CHAPTER 1INTRODUCTION TO ACCOUNTING THEORY

1.1

Pragmatic Accounting (1800-1955) General scientific period

 Theory based on observation of practice rather than deductive logic (推论) which is
more critical in current practice.
 It explain on “why accountants account as they do”
 Why it is important?
o Lead to creation of Securities Exchange Commission
o Lead to improve in financial regulations and reporting
o Give rise to several notable accounting publications, example such as “A
Tentative Statement of Accounting Principles affecting corporate reports.”

Normative Accounting (1956-1970) normative period

 It refers to the period when theorist attempted to establish “norm” for “ best
accounting practice”
 Debate predominantly about measurement rather than actual practice of recording
and reporting
 During this period, less concern about what actually happened in practice and more
concerned about developing theories that prescribed what should happen
 Two groups dominated the normative period—the critics of historical cost accounting
and the conceptual framework proponents.

Positive Accounting (1970)

 Dissatisfaction with normative theories.

 It is based on empirical (practical) approach. That is, whether what practicing
accountants produced had a decision usefulness objective, whether it filled other
roles, and whether it was inferior or superior to proposed alternatives.
 More focus on providing explanation on the practice which were being observed
 Objective of PA is to explain and predict. An example of PA is the theory that leads
to what is known as the “bonus plan hypothesis”
 It is specific scientific theory
 Explain and predict why accounting is important to various parties
 Important
 Explain the economic, or wealth, effect of accounting and why accounting is
important to various parties such as shareholders, lenders and managers
 Important in assisting in the design of contracts based on accounting numbers
that control behavior
 Helps predict the reaction of investors in the market to the action of
management and to report accounting information.

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  Enables regulator to assess the economic consequences of the various
accounting practices they consider.

PAT aims to explain why financial statements are produced and audited voluntarily, why
accountants choose the particular accounting methods over others and why accountants or
manager lobby for or against a particular accounting methods.

Relevance of accounting history (Important*)

Accounting history is the study of evolution in accounting thought, practices and institutions
in response to change in the environment and societal needs. It is a study of the heritage of
accounting and its contribution to accounting pedagogy, policy and practice.

1. Pedagogy (教学)
 Accounting history can be very helpful to a better understanding and
appreciation of the field of accounting and its evolution as a social science.
 First, a profession based on traditions built over many centuries able to
educate its members to appreciate intellectual heritage.
 Second, the important of advances in thought, of major contributions to the
literature, and of crucial positive studies may be lost, fragmented or
inadequately recognized in the longer term unless they are documented and
incorporated by scholars who have historical skills.
 Third, without access to analyses and interpretations of historical
developments in accounting thought and practice, today’s empiricist risk
basing their investigation upon incomplete or unjustified claims about the past.
OR
 (Accounting pedagogy is the teaching and learning of accounting theory for
understanding the accounting history. This is consists of the accounting and
assessment of evaluation of the social science )
2. Policy
 Accounting history is an instrumental to a better understanding of the
accounting problems and their institutional contexts as well as the formulation
of public policy. Or:
 (accounting policy is evaluation understanding of rules and regulation to solve
the accounting problem to formulate public policy )
3. Practice
 Accounting history could provide a better assessment of the existing practices
by a comparison with the methods used in the past. Or:
 (Accounting practice is method and approach of accounting history, so that
people able to assess and compare the practices within the professional
setting.)

The relevance of accounting history to accounting practice, policy and pedagogy call for
more accounting history inquiry.

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如果题目出现这些 statement， 答案就写关于 pedagogy，policy and practice
1. “better…to understand our present & forecast or control our future”
2. Accounting history is the study of the evolution in accounting thought, practices and
institutions in response to changes in the environment & social……….
3. Historical research includes biography, institutional history development of thought,
general history……
Accounting theory and recent development

 The mix development unable the development of single theory , this is because
opportunism , human greed , future uncertainty and degree of naivety on the part of
some shareholders can never be capture in a theory of accounting

Why accounting history is essential?

