What Is Accounting Theory?: Week 1 - Contemporary Issues in Accounting
What Is Accounting Theory?: Week 1 - Contemporary Issues in Accounting
What Is Accounting Theory?: Week 1 - Contemporary Issues in Accounting
Accounting is viewed as a practical discipline. Where accounting rules are the primary focus, there
may seem to be little use for theory. However, theory is necessary to understand the world we live in,
provide a basis for decisions we make and predict what may happen given actions or events.
There is no one definition of theory because theories can do different things; they can describe,
predict, explain and prescribe. Theory can be considered:
Evaluating theories
Often alternative/competing theories about same topic co-exist, for example, alternative theories
about best way to constrain corporate carbon emissions. For example:
Emissions trading schemes.
Carbon tax.
Plant and equipment carbon mitigation tax incentives.
Research and development (R&D) incentives.
Just because there is a theory about something, it does not mean that it is correct. Theories are often
accepted without ‘firsthand’ or direct knowledge. We need logically constructed consideration of
evidence that confirms or refutes the theory.
A theory can never be proved true. A single observation can prove a theory false. A range of
approaches are taken to test theories:
simple: Intuitive or anecdotal approaches
systematic approaches
scientific approaches: Role of research.
Many accounting theories exist, but knowledge and application of the following are expected.
Regulatory theories:
Normative theories:
Research is the ‘diligent and systematic enquiry or investigation into a subject in order to discover
facts or principles’ (Dictionary.com 2019). Research is often replicated and adjusted, so that
knowledge expands. Most research studies will not provide definitive answers but should contribute to
better understanding of issue. Your textbook (Rankin et al. 2018) essentially comprises summaries of
accounting research.
Research of or about accounting considers the role of accounting itself, for example:
Has the International Financial Reporting Standards body (IFRS) adoption lowered
companies’ cost of capital?
Has IFRS adoption made analysts’ forecasts more accurate?
Is the relationship between book value and share price stronger after IFRS adoption?
What impact does the enforcement regime have on accounting transparency?
What role, if any, did accounting play in the global financial crisis (GFC)?
Research in accounting:
Research in accounting focuses at the more micro level on issues within accounting, for example:
What measurements (e.g., historical cost, fair value, net present value) are being used?
What measures should be used?
What impact, if any, do changes in specific accounting policies have on share prices?
o For example, can investors see through cosmetic changes that do not change the
underlying economic substance of a company?
The case study approach is emphasised in this unit, as it allows opportunity in respect of a body of
knowledge to integrate, apply, analyse, and think critically. Cases involve a description of a scenario
or situation, within a particular discipline context, which provides opportunity to:
think about the complexities of real‐life situations
make connections between theories and real‐life practice
provide realistic, rational & practical ways of solving real‐life problems.
Step Three: Read the case study again carefully. Consider the context of the question.
Step Four: Identify the discipline, practice, concepts or issues (including the theories and research
that may be relevant and that you need to consider and/or apply).
Step Five: Apply the concepts or issues identified in step 4 to the case study.
Accounting theory in this unit is defined as either a description, explanation or prediction of accounting
practice or a set of principles on which to evaluate or guide practice.
Theories help us to understand and make sense of the world. They help to explain, describe, predict
and guide decisions and actions. Any critical analysis should be informed by theories. In financial
accounting, theories can help the understanding of current accounting practice and also provide the
means by which to improve it by:
describing and explaining current accounting practice
providing principles on which to base actions and decisions in financial accounting
identifying problems and deficiencies with current accounting practice
providing suggestions for change.
Some of the major research areas in accounting include: capital market research, accounting policy
choice research, accounting information processing research, critical accounting research and
international accounting research.
Some accounting theories describe and explain current practice for example, disclosure of non-
financial (sustainability) information. Some predict practice, for example, agency theory (what
incentives will be tying executive bonuses to share price compared with accounting numbers provide).
Other theories provide principles for decision-making, for example, decision-usefulness of accounting
information. Some of these theories are normative—they state what ‘should’ happen.
Marks Notes:
A THEORY is
A coherent set of hypothetical, conceptual and pragmatic principles forming the general
framework of reference for a field of inquiry (Hendriksen 1970, p.1)
A scheme or system of ideas or statements held as an explanation or account of a group of
facts or phenomena (The Oxford English Dictionary)
Based on logical (coherent) reasoning, and not ad hoc in nature
Theories can help us make sense of the world in which we live and can provide a structure to
understand our (social) experiences. Whether you accept a theory or don't will depend on whether the
argument supporting the theory is logical, whether you agree with the central assumptions of the
theory, whether you accept any supporting evidence provided.
