Financial Accounting Theory

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Chapter 1 – Financial Accounting Theory

1.1 What is Financial Accounting Theory?

Henderiksen (1970) – Theory is defined as:
A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry.

FASB – a coherent system of interrelated objectives and fundamentals that can lead to consistent standards.

Introduction – theories of financial accounting

Accounting is a human activity and will consider such thing as people’s behavior and/or people’s needs as regards financial information, or the reason why people within organizations might select to supply particular information to particular stakeholder group.

Theories will include consideration of:
• Prescribe how, asset should be valued for external reporting purpose (normative theories – Current cost accounting), based on a particular perspective of the role of accounting.

• Predict that managers paid bonus on the basis of measures such as profits will seek to adopt those accounting method that lead to an increase in reported profit (i.e. Positive Accounting theory)

• Predict that the relative power of a particular stakeholder group.

• Seek to explain how an individual’s cultural background will impact on the types of accounting information to provide to people outside the organization.

• Predict that organization seeks to be perceived by the community as legitimate and that accounting information can be used as a means of gaining, maintaining or regaining the legitimacy to the organization (i.e. Legitimacy Theory)

Chapter 1 – Financial Accounting Theory

1.2 A brief overview of theories of accounting
Different researchers have different perspectives of the role of accounting theory. a.Some researchers believe that the principal role of accounting theory should be to “explain and predict” particular accounting-related phenomena.

b. Other researchers believe that the role of accounting theory is to “prescribe” particular approaches to accounting based on a perspective of the role of accounting. E.g. a theory that prescribes the assets should be valued on the basis of market values rather than historical costs.

Early development of accounting theory relied on the process of induction, that is, the development of ideas or theories through observation. Period 1 (1920s to early 1960s)
From the 1920s to the 1960s, theories of accounting were predominantly developed on the basis of observation of what accountant actually did in practice. That is, they were developed by the process referred to as “induction”. This can be contrasted with a process wherein theories are developed by deductive reasoning, which is based more upon the use of logic rather than observation. Period 2 (1960s and 1970s)

While some accounting researchers continued to adopt an inductive approach, a different approach becomes popular in the 1960s and 1970s. This approach sought to prescribe particular accounting procedures, and as such was not driven by existing practices. I.e. theories being developed based on development of arguments about what the researchers considered accountant should do. Rather than being developed on the basis of inductive reasoning, these theories were being developed on the basis of deductive reasoning. Period 3 (Late 1970s)

In the mid to late 1970s, there were further changes in the focus of accounting research and development and a great deal of accounting research had the major aim of explaining and predicting accounting practice, rather than prescribing particular approach.

Chapter 1 – Financial Accounting Theory

1.3 Positive research and normative research
Research that seeks to predict and explain particular phenomena is classified as positive research and the associated theories are referred to as positive theory. A positive theory begins with some assumption(s) and, through logical deduction, enables some prediction(s) to be made about the way things...
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