1. CHAPTER 1 THE ROLE OF ACCOUNTING THEORY

2. 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.

3. 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

4. Why Accounting Theory is Important (Cont’d)
All these various parties act so as to maximize their own welfare.
Corporate managers: if corporate manager’s 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

5. Why Accounting Theory is Important (Cont’d)
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.

6. 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

7. Evolution of Accounting Theory (Cont’d)
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.

8. Evolution of Accounting Theory (Cont’d)
Another basis for the emerging accounting theory was the ongoing debate over the desirability of government regulation of financial disclosure

9. Positive and Normative Propositions
Positive propositions are concerned with how the world works.
Normative propositions are concerned with prescriptions.

10. 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

11. The Three Hypotheses of Positive Accounting Theory (Scott)
The bonus plan hypothesis
The debt covenant hypothesis
The political costs hypothesis

12. 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 researcher’s 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

13. An Outline of Methodology (Cont’d)
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.

14. An Outline of Methodology (Cont’d)
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.

15. An Outline of Methodology (Cont’d)
The Criterion for a Theory’s Success
The value of the theory to users
The costs of prediction errors.
The cost of developing the theory’s prediction.
Intuitive appeal of the theory’s 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

16. An Outline of Methodology (Cont’d)
The Important Role of Competing Theories
Competing theories arise because theories are imperfect and we can not prove a theory correct
Only test a theory’s 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.