I think you could look at legitimacy theory as a starting point here.... and also at the social contract
and at corporate social responsibility. …a concept whereby companies integrate social and
environmental concerns in their business operations and in their interaction with their stakeholders on
a voluntary basis.
Being socially responsible means not only fulfilling legal expectations, but also going beyond
compliance and investing more into human capital, the environment and the relations with
stakeholders.
(Promoting a European Framework for Corporate Social Responsibility, 2001, p. 6)
There is a general view whereby an organisation that embraces their CSR is considering the interests
of a broader group of stakeholders rather than just shareholders alone - so the question is - why do
companies do this? Why do you think it has impacted the bottom line if they don't embrace this?
Case study
Complete the following contemporary issues activities from 'Chapter 1: Contemporary issues in
accounting' of your text:
1.1 Dick Smith hearings reveal questionable accounting of rebates' (p. 6).
This article states ‘accounting standards are currently unclear’ with regard to how to account for
rebates. Given these rebates seem to be quite common, can you think of any reasons the accounting
for these could be unclear and why there may not be an accounting standard that specifies exactly
how to account for these particular transactions?
While accounting has existed in some form for thousands of years, and double-entry for more than
600 years, exponential advances in technology are predicted to change the very nature of many
accounting tasks. For some time now technology has freed accountants from a range of routine
processing and compliance tasks.
This article claims that profits were overstated by Tesco ‘because it had booked rebates from
suppliers before receiving them’. Do accounting principles require cash to be received before
recognising items in the accounting? If not, why should accounting be implicated in these profit
overstatements?
A note prepared by PricewaterhouseCoopers claims that supplier rebates are complex and as
accounting requirements are unclear.
What do you think is meant by ‘getting the accounting correct’? Can you identify any factors that
would influence the exercise of professional judgement in this context?
This article explains that blockchain is both transparent and secure. Would the adoption of a
technology such as blockchain mean that accountants would no longer need to use professional
judgement in determining how to account for or report transactions and events?
Accountants will still need to use professional judgement in reporting the financial performance of a
company to the client. Although the day-to-day activity of completing the ledger or the time delay for
banking transactions will no longer be manually complete by an accountant or banker. Accountants
will always be required to maintain stringent oversight of financial reporting, but in the coming years
an increasing amount of their time will be devoted to providing strategic insight that helps support
company initiatives.
There is extensive interest in blockchain technology, not just in accounting but for a range of other
uses and in other sectors. Developments in this area may dramatically change the way business, and
accounting, is done. Whilst there will be efficiencies in the way tasks are completely, an accountant’s
role will never become obsolete.
Identify any technologies or programs that are currently used in accounting firms or for undertaking
accounting tasks in businesses. Using the internet to research, are there any developments or
available alternatives for these technologies?
- XERO
- Flow cash etc
Accountancy will harness the power of big data: Analysis of the vast amounts of data now being
generated will allow accountants to model and benchmark information, generating insights that will
improve executive decision-making and transform and streamline organisations. Predictive analytics
will be used to assess investment risk and will aid the budgeting process. And these insights, once the
exclusive domain of multinationals, will now be available to SMEs. Accountants who develop skills in
big data analysis will play a critical role in their employer’s future.
1.3 Some answers, more questions over Dick Smith failure' (p. 15).
This article explicitly refers to earnings management research. How has this research been used in
this article to assist in explaining the Dick Smith failure?
The article states ‘If one subscribes to the conclusions within accounting research’. This proviso
implies that others may question the conclusions of the research used in this article. Can you think of
reasons why particular theories or research would not be accepted?
This article states that the auditors, Deloitte, questioned the rebates, realised that inventory values
were too high, yet certified that the company was a going concern. A review of the 2015 annual report
indicates that inventory represented almost 60% of total assets and was twice the net asset amount.
However, in this report there is no mention of these rebates or their impact on profit and the audit
report does not suggest any issues of concern. Referring to the previous definition of professional
judgement in this chapter, in your opinion what elements in that definition may not have adequately
been practiced?
