Management And Accounting Web

Hendriksen, E. S. 1977. Accounting Theory. 3rd. edition. Richard D. Irwin, Inc.1

Study Guide for Chapter 1 and Contents of Chapters 2-19

Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

Accounting Theory Main Page  |  Theories Main Page


Contents

Preface
Chapter 1: The Methodology of Accounting Theory
Contents of Chapers 2-19

Preface

Evaluations of theories and concepts include three levels:

1. The structural level - including relationships between and within procedural systems and financial reports,

2. The sematic interpretation level - the relationships of concepts and measurements to real-world phenomena, and

3. The behavioral level - how individual users and capital markets react to accounting information.

Chapter 1: The Methodology of Accounting Theory. 1-32.

Accounting theory is defined as logical reasoning in the form of a set of broad principles that provide a general frame of reference that can be used to evaluate accounting practice, and guide the development of new practices and procedures. This includes a set of theories and sub theories that can be used to explain, predict, and be modified, or abandoned with the development of new information that provides better predictions.

Levels of Accounting Theory

Three levels of theory include:

1. Syntactical theories - theories that attempt to explain accounting practice and predict how accountants react to various situations and report specific events.

2. Interpretational or semantical theories - theories focused on the relationships between an event or object and the term or symbol that represents the phenomenon.

3. Behavioral or pragmatic theories. - theories that are focused on the behavioral or decision related effects of accounting reports and statements.

Theories Relating to the Accounting Structure

There have been many descriptions of accounting practice including those by Ijiri, Sterling, Grady, Goldberg, Sanders, Hatfield, Moore, and Paton and Littleton. Most of these descriptions were about accounting practices that were thought to be generally accepted, although Paton and Littleton's 1965 An Introduction to Corporate Accounting Standards was more prescriptive.

Interpretational Theories

Theories related to how events or objects are related to terms or symbols that represent them are needed to provide meaning to accounting propositions. Canning emphasized definitions including their economic interpretations. Sprouse and Moonitz suggested that the term asset valuation represents the value of future services. Edwards and Bell provided economic interpretations to the concepts of profit and value. Generally however accounting concepts are not interpreted and have no meaning except as the result of following specific accounting procedures. Asset valuation and accounting income provide good examples. Asset valuation is the result of specific procedures such as first-in, first out, or the application of straight-line depreciation to historical costs. Accounting income is an artificial concept that represents the excess revenues over expenses based on specific rules used for their measurement. Many concepts such as current value have a variety of sub concepts including present value, discounted cash flows, market value and net realizable value, and each term can be subject to specific rules of interpretation.

Behavioral Theories

Behavioral theories attempt to measure the economic, psychological, and sociological effects of alternative accounting procedures and reporting methods. How do investors, creditors, and managers react to different accounting methods and presentations? For example, in 1974 Demski presented a model of resource allocation consequences of alternative financial reporting policies. In 1972, Hofstedt attempted to develop an understanding of how decision makers use accounting information.

Deductive and Inductive Reasoning

All formal theories that can be tested and verified must include some elements of deductive and inductive reasoning.

The Deductive Reasoning or Method - In accounting the deductive method begins with objectives and postulates that are used to derive logical principles to provide the bases for practical applications (from general premises to specific methods). It includes the formulation of general or specific objectives of financial reporting, a statement of the postulates of accounting in which it must operate, a set of constraints to guide the reasoning process, a structure, set of symbols, or framework for expressing and summarizing the idea, the formulation of principles or general statements of policy derived from logic, and the application of the principles to specific situations based on established procedures and rules. The formulation of objectives is most important because different objectives may require different principles. For example, the objectives for determining taxable income are different from those involving financial income.

The Inductive Approach - In accounting the induction process involves drawing generalized conclusions from observations and measurements related to financial data and business enterprises (from specific to the general). An advantage of the inductive approach is that it is not constrained by a preconceived model. Disadvantages are that the observer is likely to be influenced by subconscious ideas or bias related to what should be observed, and raw data from different firms are likely to be different. Both inductive and deductive theories may be descriptive or normative. Normative theories attempt to prescribe what data ought to be presented as well as how it should be presented.

Alternative Behavioral Objectives

Theories require a clear statement of their behavioral objectives as indicated above since information useful for one purpose may be of little use for some other purpose. The major emphasis in this book is on developing theory for financial accounting and reporting to stockholders, investors, creditors and other outside interests. However, the objectives of providing information to managers, as well as general social and economic interests are also considered in specific instances.

