Chapter 1: The Development of Accounting Theory

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Chapter 1 The Development of Accounting
Theory
Accounting Theory
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Introduction

• What is theory?
• Webster defines theory as
• Systematically organized knowledge, applicable
  in a relatively wide variety of circumstances, a
  system of assumptions, accepted principles and
  rules of procedure to analyze, predict or
  otherwise explain the nature of behavior of a
  specified set of phenomena.
• Normative theory (What ought to be how things
  are supposed to work)
• Positive theory (What is how things actually
  work)
• Why is the development of a general theory of
  accounting important?
• Explain why businesses elect certain accounting
  methods and predict attributes of firms that
  elect certain accounting methods
• What is the relationship of accounting research
  to accounting theory?
• Verifies or refutes theory

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Generally Accepted Accounting Principles (GAAP)

• The profession has developed GAAP that present
  fairly, clearly and completely the financial
  operations of the enterprise.
• GAAP consists of authoritative pronouncements
  issued by accounting standard setters such as
• CAP, APB, FASB

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The Financial Accounting Standards Board (FASB)

• The FASB enjoys the following advantages
  compared to its predecessor, the Accounting
  Principles Board
• smaller membership
• greater autonomy
• increased independence of members
• broader representation on the Board

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The Due Process (1 of 3)

• In establishing financial standards, the FASB
  follows a due process procedure.
• The due process gives time to interested
  persons to make their views known to the
  Board.

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The Due Process (2 of 3)
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The Due Process (3 of 3)
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Major Types of FASB Pronouncements

• Standards and Interpretations are
  modifications or extensions of standards
• Financial Accounting Concepts are objectives
  and concepts used in the development of
  standards
• Technical Bulletins provide timely guidance
  on reporting issues
• Emerging Issues Task Force Statements

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GAAP Hierarchy

• LEVEL A
• FASB Statements
• FASB Interpretations
• SEC Rules and Interpretive Releases
• Accounting Principles Board Opinions (unless
  amended)
• Accounting Research Bulletins (unless amended)

• LEVEL B
• FASB Technical Bulletins
• AICPA Industry Audit Guides that have been
  reviewed by the FASB

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GAAP Hierarchy

• LEVEL C
• AcSEC Practice Bulletins that have been reviewed
  by the FASB
• Consensuses reached by the EITF

• LEVEL D
• AICPA Accounting Interpretations (no longer
  issued)
• FASB Implementation Guides
• Other widely recognized or prevalent accounting
  practices

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Qualitative Characteristics of Accounting
Information

• Primary Qualities are Relevance and Reliability
  of Accounting Information.
• Secondary Qualities are Comparability and
  Consistency of reported information.

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Qualitative Characteristics of Accounting
Information Relevance

• Relevance of information means information
  capable of making a difference in a decision
  context.
• must be timely to be relevant.
• should have predictive value (helpful in making
  predictions about ultimate outcomes).
• should have feedback value (helps users confirm
  prior expectations).

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Primary Characteristics Reliability

• Information is reliable when it can be relied on
  to represent the true underlying situation.
• To be reliable, information must be
• verifiable
• representationally faithful, and
• neutral

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Primary Characteristics Reliability

• Information is verifiable, when, given the same
  information, independent users can arrive at the
  same conclusion.
• Information is faithful, when it represents what
  really existed or happened.
• Information is neutral, when it is free from bias.

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Secondary Characteristics

• Secondary Characteristics
• Comparability Consistency
• To be Comparable, it must be
• measured and reported in a similar manner for
  different enterprises.
• useful in the allocation of resources to the
  areas of greatest benefit.
• useful to users in identifying real differences
  between enterprises.

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Secondary Characteristics

• Accounting information is Consistent, if the same
  accounting principles are applied in a similar
  manner from one period to the next.
• Accounting principles may be changed, if the
  change results in better reporting.
• Justification for the change, and the nature and
  effect of the change, must be disclosed.

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Ingredients of Primary Qualities
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The Full Disclosure Principle

• Financial statements must report what a
  reasonable person would need to know to make an
  informed decision.
• Disclosure may be made
• within the body of the financial statements,
• as notes to those statements, or
• as supplementary information.

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Accounting in Crisis The Events of the Early
2000s

• Enron, Worldcom and the Accounting Scandals
• Two major changes in the accounting profession
  have taken place in the wake of the accounting
  scandals
• Arthur Andersen, formerly one the Big 5 audit
  firms has gone out of business
• In July 2002, President Bush signed into law the
  Sarbanes-Oxley Bill which imposes a number of
  corporate governance rules on publicly traded
  companies