Financial Accounting Theory

Craig Deegan,
3rd edition

Prepared by:
Dewan Mahboob Hossain, Assistant Professor; Department of
Accounting & Information Systems; University of Dhaka; Dhaka;
Bangladesh

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 Chapter 1: Introduction to
financial accounting theory

• Theory
• Why is accounting theory important?
• Overview of theories of accounting.
• Can we prove a theory?
• Logic and evidence.

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 Theory
• A coherent group of general
propositions used as principles of
explanation for a class of phenomena.
• Theories impose cohesion and stability.
• Whenever life is ambiguous people will
work at confronting these ambiguity
through theorizing.

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 Theories of accounting
• Examples:
• Prescribes how assets should be valued for
external reporting purposes?
• Predicts that managers paid bonuses on the
basis of profit will adopt those accounting
methods that lead to an increase in
reported profits.
• Seeks to explain how an individual cultural
background will impact on the types of
accounting information that the individual
seeks to provide to people outside the
organization.

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 Why important?
• Exposure to issues like:
2. How the various elements of accounting should
be measured?
3. What motivates managers to provide certain
types of accounting information?
4. What motivates managers to select particular
accounting methods in preference to others?
5. What motivates individuals to support and
perhaps lobby regulators for some accounting
methods in preference to others?
6. How and why capital market reacts to particular
kind of information?

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 Theories of accounting:
overview
• Many theories of financial accounting.
• No universally accepted theory.

*Explain and predict

*Prescribe (as opposed to describe)

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 Induction
• Early theories  used induction.
• Development of ideas or theories
through observation.
• 3 conditions:
-large number of observations.
-observations repeated under wide
variety of conditions.
-no accepted observation should
conflict with the derived universal law.
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 1920s to 1960s: based on
observations
• Theories of accounting were developed on
the basis of observation of what
accountants actually did in practice
induction.
• Still popular.
• Accounting Darwinism: ‘accounting
practice has evolved, and the fittest, or
perhaps ‘the best’ practices have survived.
• No prescription because, rarely have
regulatory bodies accepted suggestions.

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 1960s and 1970s
• Prescribe particular accounting
procedure not driven by existing
practices.
• Normative period what accountants
should do?
• Deductive reasoning.

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 Mid to late 1970s
• Major aim shifted to explaining and
predicting accounting practices.
• Positive theories.
• Positive Accounting Theory (PAT) was
developed by Watts and Zimmerman. It
seeks to predict and explain why managers/
accountants elect to adopt particular
accounting methods in preference to
others.
• PAT embraced the assumption of self
interest.

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 PAT

• 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 accounting method…but it
says nothing about which method a
firm should use.

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 Can we prove a theory?
• An acceptable theory might admit
exceptions.
• While we might use observations to support
a theory, it would generally be inadvisable
to state that we have proved a theory on
the basis of observations.
• Karl Popper falsification knowledge
develops through trial and error.
• Knowledge develops as a result of continual
refinement of a theory.

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 Logic and evidence
Logical deduction:

• All surfers over the age of 35 ride long

boards.
• Jack is a surfer over the age of 35.
• Jack therefore rides a long board.

• If we accept the above premises, we might

accept the conclusion. It is logical.

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 Logical deduction
• A lot of surfers over 35 ride long
boards.
• Jack is a surfer over 35.

• Therefore, Jack rides a long board.

• Not logical.

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 Logical deduction
• Self-interest tied to wealth maximization motivates
all decisions by individuals.
• Manager X is paid on the basis of reported profit.
• Accounting method Y is an available method of
accounting that will increase reported profits
relative to other methods.

• Manager X will adopt accounting method Y.

• Logical. If the premises are both logical and true,

then the conclusion will be true.

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