Alternative behavioral objectives include theories of investment valuation, predictive indicators, the events approach, the ethical approach, the use of communication theory, emphasis on sociological factors, a macroeconomic approach, the pragmatic approach, and nonspecific behavioral objectives.

Theories of Investment Valuation

Investment valuation theories from the finance literature include:

Intrinsic Value Theories - intrinsic value is what an investor believes is the real value of a security that will be reflected in the market price when other investors come to the same conclusion. Intrinsic value theory includes various modifications of discounted dividends, and discounted earnings, although Miller and Modigliani demonstrated that the two approaches are identical. The idea is that an investor will purchase a security when he or she believes its intrinsic value is greater than the market price.

The Efficient Markets Hypothesis - There are three forms of this hypothesis, but the general idea is that the market for securities will be efficient if security prices fully reflect all available information. Variations or forms include: Security prices fully reflect even privileged information (strong form), fully reflect all publically available information about the firm (semi-strong form), and fully reflect information implied by the historical sequence of prices (weak form).

Portfolio Theory - Rational investors will prefer to hold portfolios of securities that maximize the expected rate of return for a given level of risk or minimize the degree of risk for a given expected rate of return. The theory is normative in that it reflects how investors should react, and makes the distinction between systematic risk, i.e.,variability associated with the stock market, and nonsystematic risk, i.e., variability of the rate of return of a security not correlated with the return for the market as a whole.

Predictive Indicators

Predictive ability is a concept derived from the investment valuation models. If accounting data are to be relevant for investors' decisions the data must provide predictions of future objects or events. The 1969-1971 American Accounting Association Committee on Corporate Financial Reporting suggested four ways accounting data can be used in decision models: 1. Direct prediction in the form of forecasts, 2. indirect prediction based on past data assumed to have predictive ability, 3. the use of lead indicators, and 4. corroborating information used as predictive indicators. However, the predictive ability test is difficult because of the complexities of the business environment, our lack of understanding of the relationships of past and future measurements of objects and events, and the inability to formulate reliable normative descriptive decisions models.

The Events Approach

The idea underlying the events approach is that there are a wide variety of users of financial statements, and as a result financial reports should not be designed for specific assumed users. Instead, financial reports should include more detail and less aggregation. In addition, decision models cannot be developed with sufficient precision to determine the types of accounting information relevant to these models. An event is defined as an occurrence, phenomenon, or transaction that is observable and has better semantic interpretation than value measurements of assets and liabilities. The balance sheet is viewed as an aggregation of events that have occurred in the past. The income statement is a presentation of operating activities, but net income has little if any meaning. The funds statement also focuses on the activities of the firm. Disadvantages of the events approach include the vagueness of the criterion for choosing information to be presented, the possible overload of more detailed information on users, and the lack of evidence that the measurement of events is more verifiable than the measurement of objects, or that it leads to better predictions.

The Ethical Approach

The ethical approach to accounting theory is focused on the concepts of justice, truth, and fairness. The idea is that accounting reports must provide equitable treatment to all interested parties, present a true and accurate statement without misrepresentation, and should be fair, unbiased, and impartial without serving special interests. In addition, accounting procedures should allow for changing conditions, and be applied consistently whenever possible. However, truth as it relates to accounting is difficult to define and apply. For example, historical costs is based on truth (facts), but in most cases it does not represent the true value of assets in current economic terms. Fairness in accounting is based on being in conformance with generally accepted accounting principles, disclosure, consistency, and comparability. Although a statement by the auditors that the financial statements present fairly the financial position of the company implies an ethical judgment, the practical meaning in most cases is that the statements are in accordance with traditional accounting procedures. The main disadvantage of the ethical approach is that it fails to provide a sound basis for the development of accounting theory, or for the evaluation of current accounting principles.

Communication Theory Approach

Accounting may be viewed as a communication process involving what information should be recorded, and how it should be communicated and interpreted. In 1966 a committee of the AAA defined accounting as the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information (A Statement of Basic Accounting Theory).

Sociological Approach

The sociological approach focuses on the effects of accounting principles on the behavior of users and other groups in society. The idea is that accounting information should provide information related to broad welfare judgments. However, adequate principles cannot be established without a basis for determining what welfare judgments are important and what information is needed for that purpose.

