Course: Accounting Theory Chapter 1 Faculty: Faieza Chowdhury

Introduction:

In a perfect world there is no demand for published accounting reports and hence accounting
theories. However, in the real world there is always demand for financial and accounting
information. This demand comes from wide range of stakeholders both internal and external.

 Who are the internal and external users of accounting information?

 Why there users need accounting information?

In accounting theory, a major issue is related to questions around measurement. For example:
how should assets and liabilities be measured? By their historic cost, selling price, present value
of the future cash flows?

According to Hendriksen……

Theory is the coherent set of hypothetical, conceptual and pragmatic principles forming the
general framework of reference for a field of inquiry.

Accounting theory is the logical reasoning in the form of a set of broad principles
that

1. Provide a general framework of reference by which accounting practice can be

evaluated.
2. Guide the development of new practices and procedures.

In simple words we can say that a theory is the logical reasoning underlying the statement of a
belief.

Whether a theory is accepted, it depends on:

1. How well it explains and predicts reality.

2. How well it is constructed both theoretically and empirically.
3. How acceptable are the implications of the theory to a body of scientists, professionals
and society as a whole.

It is important to understand that accounting theories are not too apart from the reality. Its main
objectives are to explain why and how the current accounting practices evolved, to suggest
improvements and to provide basis for developments in such practice.
Course: Accounting Theory Chapter 1 Faculty: Faieza Chowdhury

Remember that accounting theory is a modern concept compared to the theories of

mathematics and physics. Accounting was first developed as a tool to record activities and
transactions. Often in accounting people focused on documenting data using particular system
rather than finding out from where that system has developed.

“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.”

In accounting initially in the past, the primary focus was on recording data and solving problems
instead of understanding the underlying concepts and theories. This has led to inconsistencies
in accounting practices. Examples of such inconsistencies include different depreciation
methods used or inventory methods used even within the same industry.

As we have discussed earlier, that due to lack of importance given in the past in understanding
accounting theories and their relevance, later there were many inconsistencies in practice.
However, to overcome this problem there is the conceptual framework in accounting.

What is the conceptual framework?

It is like a constitution. It is a coherent system of interrelated objectives and fundamentals that

can lead to consistent standards and prescribes nature, function and limitation of financial
accounting and financial statements.

Need for Conceptual Framework

A conceptual framework is needed:
1. To build on and relate to a established body of concepts and objectives.

2. To provide a framework for solving new and emerging practical problems.

3. Increase financial statement users’ understanding and confidence in financial reporting.

4. Enhance comparability among the companies financial statements.

Course: Accounting Theory Chapter 1 Faculty: Faieza Chowdhury

Parties involved in standard setting

1. Securities and Exchange Commission (SEC): SEC is a federal agency . Most of the
companies that issues securities to the public or listed on the stock exchange are required to file
audited financial statements with the SEC.

2. American Institute of Certified Public Accountant (AICPA): It issues standards through its
committee on accounting procedure and accounting principles board.

3. Financial accounting standards board (FASB):

It establishes and improves standards of financial accounting and reporting for the guidance and
education of the public.

4. Government accounting standards board (GASB): It establishes and improves standards

of financial accounting for state and local governments.

The Pre-Theory Period:

 Before double entry system was formalized in 1400s, very little was written about the
theory underlying accounting practices.
 During the development period of the double entry system, the main emphasis was on
practices.
 It was not until 1494 that a Franciscan monk, Fra Pacioli wrote the first book to
document the double entry system.
 For 300 years following Pacioli’s 1494 treatise, developments in accounting mainly
concentrated on refining the practices. This is referred to as the “Pre-Theory Period”.
 “No theory of accounting was devised from the time of Pacioli down to the opening of the
nineteenth century. Suggestions of theory appeared here and there but not to the extent
necessary to place accounting on a systematic basis.

Pragmatic Accounting

The period 1800-1955 is often referred to as the “general scientific period”. The emphasis was
on providing an overall framework to explain why accountants account as they do…based on
observation of practice.
Course: Accounting Theory Chapter 1 Faculty: Faieza Chowdhury

Empirical analysis relies on real world observation rather deductive logic that is critical of current
practices.

While it has been labeled as the empirical period in accounting development, there was a
degree of logical debate about the merits of measurement procedures. This was especially the
case after the Great Wall Street crash in 1929. This led to the creation of SEC in 1930s.

What is SEC?

The U.S. Securities and Exchange Commission (SEC) is an independent federal government

agency responsible for protecting investors, maintaining fair and orderly functioning of securities
markets and facilitating capital formation. It was created by Congress in 1934 as the first federal
regulator of securities markets. The SEC promotes full public disclosure, protects investors
against fraudulent and manipulative practices in the market, and monitors corporate takeover
actions in the United States.

The 1930s period also gave rise to several notable accounting publications and initiatives and
saw the birth of professionally based conceptual theory. As a result of this sporadic approach to
the development of accounting principles, American Institute of Certified Practicing Accountants
(AICPA) established the accounting principles board and appointed a director of accounting
research in 1959.

Normative Accounting

The period 1956-70 is labeled as the normative period because it was a period when accounting
theorists attempted to establish norms for best accounting practice. During this period,
researchers such as Edwards and bell in 1961 and Chambers in 1966, were less concerned
about what actually happened in practice and more concerned about developing theories that
prescribed what should happen.

This normative period was one of significant debate. It started a battle of competing viewpoints
on ideal approach to measure and report accounting information.

Two groups dominated the normative period- critics of historical cost accounting and conceptual
framework proponents. The idea of conceptual framework gained increased popularity during
this period. A conceptual framework is a structured theory of accounting. Such frameworks are
meant to encompass all components of financial reporting and are intended to guide practice.
Course: Accounting Theory Chapter 1 Faculty: Faieza Chowdhury

The normative period began drawing to an end in the early 1970s and was replaced by “specific
scientific theory” period and “positive era”. The two main factors that prompted the demise of
normative period were:

1. The unlikelihood of acceptance of any one particular normative theory.

2. The application of financial economic principles, increased supply of data and testing
methods.

Henderson, Peirson and Brown also outlined two major criticisms of normative theories
in early 1970s.

1. Normative theories do not necessarily involve empirical hypothesis testing.

2. Normative theories are based on value judgments.

Positive Accounting

The dissatisfaction with normative theories, combined with increased access to empirical data
sets and increasing recognition of economic arguments within accounting literature, led to
positive theory. Positive theory was hardly new as it was based on empirical approach, which
formed basis of general scientific method. Positive theory sought to provide framework for
explaining practices which were being observed, for example: whether practicing accountants
produced decision usefulness objectives, whether it filled other roles and whether it was inferior
or superior to proposed alternatives. The objective of positive accounting is to explain and
predict accounting practices.