Decision Analysis Lecture Summary Topics 1 to 5

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Accounting Theory

* What is an accounting theory?
Hendriksen’s definition:
…logical reasoning in the form of a set of broad principles that * provide a general framework of reference by which accounting practice can be evaluated and * guide the development of new practices and procedures. * Whether a theory is accepted depends on how:

* well it explains and predicts reality
* well it is constructed both theoretically and empirically * acceptable its implications are

The development of accounting theory has been mostly unstructured Chambers:
Accounting has frequently been described as a body of practices which have been developed in response to practical needs rather than by deliberate and systematic thinking.

* Standards have mostly been ad hoc and reactive leading to inconsistencies in practice * Conceptual framework projects haven't resolved inconsistencies.

Pragmatic accounting (1800– 1955)
The ‘general scientific period’
* based on empirical observation of practice
* provided an explanation of accounting practice
* focused on the existing ‘viewpoint’ of accounting Descriptive pragmatic approach:
* based on observed behaviour of accountants
* theory developed from how accountants act in certain situations * tested by observing whether accountants do act in the way the theory suggests * is an inductive approach

Psychological pragmatic approach:
* theory depends on observations of the reactions of users to the accountants’ outputs a reaction is taken as evidence that the outputs are useful and contain relevant information

Normative accounting (1956-1970)
* Sought to establish ‘norms’ for the best accounting practice * Focused on what should be (the ideal) v. what is
concentrated on deriving:
- true income (profit) (single measure for assets, unique correct profit) - practices that enhance decision-usefulness
* based on analytic and empirical propositions
Two competing groups dominated:
* conceptual framework proponents
* critics of historical cost
Criticism of normative period
* they do not necessarily involve empirical hypothesis testing * they are based on value judgements

Financial statements should mean what they say

Positive accounting (1950 to the present day)
* Had its origins in the ‘general scientific period’ * It seeks to explain the accounting practices being observed * Its objective is to explain and predict accounting practice (e.g. the bonus plan hypothesis) * It helps predict the reactions of ‘players’, such as shareholders, to the actions of managers and to reported accounting information Major deficiencies are:

* ‘wealth maximisation’ has become the answer to explain all accounting practices and reported information * it relies excessively on agency theory and dubious assumptions about the efficiency of markets

Positive accounting (1950 to the present day)
* Scientific approach:
* has an inherent assumption that the world to be researched is an objective reality * is carried out by incremental hypotheses
* has an implied assumption that a good theory holds under circumstances that are constant across firms, industries and time * Criticism of the scientific method:
* large-scale statistical research tends to lump everything together * it is conducted in environments that are often remote from the world of or the concerns of accountants * Naturalistic approach:

* implies that there are no preconceived assumptions or theories * focuses on firm-specific real-world problems

Scientific approach applied to accounting
Misconceptions of purpose
* Make scientists out of accounting practitioners
* Researchers = practitioners
* The desire for ‘absolute truth’
The scientific method does not claim...
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