UNIT 2: ACCOUNTING THEORY AND METHOD

Contents
2.0 Introduction
2.1 Objectives
2.2 Issues in Accounting Theory
2.3 Theory Formulation
2.4 Testing a Theory
2.5 Summary
2.6 Answers to Learning Activity
2.7 Answer to Check Your Progress Question
2.8 Glossary

2.0 INTRODUCTION

The previous unit was concerned with the evolution and development of accounting in
different parts of the world. This unit is concerned with basic issues in accounting theory, the
formulation of theory, and the testing of theory.

2.1 OBJECTIVES

After completing this unit, you will be able to:

 identify issues in accounting theory;
 describe frameworks that influence the interpretation of accounting theory;
 define the term theory;
 identify parts of a theory;
 understand methods of theory formulation; and
 understand the testing of a theory.

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2.2 ISSUES IN ACCOUNTING THEORY

The person who studies accounting theory may be asked to consider a number of issues.
These are classified into technical and measurement issues, political issues, social issues,
influence of accounting reports on share markets and investments.

Technical and measurement Issues

Some of the technical and measurement issues frequently encountered are the following:
- what is income and why is it measured?
- how should assets and liabilities be valued in the balance sheet?
- should we use buying prices, selling prices, historical costs, a general inflation index
or cash flows as the basis for measuring performance?
- what are intangible assets and why are some intangibles capitalized in the balance
sheet while others are not?

Sociological Issues
Issues which are more sociological in nature encompass such questions as:
- why do accountants and managers continue to support the use of traditional historical
cost accounting and ignore the effects of inflation in their financial reports?
- why do firms change accounting techniques and expend resources in political lobbying
for and against various accounting standards?
- will the conceptual framework project have any significant impact on accounting
practice?

Influence of accounting reports on share markets and investments

A further issue in accounting theory is the influence accounting reports have on share markets
and investments. Some of the common questions faced in this area are:
- do financial statements and various accounting techniques influenced the stock market
prices of listed companies?
- does accounting regulation affect the distribution of wealth in society?
- can financial reports predict future share returns or company failure?
- What asset valuation method provides the most useful information for assessment of a
firm's debt repayment capacity?

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The accountant is faced wit the problem of imposing some sort of order on imprecise events
and transactions which are subject to economic, social, legal, statistical or political
interpretation or analysis. At various times, the accountant may need to be a financial analyst,
a sociologist, a lawyer, a mathematical or even a political scientist. A great deal of financial
information comes in imprecise form. Even numbers perceived as objectives and verifiable
are mere abstractions of a financial world that is any thing but neat, precise, systematic or
predictable. However, the financial analyst, or accountant, must try to impose some logical
and semantic order on this disorderly areas of information. How can such problem be solved?

It seems that accountants, standard setters, and academics themselves do not agree on the
valuation problems of assets and liabilities, and on the scope, purpose, and role of accounting.
Accounting theorists seem to agree not to agree. Accountants have traditionally been seen as
objectively representing 'reality' through the use of numbers when reality is governed by
different 'world views' that accountants hold as individuals.

Frameworks in interpreting accounting theory and practice

Accounting theories and practices have been interpreted in different ways. This is due to the
presence of different frameworks. Some of these frameworks are discussed below:

1. Accounting as historical record

According to this theory, accounting is concerned with providing a faithful record of the
transaction of an entity. It is based on behavioral premises of conservatism, objectivity, and
consistency and the observation of the actions of past accountants. It is based on accounting
standards derived from professional standing.

2. Accounting as a language
Theoretically, accounting is sometimes perceived as a language through which firm
management communicates to other parties such as shareholders.

3. Accounting as intra- corporate politics

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This theory states that accounting systems reflect and support the values and needs of specific
interest groups. According to this theory, accounting information is constructed and used as a
resource in shaping company policies, especially in decision-making and furthering the aims
of management.

4. Accounting Standard setting as politics

This theory stresses that managers lobby on accounting standards to increase the likelihood
that the resultant accounting requirements will serve their own self interest. They lobby for
standards which lower taxes, increase rate setting formula, reduce political and bookkeeping
costs, and increase management compensation. Therefore, accounting standards are regarded
as an outcome of political processes and not technical efficiency.

