Introduction to

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Lecture 1

• Introduction to
• Accounting Theory

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Doris Merkl-Davies
Division Financial Studies Location Room 1.08,
Hen Goleg Telephone [phone] Email
d.m.merkl-davies_at_bangor.ac.uk
Reader in Accounting MA, PGCE (Vienna
University), MBA, PhD (Bangor University) Office
hours Mon. 9.00-10.00 Wed. 2.00-3.00 (Hen
Goleg, Room 1.08)
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Doris Merkl-Davies

• Research interests
• Corporate narrative reporting
• Impression management
• CSR reporting
• Accounting theory

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Doris Merkl-Davies

• Cant live without

• Motto

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BBS film club

• Venue Alun A0.01, 3.00-5.00pm
• WEEK 3 (WEDNESDAY 15 OCTOBER)Wall Street
  (discussant Doris Merkl-Davies)
• WEEK 5 (WEDNESDAY 29 OCTOBER)Office Space
  (discussant Tony Dobbins)
• WEEK 9 (WEDNESDAY 26 NOVEMBER)Citizen Kane
  (discussant Bernardo Batiz-Lazo)

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Module format

• Lectures Mon. 10-12 in Drama Rehearsal Room
• Tutorials
• Group A Mon, 13.00-14.00 LR5
• Group B Tue, 9.00-10.00 LR1

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Recommended Textbooks

• Deegan, C. and Unerman, J. (2011). Financial
  Accounting Theory. European edition. 2nd ed.
  McGraw-Hill. (DU) Main text I
• Rankin, M., Stanton, P., McGowan, S., Ferauto,
  K., Tilling, M. (2012). Contemporary Issues in
  Accounting. 2nd ed. Wiley. (R) Main text II
• Godfrey, J., Hodgson, A., Holmes, S. and Tarca,
  A. (2010). Accounting Theory. 7th ed. Wiley.
  (GHHT) additional reading
• Additional journal articles will be posted on
  blackboard for you to download.

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Background reading for Lecture 1

• DU Chapter 1
• Rankin et al. Chapter 1 Chapter 5, pp. 131-134
• GHHT Chapts. 13

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Overview of Lecture 1

• Definition of accounting theory
• Types of accounting theories
• Accounting theory development over time
• Relationship between theory and research
• Evaluation of theories

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Exercise 1 What is a theory?

• In groups of 6 find an example of a famous theory
• Discuss the main features of the theory
• What does this theory do?
• What do we use it for?
• Nominate a group member to report back to the
  class

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What is a theory?

• An organized way of thinking about a subject
• A set of ideas that explains something
• a scheme or system of ideas or statements held
  as an explanation or account of a group of facts
  or phenomena (Oxford English Dictionary)
• theory is a statement of concepts and their
  interrelationships that shows how and/or why a
  phenomenon occurs (Corley Gioia, 2011 12)

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What is the purpose of theories?

• To make sense of the world (physical, social,
  psychological phenomena) and communicate that
  understanding to others
• To make sense of (financial) accounting
  information
• Financial statements, corporate annual reports
• Accounting info is compiled and interpreted by
  people

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Types of theory
Type of theory Users Example
Common-sense theory Lay people (personal experience) It is not what you know, but who you know http//www.telegraph.co.uk/news/politics/10137928/Its-still-who-you-know-not-what-you-know-that-matters-say-two-thirds-of-Britons.html
Working theory Managers, investors, auditors (Generalisations made in particular professions) Crisis communication should prioritise key stakeholders http//www.bernsteincrisismanagement.com/articles/10-steps-of-crisis-communications.html
Scholarly theory Academics Accounting choice is driven by managerial self-interest Positive Accounting Theory
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Scholarly theory

• Has undergone systematic research
• Provide more thorough, accurate, and abstract
  explanations for financial accounting than
  common-sense or working theories

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What is the purpose of theories?

