Accounting Theory Construction

The acceptance of a theory depends on the ability of a theory to explain and predict the validity / logical process of the theory’s construction, and the implication of the theory. There are many different approaches to theory construction in accounting. These approaches differ from each other based on the assumptions they rely on, how they were formulated and their approaches to explaining and predicting actual events. Some of these approaches are pragmatic, syntactic, semantic, normative, and positive.
Pragmatic theory
Pragmatic approaches are based on observing the behavior of accountants or those who use the information generated by accountants. This approach can be mainly divided as descriptive pragmatic approach and psychological pragmatic approach. The descriptive pragmatic approach to accounting theory construction is an inductive approach – it is based on continual observation of the behavior of accountants in order to copy their accounting procedures and principles. Hence, a theory can be developed from observations of how accountants act in certain situations. In contrast, psychological pragmatic approach requires theorists to observe users’ response to the accountants’ outputs such as financial reports. A reaction by the user is taken as evidence that the financial statements are useful and contain information relevant to the users.
Syntactic and semantic theories
Syntactic theories are based on a logical relationship, which has to do with the rules of the language used. This theory relates basic concepts at the abstract level and emphasis on the logical reasoning and not the empirical content of the statement in the real world. It refers to a flow of logic, not to the accuracy of an argument’s representation of the real world. Semantic theory in contrast relates basic concepts of a theory with the real world. Verification is based on the premises and conclusion, not
17
on the logical reasoning. Semantics is the study of meaning. It focuses on the relationship between signifiers such as words, phrases, signs and symbols. Thus, a semantic theory provides a framework to specify word meaning.
Normative theories
Normative theories are more concerned with what should be done, rather than with analyzing and explaining what currently accepted practice is. Normative theories developed in 1950s and 1960s, which has been described as the ‘golden age’ of normative research, focused on either on deriving ‘true income’ (profit) for an accounting period or on discussing the type of accounting information which would be useful in making economic decisions (decision-usefulness). True income theorist concentrated on deriving a single measure for assets and a unique (and correct) profit figure. On the other hand, the decision usefulness approach assumes that the basic objective of accounting is to aid the decision making process of certain ‘users’ of accounting reports by providing useful or relevant accounting data.
Positive theories
Positivism or empiricism means testing or relating accounting hypotheses or theories back to experiences or facts of the real world. Positive accounting research first focused on empirically testing some of the assumptions made by the normative accounting theorists. Today, however, the greater amount of positive theory is concerned mainly with ‘explaining’ the reason for current practice and predicting the role of accounting and associated information in the economic decisions of individuals, firms and other parties that contribute to the operation of the market place and the economy.

Positive Theory / Specific Scientific Theory (1970-2000): Positive Accounting

The end of normative period led to the shift of accounting theory development to a new form of empiricism, which operates under the broad label of ‘positive theory.’ This ‘specific scientific theory’ or the ‘positive era’ in fact is not new as it was also based on the empirical approach, which provided the basis for ‘general scientific theory.’ Positive theory sought to provide a framework for explaining the practices, which were being observed. A prominent positive theory in accounting is Positive Accounting Theory (PAT) developed by Watts and Zimmerman in 1978. According to Watts and Zimmerman (1986, p.7) PAT “is concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method but it says nothing as to which method a firm should use.” Three key hypotheses are used in PAT literature to explain and predict support or opposition to an accounting method - bonus plan hypothesis, debt hypothesis and political cost hypothesis, which predict the use of accounting numbers in compensation and debt contracts and in the political process that affects a firm’s accounting.

PAT, which revolutionised accounting theory development in late 1970s, capitalized on the concurrent developments in finance and economic, to explain some of the puzzles faced by accounting researchers and practitioners during that period. The impetus to Watts and Zimmerman’s work was the seminal work of Jensen and Meckling (1976) that altered the course of the corporate finance literature through the articulation of the implications of the agency problem between a firm’s shareholders (principal) and the management (agent) and between shareholders and bondholders in an informationally-efficient capital market. The agency problem arises in part because of the imperfect observability of managerial effort and costly contracting. This nexus of contracts view of a corporation enabled Watts and Zimmerman to develop hypotheses – bonus and debt as to why there should be predictable variation in how firms account for their economic activities as well as why accounting standards would matter, even if capital markets were informationally efficient. Further, Watts and Zimmerman’s political cost hypothesis extends the economics literature on regulation in a political process, as distinct from a market process. Overall, this theory explains the economic or wealth effects of accounting, and why accounting is important to various parties such as shareholders, lenders and mangers – all of whose personal wealth is affected by accounting decisions.