5. Accounting as Mythology
According to this theory, accounting systems provide a societal resource to be used in
sustaining myths of rationality. Thus, accounting systems are a means of justifying,
rationalizing and legitimating decisions that ultimately serve other individual and social
needs.

6. Accounting as communication-decision information

This is the theory that accounting is action oriented. It is required to adjust to report the
effects of inflation in a manner suited to the needs of users. According to this theory,
accounting is expected to have an impact on the decision-making behavior of managers and
investors.

7. Accounting as an economic good

This theory asserts that accounting is part of a wider information set. It has costs and benefits.
Accounting standards impose compliance (adherence) costs. Regulation determines who bears
the costs and who benefits. Accounting assists parties to monitor the performance of
managers. It also assists managers to show how they have acted in the best interest of those
parties (ex. shareholders and lenders) whose funds they control. It is assumed that
management has chosen from alternative procedures to establish the original set of accounting
methods which minimizes the information costs of the entity. This implies that any changes in
acceptable accounting alternatives have an impact on managers.

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8. Accounting as a social commodity
This theory argues that accounting affects the welfare of different groups in society.
Accounting numbers produced by firms or regulatory bodies promote or discourage different
investments in industry. These numbers have differential impact across industries and firms.
They affect the welfare of firms, employees and society at large. They can hinder or aid
government policies.

The above theories may provide conflicting interpretations about the nature and significance
of accounting and how accounting principles have been or should be developed.

Learning Activity 2.1

1. Indicate issues that should be considered in the study of accounting theories.
2. A theory that accounting is concerned with providing a faithful record of the transactions
of an entity is ____________
3. ___________ is a theory that accounting systems reflect and support the values and needs
of specific interest groups.
4. The theory that asserts accounting is part of a wider information set is ___________.
5. In accounting as a social commodity theory, accounting affects __________.

2.3 THEORY FORMULATION

2.3.0 Overview
The previous section stresses that a number of issues should be considered in the study of
accounting theory. This section is concerned with theory formulation. It begins with the
definition of theory and accounting theory. It then represents the parts of theory.

2.3.1 Objectives
After the completion of this section, you should be able to:
- define theory
- describe deductive reasoning and inductive learning in theory
- identify the parts of a theory.

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2.3.2 Theory Defined
The term "theory" is defined as a statement of a belief expressed in a language. It is a
deductive system of statements of decreasing generality. Theories are nets cost to catch what
we call "the world", to formulate, to explain and to master it.

According to the above definitions, theories are logical arguments. Their concluding
statements of belief are hypotheses. Such theories comprise a set of premises (statements) that
are logically connected to give rise to the hypothesis. Theories may be developed through
induction or deduction. Deduction refers to reasoning from general statements to specific
statements. General premises are used to develop predictions, prescriptions, or explanations of
specific matters.

Inductive reasoning refers to reasoning from particular to general. Specific observations serve
to develop a general implication of those observations.

Some examples of deduction and indication in accounting are shown below:

Panel A:
A: Measuring assets at net realizable value

Deduction
P1: All firms should prepare financial reports to satisfy the information requirements of all
users of the reports.
P2: All users of financial reports are concerned about the solvency of the reporting firms.
C1 = P3: All firms should prepare financial reports to report the solvency of firms
C: All firms should measure assets at net realizable value in their financial reports.

Induction
P1: Firms A and B measure assets at net realizable values in their financial reports.
P2: Firms C, D, and E measure asset at net realizable value in their financial reports.
C: All firms measure assets at net realizable value in their financial reports.

Note that the terms theory, hypothesis, and proposition are used as synonyms.

Theory is a set of principles forming a general frame of reference for a field of study. These
principles must be coherent (i.e., logically consistent). They may be hypothetical (depending
on assumptions), conceptual (consists of thoughts or notions), or pragmatic (relating to

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matters of facts, or practical as opposed to idealistic). Theory is supposed to explain the
phenomenon of interest and to make predictions about its future.

Thus, accounting theory may be described as a "coherent set of concepts explaining and
guiding the accountant's action in identifying, measuring, and communicating economic
information." The modern approach to accounting theory is to develop a conceptual
framework, and then setup standards of accounting practice that are consistent with the
framework.