1. Helps practitioners to better predict what is on the horizon as the pace(进展) of global
business evolution essentials( 必不可少)
 Accounting history develops in response to the needs of the time, brought
about changes in the environment and social demand.
 Thus, production can be made based on the accounting history
2. Is the key to important phases of history
 The history of accounting is as old as civilization, key to important phases of
history, among the most important professions in economics and business, and
fascinating.
3. Is the study of evolution in accounting thought and practices
 Is the study of evolution in accounting thought, practices and institutions in
response to changes in the environment and social need.
 It considers the effect this evolution has worked on the environment.

1.2

Accounting

The process of identifying, measuring and communication economic information to permit

information judgments and decisions by user of information

What is theory?

Theory can be described as the logical reasoning underlying a statement of a belief.

Whether the theory is accepted depends on how well it explains and predicts reality, how
well it is constructed and how acceptable are the implications of the theory. The theory is
the logical flow of argument leading from fundamental assumptions and connected
statements to final conclusion. It includes assumptions, statements, the argument connecting
the assumptions and statements to come to conclusions.

Definition of theory

 Popper

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  Theory are net cast to catch what we call the world, the rationalize to
explain and to master it
 Hendriksen
 Theory is the coherent ( 合 乎 逻 辑 ) set of hypothetical, conceptual and
pragmatic principles forming the general framework of reference for a field
of inquiry
 Theory is a logical reasoning in the form of a set board principles
o Provide a general framework of reference by which accounting
practices can be evaluated
o And guided the development of new practices and procedures
 McDonald
 Theory must have 3 elements
o Encoding of phenomena to symbolic representation
o Manipulation or combination according to rules
o Translation back to real world phenomena
 Belkaoui*
 A set of interrelated constructs, definitions and propositions that present a
systematic view of phenomena by specifying relations among variables with
the purpose of explaining and predicting the phenomena
 Godfrey
Pragmatics
Language Semantics
Syntactic
 Accounting Theory
Deductive
Reasoning Inductive

Script Normative
Positive
A. Language
 Theory as language of business
 3 question should that ask about language, word, phrases
o What effect will the word have on listeners?
What is the understanding of the listener, when they heard
about this phrases
o What meaning do the words have?
o Do the words make logical sense?
 Pragmatics
o Study of the effect of the language (what effect?)
 Semantics
o Study of the meaning of language (what meaning do the word have)
 Syntactic
o Study of the logic or grammar of the language (logical sense)

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Language Explanation
1. Pragmatics Effect of words or symbols to people
How accounting concepts and real world corresponding events or
objects affect people behavior
How people react to the same message in different ways.
Example:
Accounting should provide useful information for
decision making to certain interested parties

2. Semantics Relates basic concepts of a theory with the real world (meaning)
Verification is based on the premises and conclusion , not on the
logical reasoning
Example:
P1: all assets accounts have Dr. balance
P2: sales return account is not an asset account
C: sales return account has a Dr. balance

P1 is false. Syntactically , the argument is not valid

Semantically, C can be accepted because in real world/
practice, C is true.

Based on the real world practice, not on the logical flow

on P1 and P2.

3. Syntactic Logical relationship which has to do with the rules of the

languages used.
Emphasize on the logical reasoning and not the empirical /
practice content of the statement in the real world
Refer to a flow of logic , not to the accuracy of an argument’s
representation of the real world
Example :
P1: All accounts related to assets have dr. balance
P2: accumulated depreciation is related to asset
C: Accumulated depreciation has a dr. balance

Syntactically, if the premise (P1&P2) is true, the conclusion

must be true. Thus, the argument is valid.

If the conclusion is false in the real world, the argument

still valid because of the logical rules connecting and

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 extending them to their conclusion.

