Liverpool Business School Accounting and Finance

Accounting Theory: introductory lecture in Redmonds Building

Prepared by Dr. Aneirin Sion Owen & updated on 22nd August 2019.

What is this unit about?

Accounting theory is the principles, concepts and definitions that

underpin accounting standards. Accounting standards suggest that

fixed asset can be valued at cost or market value, and they also say that

stock can be valued at cost price or net realisable value (market value,

near enough). There are a wide of range of accounting standards (AS),

but what are the underlying principles behind accounting?

Clear definitions of “assets”, “profits” and “capital” etc., are needed to

avoid confusion, and some of those definitions are already in the AS.

What is more difficult to clear up is the principles behind accounting. In

truth, accounting can be used in different ways, so there isn’t just one

guiding principle involved. There has been a debate about what

accounts are used for, and different principles have been suggested.

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When accounting principles are discussed, the idea of the aims and

objectives of accounting seems to emerge as a discussion point. What

is the balance sheet, for example? What are its’ aims? It can be

interpreted as a list of assets and liabilities, but, what are you meant to

do with a balance sheet. How do people use balance sheets. It is

sometimes argued that the balance sheet reflects the value of a

business, or, that it is a tool that investors use to monitor managers.

There are, therefore, two different ways of looking at the usefulness of a

balance sheet. It’s worth bearing in mind that you can do both, you can

use a balance sheet in both ways. The problem is finding the underlying

principle, the core aim of the balance sheet, when different investors

may use it in different ways.

Economics has developed theories about how people (consumers,

entrepreneurs, investors etc.) make decisions. Accountants have looked

to economists to find the underlying principles behind accounting, the

economic behaviours that suggest what accounting should be. When a

practical discipline like accounting looks to a theoretical subject like

economics, there will be a clash of perspectives. The practical business

perspective meets (clashes with) the theoretical and philosophical.

Valuing an asset at cost is practical and simple, but, is it logical within

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economic theory? Valuing an asset at market price, or “fair value”, is

more logical to an economist, but, is it appropriate in the business

context, is it practical for accountants, managers and financial decision

makers? The economists’ theory driven logic, can be different from the

accountants’ practical logic.

One question that has been debated more than any other in accounting

is, what is depreciation? There has been a, so called, “Revolution in

Corporate Finance” (see reading list within Canvas) which has cast

doubt on depreciation accounting, from an economists’ perspective.

Accounting practices that have become established over time, through

experience, e.g. depreciation, may lack a logical or rigorous theoretical

explanation within existing economic theory. You’ll get both sides of the

argument in this unit, the strengths of depreciation (matching) and the

weaknesses (it’s not cash flow)

In contrast, some accounting practices, e.g., discounted cash flow, are

perfectly logical from the economists’ perspective, but, they don’t work

quite so well in practice, see various research findings on decision

making and the continued use of “payback period” for example.

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In the scheduled lectures and workshops we will deal with theory, but in

constant touch with accounting theory’s (AT) implications for Annual

Reports and Accounts and the accounting policies adopted. Because

economic theories can be debated at length, it is important to state

clearly the purpose of AT debates. They must lead to improvements in

accounting practice. The purpose of the IFRS Conceptual Framework

(2010) is to improve accounting practice by strengthening, consistency,

relevance or faithful representation.

When I use the word “theory”, I mean economic theory, and, therefore,

logical ideas about why people make decisions. The key attributes of

theory are that it must be based on robust definitions and concepts,

have clear logical links, explain human decision making and be relevant

to key problems, e.g., financial instability and creative accounting. In

recent years, the final one has emerged as more important. A strong

conceptual framework for accounting can help stabilize financial markets

and encourage investment.

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One of the most difficult things to understand in accounting is the fact

that accounting issues and problems gain exposure during a recession,

but, as economic growth returns, the issues are forgotten, only to re-

emerge in more or less the same form when recession resumes.

Debate about accountings’ conceptual framework is cyclical, and recent

debate has been shaped by growing awareness of financial instability.

Starting in the 1980’s, the growth in global capital markets created a

need for globally comparable data, annual reports and accounts. There

was a need for an agreed framework to achieve comparability, an

agreed accounting theory. Financial markets have other needs as well,

e.g., the problem of managing risk, and it seems to me the emphasis

needs to shift now towards a conceptual framework for financial stability

and investment.

Financial markets and regulators, like the Financial Reporting Council,

are dealing with the problem of financial instability, but, at the same time,

accounting is not in good shape. The problems are not terminal, but

accounting is far from perfect. “Creative accounting” was first

recognised in UK in the early 1980’s, more than 30 years ago and the

problem has not been solved, e.g., Tesco plc accounting, UK Banking

collapses, Enron in USA. Other accounting problems include the audit

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expectations gap (why didn’t auditors stop the banking crisis?) and the

dominant position of four big accounting firms (not enough competition).

This final point emphasises the gap between economic theory based on

perfect markets, and the economic reality of accounting in which four

firm dominate.

In my view modern accounting theory, based on an Americanised

version of economic theory, has limitations that have been

underestimated. I prefer the traditional approach of historical cost and

accruals, but we will study both sides of the argument.

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 Modern accounting Theory Traditional accounting practice

Investors’ decision-making is the driving Investors’ need to monitor and control

force behind accounting. management is the key to accounting.

Market value of the company is the key The profitability of the company and the

figure & it’s an “efficient” figure (EMH) strength of the balance sheet

The share price is the key Earnings per share is the key

Discount rate, or, time value of money is Rate of Return on Capital and double

the key concept entry book keeping are the key ideas

Assets are sources of future cash Assets are used in the business & stated

at cost

Capital is PV of future cash flow. Capital is shareholders’ funds.

Economics Political Economy, the investors

Economic theory Accounting practice

USA UK

The idea that the value of an asset or a company is derived from its

future cash flow, discounted back to a PV, is an idea that I want to

question, and I want you to question it too. Over the next few weeks I

will argued that DCF is an “American fantasy”, because it is so distant

from practical accounting reality.

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In textbooks and academic papers they use different terminology to

describe these two perspectives, and they do not pose them as

opposites of each other. I prefer to start by making a clear distinction

between the two, which helps highlight the differences.

Let us look in more detail at the problems of finance and accounting…..

END OF THIS LECTURE