Complete the following case studies from 'Chapter 1: Contemporary issues in accounting' of your text:
'1.1 Economic theories that have changed us: Efficient markets and behavioural finance' (p.
26).
'1.2 Accounting for power: the history of an industry that shaped the world' (p. 28).
The article, Slater & Gordon's murky accounting (Boyd 2015) shows some of the complexities
associated with contemporary accounting practice.
The trials and tribulations of global law firm Slater & Gordon will reinforce the general reluctance of
professional services firms to abandon the cosy private partnership model in favour of stock market
listings. Murky accounting has put Slater & Gordon in the crosshairs of short sellers who have
capitalised on the uncertainty surrounding how the firm accounts for its work in progress. The short
sellers could well have taken inspiration from famous New York fund manager Jim Chanos who once
said:
“When the accounting gets murky, people tend to shy away from rigorous analysis and rely on
management and just take earnings per share at face value. Therein lies the opportunity.”
That is not to say that Slater & Gordon's management led by chief executive Andrew Grech is not to
be trusted.
Question
Extract the main points from the Slater & Gordon's murky accounting (Boyd 2015) article and consider
how you could apply theories learned in this unit to the ideas presented within.
Questions:
Accounting is merely technical exercise, and all accountants need to do is follow the rules’.
Drawing on your understanding of accounting, discuss whether this statement is correct.
What is meant by “professional judgement”? Consider the Pathways Vision Model in figure
11.1 and explain the role of professional judgement in accounting.
The definition in the text from the American Accounting Association defines professional judgement
as:
Professional judgement is a process used to reach a well-reasoned conclusion that is based
on the relevant facts and circumstances available at the time of the conclusion.
The American Accounting Association further states in relation to professional judgement that:
A fundamental part of the process is the involvement of individuals with sufficient knowledge
and experience. Professional judgement involves the [clarification of issues and objectives,
and the] identification, without bias, of reasonable alternatives; therefore, careful and
[unbiased] consideration of information that may seem contradictory to a conclusion is key to
its application. In addition, both professional scepticism and objectivity are essential to the
process and to reaching an appropriate conclusion.
Tus the first requirement for professional judgement is a person who has the requisite
knowledge and skill set given the particular context.
Define what is meant by ‘theory’ and explain how theory is useful. Do you think
theory needs to be considered in accounting.
As the text notes there is no simple definition of ‘theory’ and it can mean different things in
different contexts. The following are dictionary definitions of what a theory is:
a belief or principle that guides actions or behaviour (such as behavioural theories of positive
reinforcement or theories in management about motivating employees)
an idea or set of ideas that is intended to explain something (such as Darwin’s theory of
evolution)
the set of principles on which a subject is based or of ideas that are suggested to explain a
fact or event (such as economic theory or the theory of relativity)
more generally, a conjecture or an opinion.
So, for example, theory needs to be considered in financial accounting to reflect the decision making
behaviour of managers and investors, company policies, political activity or professionalism of
accountants.
Accounting theory definition means as stated by Henderson et al. 2004 p. 4 ‘a description, explanation
or a prediction [of accounting practice based] on observations and/or logical reasoning’… ‘Logical
reasons in the form of a set of broad principles that (1) provide a general framework of reference by
which practice can be evaluated and (2) guide the development of new practice and procedures’
Students should discuss how theory can help in accounting. Theories can:
describing and explaining current accounting practices
predicting accounting practice
providing principles to take into account when taking action or making decisions
help to identify problems and deficiencies with current accounting practice and improve
accounting practice.
It has been stated that ‘many people accept theories without justification’. Identify reasons
people may accept theories. Provide examples of theories that you accept or believe although
you may not have direct knowledge in the area.
Students may identify various theories that they accept but have no expert or direct knowledge of: e.g.
theories re global warming, theories on punishment (e.g. that deters crime), theories on black holes in
space; theories on causes of diseases (such as genetic depositions).