Macroeconomic Approach

The macroeconomic approach may be descriptive (i.e., explain the effect of alternative reporting methods on economic measurements and activities), or normative (i.e., to direct the economic behavior of firms and individuals toward specific economic policies). Some countries, notably Sweden have used this approach to influence macroeconomic outcomes, but in the U.S. macroeconomic policy has had little influence on accounting theory and practice.

The Pragmatic Approach

The pragmatic approach involves developing accounting concepts and techniques that are useful in realistic situations, i.e., help managers,  stockholders and others interpret accounting to accomplish their specific objectives. However, this approach has several disadvantages. For example,  there are no basic criteria for determining what is useful, and the pragmatic approach has not been applied to accounting in a logical way.

Nonspecific Behavioral Objectives

Most accounting practices have been established without a theoretical foundation. The principles and techniques that have been recommended by the APB and FASB have become generally accepted through general acceptance in actual practice. This general acceptance has been viewed as proof of their utility. Limitations of this practical approach are that generally accepted principles and methods are not necessarily the most useful for decision making, and assuming that they are the best methods available may deter further progress in the development of accounting theory and practice.

Verification of Accounting Theories

To be persuasive, accounting theories must be subject to verification or confirmation. Premises related to the real world should be based on observable phenomena, statements in the theory should be tested for logical consistency, and any premises based on value judgments in the theory should be subject to independent empirical verification. A question arises as to how a premise or hypothesis is confirmed? One method is to measure the empirical truth value of the premise or hypothesis under a given level of statistical significance.

Controversy in the Development of Accounting Principles and Procedures

In this textbook the critical analysis of accounting principles is based on an eclectic concept of accounting theory. Each of the approaches has some merit while none of the approaches is adequate by itself. However, any complete theory must be accompanied by some deductive reasoning. The controversy is that some method is needed to permit the results of accounting theory to influence the choice of accounting alternatives in practice. The laissez faire approach allowing each accountant to do as he or his client desires is not the answer. A second method involves voting by accountants or by users of accounting reports, but this approach also includes several disadvantages. The determination of accounting procedures by an official body is a third method and appeared to be the direction the U.S. and most other countries were moving when this textbook was written.

Selected Additional Reading on Chapter Topics

This section includes many readings on general methodology, behavioral theories, deductive and inductive reasoning, normative theories, theories of investment valuation, predictive ability, the events approach, the ethical approach, the communication theory approach, the sociological approach, the macroeconomic approach, the pragmatic approach, and verification of accounting theories.

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1 There were several editions of this textbook, 1965, 1970, 1977, 1982, and 1991. I have the 1970 and 1977 editions. The 1991 edition was written with Michael F. Van Breda.

Related summaries:

Backer, M. editor. 1966. Modern Accounting Theory: A Revision of Handbook of Modern Accounting Theory. Prentice-Hall, Inc. (Contents).

Covaleski, M. and M. Aiken. 1986. Accounting theories of organizations: Some preliminary considerations. Accounting, Organizations and Society 11(4-5): 297-319. (Summary).

Covaleski, M. A., M. W. Dirsmith and S. Samuel. 1996. Managerial accounting research: The contributions of organizational and sociological theories. Journal of Management Accounting Research (8): 1-35. (Summary).

Johnson, H. T. 1983. The search for gain in markets and firms: A review of the historical emergence of management accounting systems. Accounting, Organizations and Society 8(2-3): 139-146. (Summary).

Johnson, H. T. 1987. The decline of cost management: A reinterpretation of 20th-century cost accounting. Journal of Cost Management (Spring): 5-12. (Summary).

Martin, J. R. Not dated. 200 years of accounting history dates and events. Management And Accounting Web. Accounting History Dates And Events

Neimark, M. and T. Tinker. 1986. The social construction of management control systems. Accounting, Organizations and Society 11(4-5): 369-395. (Summary).

Solomons, D. 1966. Economic and accounting concepts of cost and value. In Backer, M. ed. 1966. Modern Accounting Theory. Prentice-Hall Inc. Chapter 6: 117-140. (Summary).

Tiessen, P. and J. H. Waterhouse. 1983. Towards a descriptive theory of management accounting. Accounting, Organizations and Society 8(2-3): 251-267. (Summary).