2.3.3 Parts of a Theory

A theory must be expressed in a language which can be either verbal or mathematical. Theory
development begins in the "unreal" world of abstraction i.e., in the human mind. But it must
be eventually related to the real world (i.e., the world of experience) in order to be useful.

Theory has three major parts, namely, syntactic, semantic, and pragmatic.

1. Syntactics
Syntactics, also called logical relationship, has to do with the rules of the language employed.
For example, if the theory is expressed in English, then this relation refers to the rules of
grammar. Syntactics relate to a flow of logic, not to the accuracy of an argument's
representation of the 'real' world. As such, evaluating the Syntactics of a theory involves
evaluating the validity (i.e., the logic) of argument that constitutes the theory. It does not
involve establishing the truth of an argument where 'truth' is regarded as accuracy in relation
to observations from the real world. If an argument is valid, then, if its premises are true, its
conclusion must be true. An argument can still be valid if its premises do not accurately
represent real world phenomena or if its conclusion is not absolutely correct. The test of
validity is simply to ask whether the conclusion would necessarily follow if the premises are
true. For example, consider the following argument.

Premise 1: All accounts relating to assets have debit balances

Premise 2: The accumulated depreciation account is an asset
Conclusion: The accumulated depreciation account has a debit balance.

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The conclusion (hypothesis) that the accumulated depreciation account has a debit balance is
clearly incorrect. However, the logic (syntactic relationship) is valid because if the premises
where both true, the conclusion would also true. In the foregoing example, premise is
incorrect because there are accounts that relate to assets (contra asset accounts) that have
credit balances.

2. Semantics
The semantic relationship links the basic concepts of a theory to objects in the real world.
These relations are sometimes refereed to as rules of correspondence, or operational
definitions. Semantics concern the relationship of a word, sign or symbols to a real-world
object or event. It is the semantic relations that make theory realistic and meaningful. For
example, the accounting equation, A = L + C, is purely abstract. Only as we correlate each
concept to real world objects do we make the equation realistic. The truth value (or semantic
accuracy) of a premise is established by reference to real-world descriptive accuracy. It is
established in relation to individual premises and the conclusion, but not to the line of logic
(argument) which can only be assessed for validity.

3. Pragmatics
Pragmatic relationship pertains to the effect of words or symbols on people. The nature of
accounting is such that an overall theory of accounting must have a pragmatic orientation. It is
concerned with how accounting concepts and their real world corresponding events or
objective affect the behavior of the people. This concern is revealed by one accounting
statement on the objective of accounting; namely, that it should provide useful information for
decision-making to certain interested parties.

In recognizing the pragmatic nature of much accounting theory, a popular approach to theory
formulation is that accounting information must satisfy the information needs of users.
Another pragmatic approach is to observe that people react to the same message in different
ways. In an accounting context, the release of an accounting standard may motivate some
managers to support that standards while others will lobby for its withdrawal.

Learning Activity 2.2

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1. Which of the following is true about theory?
a) a statement of belief
b) logical argument
c) a deductive system of statements of decreasing generality
d) set of principles
2. Deductive learning refers to reasoning from general statements to specific statements.
(True/ False)
3. Which of the following is the role of general premises?
a) used to develop predictions of specific matters
b) used to develop prescriptions of specific matters
c) used to develop explanations of specific matters
d) all of the above
e) a and c
4. A principle is said to be hypothetical if it:
a) consists of thoughts
b) depends on assumptions
c) relates to matter of facts
d) relates to practice
e) relates to idealistic
5. A principle is said to be pragmatic if it:
a) depends on assumptions
b) consists of thoughts
c) relates to idealistic
d) none of the above
6. The modern approach to accounting theory is to develop a conceptual frame work.
(True/False)
7. Theory development begins in the world of experience (True/False)
8. In order to be useful, theory must eventually related to:
a) the unreal world of abstraction
b) the world of experience
c) the real world

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 d) a and b
e) b and c
9. Syntactics relate to the accuracy of an argument's representation of the real world
(True/False)
10. A part of theory that links the basic concepts of a theory to objects in the real world is:
a) Syntactics relationship
b) semantics relationship
c) logical relationship
d) pragmatic relationship
e) a and c

2.4 TESTING A THEORY

2.4.1 Overview
An important function in scientific methodology is the testing of a theory to determine
whether it is worthy of acceptance. This is considered more important than the particular
method (such as syntactic, pragmatic) used to construct the theory. The previous section was
concerned with theory formulation. This section deals with testing a theory.