For many theories that a person considers that particular individual may not have an in-depth
knowledge of the area relating to the theory. For example, I believe that the world is not flat and that in
fact the theory that the world is round is true. However, I am not a scientist; I have not studied detailed
evidence about this theory in any scientific or systematic manner, so what makes me accept this
theory, or other theories that are not in my area of expertise. People accept theories every day that
they may not fully understand (such as theories of global warming; the theory of relativity; theories
about how certain diseases are spread). There are a number of reasons why we may accept theories
without ‘first–hand’ or direct knowledge, these include:
If the theory comes from a source perceived as having specific knowledge and expertise, then
we may defer to their superior experience and wisdom. If the ‘experts’ in the area say it is true then
we are more likely to believe it is true, particularly when the expert provides evidence to support the
theory. Statements and theories from eminent scientists or researchers in an area, by teachers (such
as university lecturers), from textbooks, even from media sources (such as television and
newspapers) are often viewed as authoritative. We are willing to often accept a theory as correct due
to whom or where the information about the theory comes from (they wouldn’t say it if it isn’t true
would they?).
We are also more willing to accept a theory if the theory matches our own experiences and
observations. The theory that the earth is not flat and is in fact round agrees with my own
observations of the slightly curved horizon, and the sun setting so I am willing to accept this
theory.
3. It makes sense
‘If a man is offered a fact that goes against his instincts, he will scrutinize it closely, and
unless the evidence is overwhelming, he will refuse to believe it. If, on the other hand, he is
offered something which affords a reason for acting in accordance to his instincts, he will
accept it even on the slightest evidence. (Bertrand Russell).
For example, there are various debates about how much alcohol is safe to drink and that one
or two drinks a day may actually be of benefit to a person’s health. Many people would
believe this is reasonable and further it may fit with their own preference to drink alcohol so
would accept this.
A key influence on many people’s beliefs is what other people believe. If a theory appears to
be accepted by many people, particularly if it is repeated. For example, if a poll shows that
82% of people believe that introducing gun controls will reduce violent crime, you may be
more likely to accept this. This appeal to general acceptance is often used in advertising and
political campaigns, such as ‘3 million Frenchmen can’t be wrong. Buy a Renault’. Of
course, just because most people believe something does not make it true. As we noted
earlier, many people believed the world was flat but this did not mean that the world was in
fact flat.
These approaches to accepting theories are intuitive rather than scientific or systematic and
given that any individual’s expertise is necessarily limited, provide a practical and rational
way of determining whether an individual accepts a specific theory.
Identify a theory that you have heard about (this can be about any area; e.g. global warming).
Consider how you would test whether this theory was true. Do you think you could prove it?
Think of a theory that describes what is happening or explains what is happening. The first step in
testing the theory would be to evaluate its logic. Is the theory logical and gives a valid conclusion
given its premises? So for example, there may be a theory about global warming that measures the
hole in the ozone layer and links this to changes in average temperatures.
The next consideration would be to consider the evidence. Does the evidence ‘fit’ with, or perhaps
contradict, the theory? For example, if the theory regarding temperature change related to global
warming simply predicted that the temperature may change whatever happened, would fit with the
theory and this could not really be tested. However if it made a clear prediction — for example, that in
2008 temperatures in a particular region would increase by 1% then we could test this by observing
the temperatures in that region. If the observations are not consistent with the predictions of the
theory we have established then the theory is incorrect. If the observations ‘fit’ with the theory then we
can claim that the evidence supports the theory (i.e. that it has not been contradicted or falsified). It is
generally accepted that theories cannot be ‘proved’ correct because of the problem of determining
how many ‘correct’ observations are enough to establish the truth of a theory.
Students should recognise that even well accepted theories (such as Einstein’s theory of the Big
Bang) have been later proven wrong when better observations have been able to be made.
Research is planned search or critical investigation aimed at discovery of new knowledge with
the hope that such knowledge will be useful in developing a new product or service or new
process or technique or in bringing about a significant improvement in an existing product or
for a significant improvement to an existing product or process whether intended for sale or
use. It includes the conceptual formulation, design and testing of product alternatives,
construction of prototypes, and operation of pilot plants. It does not include routine or periodic
alterations to existing products, production lines, manufacturing processes, and other ongoing
operations even though these alternations may represent improvements and it does not
include market research or market testing activities.
Students should firstly understand that research is activity. The relationship to theory depends on the
reason for the research being undertaken, the type of research and/or the results/findings of the
research. Research can be undertaken before any theory has been formed or considered. The
findings of such research could lead to the formation of a theory (either positive or normative).
Research can also be used to test theories. For example, you could test the hypothesis of a positive
theory and see if the findings match the predictions of the theory.
Below some types of research are listed – these are not discussed in the text but may be useful to
provide examples to students of research. It may also be useful to have students examine abstracts of
academic articles and consider how the research in these relates to theory.
