1. Financial Accounting Theory Craig Deegan
Chapter 1
Introduction to financial accounting theory
Slides written by Craig Deegan
Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

2. Learning objectives
In this chapter you will be provided with evidence that shows that:
there are many theories of financial accounting
knowledge of different accounting theories increases our ability to understand and evaluate various alternative financial accounting practices
the different theories of financial accounting are often developed to perform different functions, such as to describe accounting practice or prescribe particular accounting practices
Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

3. Learning objectives (cont.)
theories, including theories of accounting, are developed as a result of applying various value judgements and that acceptance of one theory, in preference to others, will in part be tied to one’s own value judgements
we should critically evaluate theories before accepting them
there is good reason for students of accounting to study theories as part of their broader accounting education
Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

4. What is a theory?
‘A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry’ (Hendriksen 1970, p.1).
‘A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’ (The Oxford English Dictionary)
A theory could be based on numerous observations (inductive reasoning) or developed on the basis of logic (deductive reasoning)
Could be ‘positive’ or ‘normative’
Theories can help us make sense of the world in which we live and can provide a structure to understand our (social) experiences
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5. Accounting theories Accounting is a human activity
It would seem illogical to study financial accounting (for example, the accounting standards) without also studying accounting theory
Theories of accounting consider
people’s behaviour with respect to accounting information
people’s needs for accounting information
why people within organisations elect to supply particular information
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6. Examples of uses of accounting theories
Theories might:
prescribe how assets should be valued
predict why managers will choose particular accounting methods
explain how an individual’s cultural background affects accounting information provided
prescribe what accounting information should be provided to particular classes of stakeholders
predict that the relative power of a stakeholder group will affect the accounting information it receives
explain or predict how accounting disclosures might be used as part of a strategy to legitimise the operations of an organisation
Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

7. Why study accounting theories?
how elements of accounting should be measured
motivation for individuals to support or lobby regulators for some accounting methods in preference to others
the implications for organisations and their stakeholders if one accounting method is chosen or mandated in preference to others
how and why the capital markets react to particular information
whether there is a ‘true measure’ of income
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8. Overview of theories of accounting
Many theories of financial accounting exist
No universally accepted theory of accounting
different perspectives about the central objective, role and scope of financial accounting
No universally accepted perspective about the role of accounting theory
different researchers have different perspectives of the role of accounting theory (for example, to explain and predict practice versus prescribing particular practice)
a researcher’s own values will influence which theory he or she elects to embrace
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9. Early development of accounting theory
Relied upon the process of induction
development of ideas or theories through observation
3 conditions (Chalmers 1982):
-large number of observations.
-observations repeated under wide variety of conditions.
-no accepted observation should conflict with the derived universal law.
1920s to 1960s theories developed from observing what accountants did in practice
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10. After observing what accountant did in practice were codified in form of conventions of accounting. Notable theoriests at that time are: Paton(1922), Paton and Littleton(1927), Hatfiled(1927), Canning (1930).
Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

11. Prudent concept, monetary unit measurement were observed and then generalized as accounting principles at that time.
But after 1960 research based on inductive approach was subject to many criticism like: what is not or what should not be these issues were not addresses.
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12. Example of inductive approach to theory development
Grady (1965) undertook research commissioned by the American Institute of Certified Public Accountants (AICPA). Later AICPA went for prescriptive studies for measurement systems be changed from historical cost to a system based on current values.History shows that regulatory bodies rarely accepted prescriptions for significant change to accounting practices.
Formed the basis of APB Statement No. 4 ‘Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises’
reflected generally accepted accounting principles at the time
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13. Theory development—1960s and 1970s
Known as the ‘normative period’ of accounting research
Sought to prescribe particular accounting practices
known as normative theories (normative theories provide prescription)
Not driven by existing practices, and hence not typically inductive in nature (that is, not based on observation)
Rather, were deductive in nature and, based on logical argument, sought to develop new methods of accounting
Theories critical of historical cost accounting
Sought to provide improved approaches to asset valuation in a time of widespread inflation
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14. Example of prescriptive theory
1961 and 1962 studies by Moonitz, and Sprouse and Moonitz commissioned by the Accounting Research Division of the AICPA
Authors proposed that accounting measurement systems be changed from historical cost to a system based on current values
Such research should not be evaluated by reviewing current practice (indeed, there is a general rule that prescriptions about what should be should not be evaluated by reviewing observations of what is)
Not supported by AICPA as too radically different from current practice
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15. Normative theories
Based on what the researcher believes should occur in particular circumstances
not based on observation
Example of normative theory
Continuously Contemporary Accounting (CoCoA) by Raymond Chambers
Conceptual Framework of Accounting
Social and environmental reporting
Should not be evaluated on whether they reflect actual accounting practice
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16. Classifications of normative theories
True income theories
make assumptions about the role of accounting then seek to provide a single ‘best measure’ of profits
Decision usefulness theories
ascribe a particular type of information for particular classes of users on the basis of assumed decision-making needs
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17. Decision usefulness theories
Decision-makers emphasis
undertaking research that seeks to ask decision makers what information they want
knowledge then used to make prescriptions about what information should be supplied
Decision-models emphasis
develops models based on the researchers’ perceptions about what is necessary for efficient decision making
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18. Theory development—mid to late 1970s
Research aimed at explaining and predicting accounting practice rather than prescribing particular practices
Known as positive theories
Contrast with normative theories
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19. Positive theories Seek to predict and explain particular phenomena
Begins with assumption(s), and through logical deduction enables prediction(s) to be made
If predictions are sufficiently accurate when tested against observations of reality, they are regarded as having provided explanation of why things are as they are
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20. Positive theories (cont.)
Positive Accounting Theory
developed by Watts and Zimmerman
is a specific example of a positive theory of accounting
seeks to predict and explain why accountants elect to adopt particular accounting methods in preference to others
based on ‘rational economic person’ assumption
individuals motivated by self-interest tied to wealth maximisation
challenges the view that accountants will be ‘objective’
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21. Criticism of normative theories—an example
Normative theories have been criticised for lack of empirical observation
they are based on personal opinion about what should happen
positive theorists argue that they would prefer to provide information about expected implications of actions and let others decide themselves what they should do
positive theorists also make value judgements
Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e