B. Reasoning
 The argument flow of the theory
o Generalization to Specification (Deductive)推论
o Specification to Generalization (Inductive)诱导

Accounting Theory Construction and Formulation

Accounting theory can be constructed by using deductive or inductive

Reasoning Explanation
1. Deductive Begins by setting up the basic accounting postulates, and then
determines the logical of the accounting postulates which can be
transferred into accounting principles that will help to develop the
techniques of accounting.
The construction of accounting theory is derived logical conclusion
and basic proposition
From general premises to develop predictions, prescription or
explanation of specific matters. (also known as Top-down/Waterfall
approach)
Steps: (SSDD)
a. Specifying the objectives of financial statements
b. Selecting the postulates (假设) of accounting
c. Deriving the principles of accounting
d. Developing the techniques of accounting
Example:
P1: All assets account have dr. balances (generally)
P2: Building and machine accounts are asset accounts
C: Building and machine account have dr. balance (Specifically)
Advantages :
o If premises are false , conclusion may also be false
o Provide a basis for practical rules.
Criticism :
o Misunderstands the meaning of theory
o The theory not necessarily to be entirely practical
Theory
Hypothesi
Observation
Confirmation

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 After constructing a theory, a theory needs to put into practice to
determine the conformity of the theory with the practice.
If there is a divergence between theory and practice, hence either
theory or practice needs to be amended.
The techniques, principles, postulates and objectives under this
approach must be always true.
If it is acceptable, the theories will be verified, if not will be falsified.
2. Inductive Begins with observations and measurement and moves towards
generalized conclusions.
The construction of accounting theory is based on observation,
measurement and analysis to obtain generalized conclusion.
Lead to positive approach
From specific observations to develop a general implication of those
observation (also known as bottom-up/ hill climbing approach)
The true or falsity of the propositions does not depend on other
propositions, but must be empirically verified.
Steps: (RAIT)
a. Recording all observations
b. Analysis and classifying of these observations to detect
recurring relationship or similarities
c. Inductive derivation of generalizations and principles of
accounting from observations that depict recurring relationships
d. Testing the generalizations.
Example:
P1: Building account is an asset account has a dr. balance
P2: Machine account is an asset account and has a dr. balance
P3: Land account is an asset account and has a dr. balance
C: all asset account have dr. balance (Generally)
Advantages:
o Not necessarily constrained by a structure
o Free to make relevant observation
Criticism :
o Influence by the idea of relevant relationship
o Raw data are likely to be different

This theory is tested whether its results are acceptable in practice

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 The conclusion of the theory is based on the premises, thus it
involves degree of uncertainty, and the truth or falsity of the premises
are subject to empirically tested by repeating testing the relationships
between the items in the premises and jot down the results of
observation .

C. Script
 Theory may be
o To set forth and explain what and how financial information is
presented and communicated to users of accounting data. (Descriptive
or Positive)
o To prescribe what data should be presented. (Prescriptive or
Normative)
 Normative (Prescriptive)
 Positive (Descriptive)

Normative (prescriptive 规定)

 1950s-1960s
 More concerned on :
 Policy recommendation
 “What should be done”rather than “what is”
 What accounts should be report and the best way to do that
 How accounting should be practiced
 Main focus:
 Deriving true income for an accounting period
 True Income
 True income theorists concentrated on deriving a single
measure for assets and a unique (correct) profit figure
 Discussing type of accounting information which would be useful in making
decision (decision usefulness)
 Decision usefulness
 Decision usefulness approach assumes that the basic objective
of accounting is to aid the decision-making process of certain
users of accounting reports by providing useful accounting
data.
 Assumptions are rarely subject to any empirical testing
 Normative researchers based their theory on both analytical (syntactic) and empirical
(inductive)
 The normative researches also made assumptions about the nature of the firm’s
operations based on their observations

Positive (Descriptive)

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  1970s
 Explain on what and how and predict accounting practices
 Concerned mainly with :
 Explaining the reasons for current practices
 Predicting the role of accounting and associated information in the economic
decision making of individual, firm and other parties.
 Referred as positive methodology/ empirical methodology , which means testing
theories or hypotheses back to facts of the real world
 Main focus :
 Empirically testing some of the assumptions made by normative accounting
theorists
 Important :
 Explain the economic, or wealth, effect of accounting and why accounting is
important to various parties such as shareholders, lenders and managers
 Important in assisting in the design of contracts based on accounting numbers
that control behavior
 Helps predict the reaction of investors in the market to the action of
management and to report accounting information.
 Enables regulator to assess the economic consequences of the various
accounting practices they consider.