Research may be exploratory, descriptive, investigative, causal or some combination of these (Kent,
2001). Exploratory research aims at finding out whether or not something exists (Dane, 1990, p. 8).
As such it is about generating ideas, insights or hypotheses rather than measuring, testing or
evaluating those ideas, insights or hypotheses. For example, early research in environmental
accounting was aimed at finding out if companies were providing environmental information in their
annual reports. Descriptive research is concerned with providing more detail (a more complete
picture) about something, and so may involve measuring the sizes, quantities or frequencies of
characteristics, but not investigating the relationships between them. For example, research in
environmental accounting has investigated the exact nature of the environmental disclosures made by
companies by recording the quantities of words included in reports about the environment and the
nature and type of environmental information provided. When the research focuses on the extent of
association or correlation between two or more variables, the research is investigative. This may often
involve predictions (i.e. if one event occurs can predict that another event will occur) although it may
not explain the cause of this link or correlation. For example, researchers have investigated the
question of what factors are associated with companies that report environmental information and
others that do not. Findings in this area have indicated that there appears to be a correlation between
the size of a company and the type of industry, and whether it reports environmental information (e.g.
that larger companies or companies in more environmentally sensitive industries, such as mining, are
more likely to include this type of information in their annual reports).
Causal research extends the investigation by distinguishing between dependent and independent
variables, and examines the degree of, and reasons for, the influence of one or more independent
variables upon the one or more dependent variables. For example, this may investigate the question
as to why (what causes) companies that are large include environmental information in their annual
reports more often? Researchers have considered that one reason could be to manage the
relationships and expectations with stakeholders.
The answer above provides types/classifications of research in general. In accounting research, there
are 2 broad classifications. These are:
research of or about accounting. This considers the broader role of accounting
research in accounting which focuses more on the actual practice of accounting.
In addition, research in accounting can be classified into particular areas (although these overlap).
The text identifies:
Capital markets research. Capital-market research was undertaken by Ball & Brown (1968)
and Beaver (1968) that began the positive research stream. Their studies investigated the
use and impact of accounting information by capital markets.
Accounting Policy choice research. Accounting policy choice research is commonly known as
positive accounting theory for its domination of research which began with Watts &
Zimmerman (1978). This research attempted to explain the motivation.
Accounting Information Processing Research. Accounting information processing research
investigates the use and users of information in the decision-making process and uses
theories and models from psychology.
Critical Accounting Research. Critical accounting research considers the role of accounting in
society and the social content.
International Accounting Research. International accounting research considers the call for
uniform accounting standards worldwide and to harmonise financial accounting.
Explain why case studies are used and outline the suggested steps in answering case studies.
Case studies are trying to portray a ‘real life’ problem but often in simplified form. This allows students
to:
be exposed to some of the complexities of ‘real life’ problems
practice integrating and applying discipline knowledge and theory
develops analytical and critical thinking skills
develops communication skills
practice decision making and judgement, especially where alterative solutions are possible.
Week One Summary Notes:
There is no one definition of theory because theories can do different things; they can
describe, predict, explain and prescribe.
Accounting theory in this text is defined as either a description, explanation or prediction of
accounting practice or a set of principles on which to evaluate or guide practice.
1.3 Reflect on why theory is needed and appreciate the need to evaluate theories
Theories help us to understand and make sense of the world. They help to explain, describe,
predict and guide decisions and actions. Any critical analysis should be informed by theories.
In financial accounting, theories can help the understanding of current accounting practice
and also provide the means to improve it by:
o describing and explaining current accounting practice
o providing principles on which to base actions and decisions in financial accounting
o identifying problems and deficiencies with current accounting practice
o providing suggestions for change.
There are a number of reasons theories might be accepted without first-hand or direct
knowledge. These include:
o the authority of the source of the theory
o whether the theory makes sense and fits with personal experiences and beliefs
o whether other people accept the theory.
Research is an activity that involves investigation. Research can be used to test or to derive
theories.
Various types of research is undertaken in financial accounting, which contributes to
knowledge of financial accounting issues and can also result in changes to financial
accounting practice and developments.
Research of or about accounting considers the role of accounting itself (the bigger picture) at
the macro level.
Research in accounting focuses more at the micro level on issues within accounting.
1.6 Understand the case study approach and the steps to take in answering case study questions
Week 1 – Quiz