2.4.2 Objectives
After the completion of this section, you should be able to:
- distinguish between the definition of truth and the criteria of truth
- understand the different criteria of truth.

2.4.2 Criteria of Truth

A distinction should be made between the definition of truth and the criteria of truth. The
definition of truth deals with the question of what it means for a statement to be true. The
criteria of truth deals with the question of how we are to recognize (judge) a statement as true.
For years philosophers have attempted to define truth but have never been entirely successful.
However, this failure has not stopped scientists from testing theories. Every one has a good
definition, but would disagree on one or several points with the definitions given by others.
Despite the fact that the precise meaning of truth cannot be agreed upon, it is still possible to
establish criteria for recognizing truth. Epistemologically, the term 'truth' refers to a quality

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that is attributable to a statement or belief. It is often used as a colloquial abbreviation for the
phrase 'true statement' or 'true belief'.

There are various ways in which a person comes to belief that certain statement is true or
false. The critical factor in support of a statement is the perceived authority. However, what is
authoritative to one person may not be so for another. People have confidence in different
criteria of truth. Generally, there are three different kinds of criteria of truth; namely,
dogmatic, self-evident, and scientific.

1. Dogmatic Basis
Whenever we believe in statements made by others simply because, they have been made by
an authority, we are employing the dogmatic basis for judging the truth. The confidence
people have in those who make the statements is the underlying for dogmatic basis. Some of
the practical situation of dogmatic basis are:
- reading the newspapers and believe what is reported
- believing what teachers tell at school
- believing what you read in textbooks
The sources of confidence in believing others are
- religion
- political belief
- training
- charisma
- credentials
- position

Where dogmatism is manifested in accounting? In accounting, dogmatism is the basis by

which accountants come to accept the validity of rules and procedures. The FASB approves
pronouncements or accounting standards that are accepted by those in the profession. This
model of operation is believed to be desirable because a certain uniformity of practice is
deemed necessary. The issue is whether confidence in the authoritative body is well placed.
What is the weakness of the dogmatic basis? The weakness of the dogmatic basis is that
introspective evidence, including personal bias, is acceptable in determining the truthness of

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the statement. The critical factor is the individual's personal opinion about the person or group
making the statement. The objective evidence in support of the statements is secondary.

2. Self-Evident Basis
The justification of self-evidence as a way to determine truth is the reasonableness, sensibility
or obviousness of a statement based on our general knowledge experience, and observation.
For example, accounting that involves the use of market prices is self-evidently true. It hardly
seems necessary to conduct an empirical study to determine this. Besides, it is an observable
fact that:
- people seek accounting information so that their actions are better informed
- accounting is concerned with the economic aspects of actions
- accounting information bears on the actions of people in their relations to others.
- The process of accounting involves manipulation of numerical symbols
- Accounting implies communicating.

However, the criterion of self-evidence has revealed its untrustworthiness in the sciences.
Some propositions formerly regarded as self-evidently true have been shown to be false.

3. Scientific Basis
It was recalled that we identified three different parts of a theory; namely, syntactic, semantic,
and pragmatic. Each part suggested different scientific methods to formulate or develop that
theory. However, the way in which scientific theories are developed, tested, and progress is a
matter of some considerable controversy and debatable in the philosophy of science.

In science, to be meaningful a theory or statement must be formulated in such a way as to

make it testable. That means the theory must be formulated so that it falls into either syntactic
category, or induction category.

Statements (theories) that can be ascertained to be valid or invalid by logic (reasoning) alone
are categorized as syntactics. Examination of the syntactic rules is the basis of the test. The
validity of an argument and the truth of any resultant statement can be established without
reference to sensory experience. For example, 3+3 = 6 can be determined to be true by
reference to mathematical rules that are verified from observation of real-world events. This
statements, are known as a prior.

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Those statements (theories) whose truth or falsity can only be known by reference to
empirical evidence as categorized as induction. The truth of the statements is assessed
according to its correspondence with observations of real-world phenomena. Thus, these
statements are known as a posteriori and to be contingent.