Normative Accounting Positive Accounting

Types  Prescriptive  Descriptive or explanatory
Explanation  Prescribe how people such as  Do not prescribe how people
accountant should behave to should behave to achieve an
achieve an outcome that is outcome an outcome that is judged
judged to be right, moral, just or to be good
otherwise a “good” outcome  Rather , they avoid making value-
laden prescriptions
 Instead , they describe how people
do behave regardless whether it is
right , they explain how people
behave in certain manner
 Example:
 To achieve some objective
such as maximizing
personal wealth regardless
whether that is “right”
Although both theorists do not accept the value of each theory. In fact, the
theorists can coexist, and can complement each other. PAT help provide an
understanding of the role of accounting which in turn, can form the basis for
developing normative theories to improve the practice of accounting.

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Accounting theory

A set of broad principles that provide a general framework of reference by which accounting
practices can be evaluated. Its main purpose is to explain current accounting practice and
guide the development of new practices and procedures.

Nature of Accounting (Chilli PMC)

1. Ideology
 Accounting as a capitalist tools to measure profit
 Accounting as a means of sustaining and legitimizing the current social,
economic and political arrangement
 Perception of accounting as an instrument of economic rationality
2. Language
 Perceived as a language of business
 Accounting can be regarded as a language through which the multitude of
transactions an entity enters into are translated into words and numbers that
convey how well the firm is performing
 View as languages used to translate economic event and transactions into
something that can be understood by users
3. Historical Record
 It concerns with providing a faithful record of the transaction of an entity and
manager stewardship of the owner’s resources
 It has been based on assumptions of prudence (conservatism), objectivity and
consistency , and the observation of the actions of the past
4. Current economic reality
 Balance sheet and income statement should be based on a valuation basis that
is more reflective of economic reality rather than historical cost. Focus on
current and future price
5. An Information system
 Accounting is the process that link information source of transmitter
(accountant), a channel of communication, and set of receivers (users).
6. Commodity
 Provide ideal ground for policy and contracts between the organization and
environment
7. Mythology
 Accounting systems provide a societal resource in sustaining concepts of
rationality and means of justifying, rationalizing and legitimizing decisions
that ultimately serve other individual and social ends.
8. Rationale
 Accounting used to attach the meanings to events and therefore provide a
justification for future occurrence
9. Imagery
 Accounting create impression of an organization through it financial report,
such as Air Asia profitable company, MAS  loss company

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 10. Distortion /Magic
 Accounting is able to make the financial statements appear to be something
they are not.
 It is a method of deceiving the users of reports.
 For example, when accounting techniques are used to disguise pending
corporate failure (Enron Case)
11. Economic good
 Accounting is including macroeconomic, political, taxation and other specific
information that affects the performance of a firm. Therefore, accounting
information has cost to produce and accounting standards impose compliance
costs. Managers will choose accounting rules that minimize information costs
whereas shareholder and lenders will impose accounting rules that improve the
ability to control and monitor the actions of managers. (agency costs)

Testing a theory

1. Dogmatic basis(people with higher authority 讲的话可信度较高)

 We prefer to believe in statements made by others simply because they have
been made by an authority, and we use this basis to judge the truth.
 Example
 we read the newspapers and believe what is reported
 Weakness
 Introspective (tending to think a lot) evidence including personal bias
about the person or group making the statement
2. Self-evidence basis(base on skills , basis and knowledge)
 Basis that determines the truth by its reasonableness based on general
knowledge, experience and observation
 Weakness
 Untrustworthiness in the science since we always observe something
and believe it to be true.
3. Scientific basis
a. Syntactic rules (not based on real-world)
 Examination of the logic of the argument making up the theory is the basis
of the test.
 The validity of the argument can be established without reference to
sensory (感官) experience.
 The truth can be known by reasoning (推论) without having verified them
from observation of real-world events.
b. Induction (based on real-world)
 The true or false of the statement can only be known by refer to empirical
evidence
 It is according to the correspondence with observations of real-world
phenomena.
c. Popper