• Theories are used to
• Describe what people do Descriptive theories
• Suggest the best way (i.e., prescribe) to deal
  with specific types of human behaviour
  prescriptive or normative theories
• Explain and predict what people do predictive
  or positive theories

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1. Descriptive theories

• Describe what people do
• Based on common practice
• Describe
• Common practise of bringing up children
• Common practises for dealing with underage binge
  drinking in various countries
• Describe accounting practice
• Common practise of accounting for fixed assets
• Future accountants are trained by practising
  accountants

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Descriptive theories

• Advantage
• Tends to be accepted by majority
• Disadvantage
• Does not entail critical evaluation
• Does not allow for change

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2. Prescriptive ( normative) theories

• Also called normative theories
• What people should do
• Suggest best way to
• Bring up children, i.e., authoritarian,
  laissez-faire style, etc.
• Prescribe particular accounting practices
• Account for fixed assets, i.e., historical cost,
  current cost, exit price, etc.
• Advantage
• Can improve accounting practises
• Disadvantage
• Assumes that there is one best way

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3. Predictive ( positive) theories

• Also called positive theories
• Concerned with explaining reasons for behaviour
  and predicting future behaviour
• Explain characteristics of children are most
  likely to engage in binge drinking, i.e., social
  class, gender, parenting style
• Predict what effect a change in licensing laws
  will have on underage teenage drinking
• Explain and predict accounting method choice
• Characteristics of companies most likely to
  revalue their assets
• What effect a change in accounting standards on
  leases will have on the way firms finance their
  assets

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Comparison of descriptive, prescriptive and
predictive theories
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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 individuals 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
• predict that accounting information is used to
  present organisations as legitimate

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Accounting theories

• Accounting is a human activity
• Explain the behaviour of people within and
  outside of organisations with respect to
  accounting information
• Theories of accounting consider
• Why people within organisations elect to provide
  particular information (preparer perspective)
• Peoples behaviour with respect to accounting
  information (user-perspective)
• Peoples needs for accounting information
  (user-perspective)

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Accounting theories

• Accounting is a social phenomenon
• Accounting theories are theories about human
  behaviour
• Borrow from disciplines dealing with human
  behaviour
• Psychology, sociology

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Exercise 2

• Which of the following is NOT an assumption used
  in normative theory construction?
• A. Profit and value can be measured precisely
• B. Financial accounting is useful for making
  economic decisions
• C. There are multiple available profit measures
• D. Markets are inefficient and can be fooled by
  'creative accountants
• E. All of the above

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Why do we need accounting theories?

• Accounting is viewed as a practical discipline
• Learning how to apply accounting rules
• Theories are necessary to understand the (social)
  world we live in
• They provide a basis for the decisions we make,
  e.g. whether to include an item in the financial
  statements or not (materiality and recognition
  criteria)

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Why do we need accounting theories?

• We can make better predictions and decisions if
  we get the contradictions out of our thinking, if
  we consider what is known on the many sides of
  the issue
• i.e. the various theories which exist on
• The regulation of accounting, e.g. whether we
  need regulation or not
• The provision of financial information, e.g. Why
  accountants choose particular accounting methods
• The way financial information is received, e.g.
  How people react to particular accounting numbers

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Why study accounting theories to understand

• Motivation for individuals to support or lobby
  regulators for some accounting methods in
  preference to others (? Regulatory theories)
• How and why the capital markets react to
  particular information (? Positive accounting
  theory)
• Whether there is a true measure of income (?
  Asset valuation theories)

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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

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Accounting Theory Timeline
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Early development of accounting theory

• Descriptive theories
• Relied upon the process of induction
• Development of ideas or theories through
  observation
• 1920s to 1960s theories developed from observing
  what accountants did in practice
• Codified as doctrines or conventions of
  accounting

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Criticisms of inductive method

• concentrates on the status-quo, is reactionary
  in attitude, and cannot provide a basis upon
  which current practice may be evaluated or from
  which future improvements may be deduced. (Gray,
  Owen and Maunders 1987, p. 66)
• Assumes what is done by the majority is the most
  appropriate practice
• Perspective of accounting Darwinism

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Example of inductive approach to theory
development

• Grady (1965) undertook research commissioned by
  the AICPA
• 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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Theory development - 1960s and 1970s

• Sought to prescribe particular accounting
  practices
• Known as normative theories
• Not driven by existing practices
• Theories critical of historical cost accounting
• Sought to provide improved approaches to asset
  valuation in a time of widespread inflation