Learning Activity 2.3

1. ____________ is concerned with the question of what it means for a statement to be true.
2. ____________ deals with the question of how the statement is judged to be true.
3. ____________ refers to the quality that is attributable to a statement or belief.
4. What is the critical factor in the support of the truthness of a given statement?
5. What are the three major criteria of truth?

2.5 SUMMARY

A number of conflicting theories have been developed about the nature and significance of
accounting and how accounting principles have been, or should be, developed. When
accounting theory is studied, several factors should be considered, such as technical issues,
measurement basis, sociological issues, etc.

A theory generally consists of three distinct parts; namely, syntactic, semantics, and
pragmatics. Syntactics are the formal or logical parts of a theory. Semantics are the
assignment of concepts or measurements to real world events. Pragmatics are the observations
of human reactions or behavior.

Accounting theories and practices are interpreted in different ways. Some of these are:
- accounting as a historical record
- accounting as a language
- accounting as intra corporate politics
- accounting standard settings as politics
- accounting as mythology
- accounting as an economic good
- accounting as a social commodity

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There are several criteria which may be used to judge whether a theory is true or false. These
include the dogmatic, self-evident, and scientific bases. The scientific basis in compasses
syntatics, induction, falsification, research programs, or communities and pluralistic, multi-
parading approaches. In dogmatic basis, the truthness of the statement is judged based on the
confidence people have in those who make the statement, the source of confidence being
religion, political belief, training, charisma, credentials, and position. Under self-evident
basis, the truthfulness of the statement is judged on the reasonableness, sensibility or
obviousness of a statement which in turn, is based on general knowledge, experience and
observation.

Check Your Progress Questions 2-1

1. A theory that stresses that accounting is perceived as a language through which firm
management communicates to other parties is ________________.
2. A theory which states that accounting systems provide a societal resource to be used in
sustaining myths of rationality is ______________.
3. A theory which argues accounting affects the welfare of different groups in society is
___________.
4. ____________ is a set of principles forming a general frame of reference for a field of
study.
5. A principle is said to be conceptual if it consists of ___________.
6. _____________ is the basis by which accountants come to accept the validity of rules
and procedures.
7. The basis of truth that "accounting is concerned with the economic aspects of actions" is
_________________.
8. The confidence people have in those who make the statements is the underlying for
_______________.
9. The criterion of truth that involves that "accountants accept the pronouncements of
FASB concerning accounting standards" is _______________.
10. Statements that can be ascertained to be valid or invalid by reasoning alone are
categorized as ____________.

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 11. Statements whose truthness are determined by reference to mathematic rules that are
verified from observations or real world events are ______________.

2.6 ANSWER TO LEARNING ACTIVITY

Learning Activity 2-1

1. Technical issues, measurement issues, sociological issues, and the like.
2. Accounting as a historical record
3. Accounting as an intra-corporate politics
4. Accounting as an economic good.
5. The welfare of the different groups in society.
Learning Activity 2.2
1. E 4. B 7. False 10. B
2. True 5. C 8. E
3. D 6. True 9. False

Learning Activity 2-3

1. Definition of truth
2. Criteria of truth
3. Truth
4. the perceived authority
5. Dogmatic basis, self-evident basis, and scientific basis

2.7 ANSWER TO CHECK YOUR PROGRESS QUESTIONS 2-1

1. Accounting as a language
2. Accounting as mythology
3. Accounting as a social commodity
4. Theory
5. thoughts/notions
6. pragmatism
7. self-evident basis
8. dogmatic basis

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 9. pragmatism basis
10. syntactic
11. A priori

2.8 GLOSSARY

Theory:
Theory: A statement of a belief expressed in a language.
Semantic:
Semantic: Part of the theory that is concerned with the relationships of a world, sign or
symbol to a real world object or event.
Syntactics:
Syntactics: Part of the theory that involves evaluating the validity of argument that constitutes
the theory.
Pragmatics:
Pragmatics: Part of the theory that pertains to the effect of words or symbols on people.
Definition of truth:
truth: the question of what it means for a statement to be true.
Criteria of truth:
truth: the question of how we are to recognize (judge) a statement as true.
Truth:
Truth: A quality that is attributable to statement or belief.

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