However, positive approach in accounting has attracted much criticism due to the seemingly biased manner that these theorists dismiss alternative viewpoints. This has resulted in resurgence especially in the 1980s, the behavioural research in accounting, which is concerned mainly with the broader sociological implications of accounting numbers and the associated actions of key players such as shareholders, lenders, managers and the government as they react to accounting numbers. Behavioural Accounting Research (BAR) tends to focus on psychological and sociological influences on individuals in their use and/or preparation of accounting. Although

15

BAR had resurgence in the 1980s and continues to be important, it emerged in the early 1950s and first appeared in the accounting literature in 1967 as cited by Birnberg and Shields (1989). Initially, BAR explored the production and use of financial information. However, it gradually started focusing on the decision processes and decision outcomes of individual users, drawing upon the discipline of psychology for its concepts, models and methods.

Normative period (1956-1970): Normative Accounting

The period 1956-1970 is labeled as the ‘normative period’ as during this period accounting theorists attempted to establish ‘norms’ for ‘best accounting practice.’ In this period, the accounting researchers were less concerned about what actually happened in practice but more concerned with developing theories that prescribed what should happen in practice. The major focus of normative theorists during this period was the impact of changing prices on value of assets and the calculation of profit owing to the recorded levels of inflation experienced during this period. Two groups dominated the normative period - the critics of historical cost accounting and proponents of the conceptual framework for accounting. The critics of historical cost accounting tried to develop theories of accounting where asset measurement and profit measurement depended on inflation and/or specific price movements. On the other hand, the conceptual framework is a structured theory of accounting, which is meant to encompass all components of financial reporting and is intended to guide the practice. However, normative period began to drawing to an end in the early1970s due to two main reasons: the unlikelihood of acceptance of any particular normative theory and the availability of financial economic principles and testing methods. These factors are associated with the inability to empirically test normative theories as they prescribed what ought to be. Further, these prescriptions are associated with the value judgment of theorists. These factors created general

Evolution of Accounting Theory

Accounting theory is mainly a modern concept when compared with theories

emancipating from mathematics or physics. Accounting developed as a set of tools to

record activities or transactions. Even Luca Pacioli’s treatise on double-entry

accounting (which provides the basis for modern double-entry booking system) was

about documenting the processes involved, not about explaining the underlying basis

for this method of recording. Unlike disciplines that have natural laws, accounting is

an instrument of human behaviour. It is developed and used for the specific purposes

of individuals who are preparing the information. Chambers (1963) summarized the

view that accounting has been developed in an improvised fashion rather than from a

structured theory as follows: “Accounting is frequently described as a body of

practices which have been developed in response to practical needs rather than by

deliberate and systematic thinking.” Many accounting prescriptions have been

developed to resolve problems as they arose. Hence, the theory underlying those

prescriptions also developed in a largely unstructured manner.

Before 1400s

Before the double-entry system was formalized in the 1400s, very little had been

written about the theory underlying accounting practices. The era before emergence of

double entry system has a certain historical interest but very little relevance to current

accounting issues. However, the record keeping, control and verification problems

encountered in the ancient world were many ways like of our own. In ‘Accounting

Evolution to 1900’ written by A.C. Littleton in 1966 lists seven preconditions that led

to the emergence of systematic bookkeeping as follows:

(1) Art of Writing (since booking is first of all a record);

(2) Arithmetic (since mechanical aspect of bookkeeping consists of a sequence of

simple computations);

(3) Private Property (since bookkeeping is concerned only the facts of property

and property rights);

(4) Money (i.e. a money economy – since bookkeeping is unnecessary except as it

reduces all transactions in properties or property rights to this common

denominator);

(5) Credit (i.e. incomplete transactions – since there would be little impulse to

make any record whatever if all exchanges were completed on the spot);

(6) Commerce (since a merely local trade would never have created enough

pressure [volume of business] to stimulate men to coordinate diverse ideas

into a system) and

(7) Capital (since without capital, commerce would be trivial and credit would be

inconceivable).