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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
• Not supported by AICPA as too radically different
  from current practice

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Theory development - mid to late 1970s

• Research aimed at explaining and predicting
  accounting practice rather than prescribing
  particular practices
• Known as positive theories

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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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Positive theories - continued

• Positive Accounting Theory
• Developed by Watts and Zimmerman
• Seeks to predict and explain why accountants
  elect to adopt particular accounting methods in
  preference to others
• Based upon rational economic person assumption
• Individuals motivated by self-interest tied to
  wealth maximisation

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Relationship between theory and research

• Theories are used to understand accounting
  practice better
• Accounting researchers use theories
• Theories are used in empirical research (i.e.,
  research based on data, such as financial
  statements, annual reports, share prices) to
  explain phenomena and make predictions
• Theories help us to critically evaluate a
  phenomenon (i.e., accounting method choice)

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Relationship between theory and research

• "... all research emanates from the researcher s
  implicit or explicit theory of the phenomenon
  under investigation" (Rocco Plakhotnik, 2009
  121).

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Testing a Theory in Research
Theory plane
1. Identify research problem
Observation plane
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Testing a Theory in Research

• Identify research problem
• Bias in corporate narrative documents
• Develop theoretical framework
• Agency theory assumptions
• Information asymmetry between managers and
  investors managers are self-interested (want to
  maximise their compensation) managers manipulate
  presentation of information in corporate
  narrative documents (e.g., annual report)

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Testing a Theory in Research

• State research question/hypothesis
• Managers in firms with negative financial
  performance are more likely to introduce
  reporting bias (in the form of pro-forma earnings
  number into corporate narrative documents than
  managers of firms with positive financial
  performance
• Construct research design
• Sample of firms split into two groups based on
  positive/negative percentage change in earnings
  chairmens statements (pro-forma earnings vs.
  GAAP earnings)

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Testing a Theory in Research

• Observe/Analyse
• Conduct statistical association tests
• Evaluate
• Do findings confirm/disconfirm hypothesis
  compare with findings of prior research
• Assess limitations/constraints
• E.g., small sample size

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Criteria for evaluating theories
Area of evaluation What to look for
Accuracy Has research supported that they theory works the way it says it does?
Practicality Have real-world applications been found for the theory?
Succinctness Has the theory been formulated with the appropriate number (fewest possible) of concepts or steps?
Consistency Does the theory demonstrate coherence within its own premises and with other theories?
Acuity To what extent does the theory make clear and otherwise complex experience?
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Evaluation of theories

• Theories of accounting are only abstractions of
  reality
• The choice of one theory in preference to another
  is based on value judgements
• Cannot expect to provide perfect explanations or
  predictions of human behaviour or assess what
  types on information users actually need

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Evaluating theories of accounting

• When evaluating theories need to consider
• Assumptions whether you agree with the central
  assumptions/premises of the theory
• Logic whether the argument supporting the theory
  is logical
• Research methods Whether the research methods
  are appropriate
• Evidence whether you accept any supporting
  evidence provided
• Rhetoric the use of rhetoric used for persuasion

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The role of assumptions

• Even though an argument is logical we might only
  accept the argument if we accept any critical
  assumptions being made
• If we reject any central assumptions we may
  reject the prediction

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Logical deduction

• Acceptance of an argument must be based upon the
  accuracy of the premises
• An argument is logical to the extent that if the
  premises on which it is based are true, then the
  conclusion will be true
• To determine the logic of an argument we do not
  need to refer to real world observations

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Research methods

• Generalizing theories from the testing of samples
• Methods borrowed from sciences ? phenomena will
  behave the same in all situations
• Not possible when dealing with human behaviour
• Sample selection (firm size, industry, country of
  origin, listed/unlisted, etc.)
• Keep in mind not only how the argument is
  developed, but also how it is tested!!!

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Evidence

• Is there enough evidence to support the theory?
• Is there conflicting evidence?

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Rhetoric

• Thouless (1974) identifies 38 dishonest tricks
  some writers use to support their argument
  including
• emotionally toned words
• statements where all is implied but some is
  true
• diversion to another question or to a side issue
• use of speculative argument
• prestige by false credentials
• appeal to mere authority

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Any questions?