAL-INDUCTIVE PARADIGM

A descriptive-inductive approach to the construction of an accounting theory based on a belief in the value of extant accounting practices. Gives rise to two types of theories:

(1) attempts to explain and justify existing accounting practices such as historical cost valuation, and

(2) attempts to explain management's role in the determination of techniques (includes income smoothing and positive theory approaches)

TRUE INCOME - DEDUCTIVE PARADIGM

A normative-deductive approach to the construction of an accounting theory based on a belief that, ideally, income measured using a single-valuation based would meet the needs of all users. Five schools of thought have emerged: (1) price level adjusted accounting (2) replacement cost accounting (3) deprival value accounting (4) continuously contemporary (net realizable value) accounting and (5) present value accounting.

DECISION USEFULNESS - DECISION MODEL PARADIGM

Tends to be an empirical approach (inductive). The subject matter is the usefulness of accounting information to decision models (or relevance to a decision model). Two kinds of theories: (1) information needed to decision models like EOQ, capital budgeting, etc. and (2) predicting economic events like bankruptcy, mergers, bond ratings.

DECISION USEFULNESS - DECISION MAKER - AGGREGATE MARKET BEHAVIOR PARADIGM

Tends to be empirical. Subject matter is aggregate market behavior (stock prices). If an accounting disclosure affects market prices, it must have been useful to decision makers. Thus, the information content of accounting information is examined by stock market reaction. Underlying theory is from finance: capital asset pricing model or divident capitalization model.

DECISION USEFULNESS - DECISION MAKER - INDIVIDUAL USER PARADIGM

Tends to be empirical. Accounting is viewed as a behavioral process. The objective of behavioral research is to understand, explain and predict human behavior in an accounting context. The users can be internal or external, auditors, general public. Basic theories often borrowed from other fields like psychology. Research methods include laboratory experiments, interviews, and questionnaires.

INFORMATION ECONOMICS PARADIGM

A deductive, normative and often mathematical approach. Premise: information is an economic commodity, the acquisition of which amounts to a problem of economic choice. Accounting information is evaluated in terms of its ability to improve the quality of the optimal choice in a basic choice problem. Assumes consistent rational behavior: the choice will be the action with the highest expected payoff or utility. Uses statistical decision theory and economic theory of choice as basis for analytical reasoning.

PRINCIPAL-AGENT PARADIGM

Usually deductive although some inductive work has been done. Related to behavioral research but the roots are finance and economics. Agency theory is concerned with the various costs of monitoring and enforcing relations among various groups to a contract (stockholders versus management). Many agency relationships are defined or governed by accounting numbers (management compensation contracts with bonus based on income). Thus the choice of an accounting method may be influenced by existing contractual arrangements.

epistemology, branch of philosophy dealing with the origin and nature of knowledge, a fundamental theme since the 17th cent. The rationalist view, led by Descartes, Spinoza, Leibniz, and others, sought to integrate a belief in the existence of certain innate ideas with an acceptance of the value of data received by experience. Empiricism, expounded by Hume, Locke, and John Stuart Mill, denied the existence of innate ideas altogether, maintaining that all knowledge comes from human experience. Kant attempted to combine the two views. In later theories the split was reflected in idealism and materialism. The empirical view has been central to pragmatism, as taught by C.S. Peirce, William James, and John Dewey, and to the development of the modern scientific approach.

metaphysics, (mèt´e-fîz¹îks) branch of philosophy concerned with the ultimate nature of existence. Ontology (the study of the nature of being), cosmology, and philosophical theology are its main branches. The term comes from the metaphysical treatises of Aristotle, who presented the First Philosophy (as he called it) after the Physics [Gk. meta-physic, = after physics]. Metaphysical systems in the history of philosophy have included Aristotelian scholasticism and the rationalistic systems of the 17th cent. (e.g., those of Descartes, Spinoza, and Leibniz). Kant, in the 18th cent., held scientific metaphysical speculation to be an impossibility but considered metaphysical questions a moral necessity. His work influenced that of Fichte, Schelling, and Hegel. Since the mid-19th cent. philosophy has generally denied validity to metaphysical thought. Modern interest in metaphysics has centered on analyzing the metaphysical systems that inform prevailing modes of thought. See also logical positivism.

ontology (òn-tòl¹e-jê) noun

The branch of metaphysics that deals with the nature of being.

— on´to·log¹i·cal (òn´te-lòj¹î-kel) adjective, — on´to·log¹i·cal·ly adverb, — on·tol¹o·gist noun

[1]The World Almanac® and Book of Facts 1996 is licensed from Funk & Wagnalls Corporation. Copyright © 1995 by Funk & Wagnalls Corporation. All rights reserved. The World Almanac and The World Almanac and Book of Facts are registered trademarks of Funk & Wagnalls Corporation.

[3] Ibid.

[4] Ibid.

Accounting Theory