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CHAPTER 1

THE ROLE OF
ACCOUNTING THEORY

Nature of Theory

The objective of accounting theory is to


explain and predict accounting practice.
Auditing practice is included as part of
accounting practice
Explanation: providing reasons for
observed practice.
Prediction: the theory predicts unobserved
accounting phenomena.

Why Accounting Theory is


Important

Many individuals have to make decisions


about external accounting reports.

Corporate managers
Public accountants
Officers of lending institutions
Investors and financial analysts
Individuals in accounting standard-setting
bodies

Why Accounting Theory is


Important (Contd)

All these various parties act so as to maximize


their own welfare.

Corporate managers: if corporate managers welfare


is dependent on the market value of the corporation,
he/she wants to know the effect of accounting
decisions on stock/bond prices.

Determining the relation between accounting


reporting decisions and variables affecting
individual welfare is difficult

Can not be determined by mere observation

Why Accounting Theory is


Important (Contd)

They requires a theory that explains the


relation between the variables
By using large number of observations and
carefully constructed empirical tests,
researchers should be able to provide
theories that are more useful to decision
makers in maximizing their welfare.

Evolution of Accounting Theory

After the US Securities Acts of 1933 and 1934:


accounting theorists became more normative
concerned with what should be done.
Development in finance, which inherited the
concept of economics
Empirical tests of hypotheses were facilitated by the
creation of a large computer data base of security
prices (CRSP) and combined with the availability
of computer.

Led to the development of the efficient market


hypothesis

Evolution of Accounting Theory


(Contd)

Article that had the biggest impact on the


accounting literature was Ball and Brown
(1968).
By mid 1970s accounting researchers had
observed systematic accounting behavior in
accounting practice, which suggested that a
theory could be developed to explain
accounting practice.

Evolution of Accounting Theory


(Contd)

Another basis for the emerging accounting


theory was the ongoing debate over the
desirability of government regulation of
financial disclosure

Positive and Normative


Propositions

Positive propositions are concerned with


how the world works.
Normative propositions are concerned with
prescriptions.

Positive Accounting Theory (Scott)

PAT is concerned with predicting such


actions as the choices of accounting
policies by firm managers and how
managers will respond to proposed new
accounting standards

The Three Hypotheses of


Positive Accounting Theory (Scott)

The bonus plan hypothesis


The debt covenant hypothesis
The political costs hypothesis

An Outline of Methodology

Development of a Theory

A theory consists of 2 parts: the assumptions


and the set of substantive hypotheses.
If the phenomena the research address and/or
the empirical results are interesting, others
researchers will try to improve the original
researchers methodology, apply it to
different phenomena, find and test alternative
explanations, and so on, and a literature will
develop

The theory will change and evolve

An Outline of Methodology (Contd)

The Nonexistence of Perfect Theories and the


Role of Anomalies

A theory can not explains and predicts all accounting


phenomena
Theories are simplifications of reality and the world
is complex and changing.
The mere fact that a theory does not predict perfectly
does not cause researchers or users to abandon that
theory.
But prediction errors are important, because
investigation of them frequently leads to
improvement in the accepted theory.

An Outline of Methodology (Contd)

The Nature of Evidence

Concern with anecdotal evidence:


In some circumstances, that evidence is the only
evidence available, and some evidence is better than
none.
It can suggest ways to improve the theory.

An Outline of Methodology (Contd)

The Criterion for a Theorys Success

The value of the theory to users


The costs of prediction errors.
The cost of developing the theorys prediction.
Intuitive appeal of the theorys explanation for
phenomena and by the range of phenomena it can
explain and predict as well as by the usefulness of
its prediction to users.
Competition between alternative theories

An Outline of Methodology (Contd)

The Important Role of Competing Theories

Competing theories arise because theories are


imperfect and we can not prove a theory
correct

Only test a theorys hypotheses

There is often competition among alternative


theories about the same phenomena.
If competing theories exists, we have to
investigate the variables that those competing
theories suggest are important.