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  Popper describes scientific endeavor (尝试) as the trial-and-error testing of
speculative (猜测) hypotheses which can never be proven absolutely true,
but can be rejected when shown to be false.
 Under falsification view, all hypotheses proposed must be capable of
falsification.
 A theory that gains acceptance is one that has not been proven false by
tests that are designed to reject the theory it if is not true
d. Research programs
 Scientific theory that consist of positive auxiliary and negative heuristic
(教育)
 Positive heuristic
 Surrounds the core and forms a protective belt of auxiliary ( 铺 助 )
hypotheses
 Negative heuristic
 Is the hard core of the research program and it stipulates the basic
assumption of science
e. Kuhnian paradigm
 Very radical changes. If the theory does not fulfill the practices, it will be
thrown away and develop new theory. (abandonment of one theory and its
replacement with another )
 Stages :
 Pre-Science
 No generally accepted ideas or scientific principles
 Focus on a single paradigm
 Normal science
 Attempts to articulate (清楚说明) a paradigm (典范) with the
aim of improving the match between it and nature
 Crisis revolution
 Repeated failures to resolve these serious anomalies ( 异 常 )
eventually lead to loss of confidence in the paradigm and
finally new paradigm emerges
 New normal science
 With new paradigm , a new normal science begins
 New Crisis
 The replacement of the old paradigm by the new paradigm,
new crisis start.
f. Feyerabend’s approach
 Any approach is valid as long as follow the procedures
 Argued that reality and society are far too complex and dynamic for any
one method or paradigm to dominate science.
 There is no single scientific way of getting ideas where they can arise from
many intellectual pursuits and any approach is valid.

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Approaches to the development of accounting theory (*important)

1. Pragmatics theories
a. Descriptive pragmatic approach (accounting behavior)
o It is an inductive approach where it based on continual observation of
the behavior of accountants in order to copy their accounting procedures
and principles.
o Criticism
 Does not include an analytical ( 分 析 ) judgment of the quality of an
accountant’s actions
 Does not provide for accounting techniques to be challenge and does
not allow for change
 Focus on accountant’s behavior not on measuring the attributes of the
firm
b. Psychological pragmatic approach (User’s response)
o Observe users’ response to accountant output (Financial Report)
o Reaction of user is taken as evidence that financial statements are useful
and relevant information
o Criticism :
 Users react in an illogical manner, have preconditioned response
and may not react when they should
2. Syntactic and Semantic approaches
o Syntactic (general-specific)
 Theoretical interpretation of traditional historical cost accounting
o Semantic (Specific -general)
 This theory consist of semantic content on the basis of its input
 There is no empirical operation to verify the calculated outputs.
o Semantics inputs are the transaction and exchanges recorded in vouchers,
journals and ledgers. The inputs are then manipulated on the basis of the
premises and assumptions of historical cost accounting. The output maybe
syntactically accurate but nevertheless be valueless due to lack of semantic
accuracy
3. Normative Theories (Best practice)
o 1950s-1960s
o More concerned on :
 Policy recommendation
 “What should be done”rather than “what is”
 What accounts should be report and the best way to do that
 How accounting should be practiced
o Main focus:
 Deriving true income for an accounting period
 True Income

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  True income theorists concentrated on deriving a single
measure for assets and a unique (correct) profit figure
 Discussing type of accounting information which would be useful in
making decision (decision usefulness)
 Decision usefulness
 Decision usefulness approach assumes that the basic objective
of accounting is to aid the decision-making process of certain
users of accounting reports by providing useful accounting
data.
o Assumptions are rarely subject to any empirical testing
o Normative researchers based their theory on both analytical (syntactic) and
empirical (inductive)
o The normative researches also made assumptions about the nature of the
firm’s operations based on their observations
4. Positive (Descriptive)
o 1970s
o Explain on what and how and predict accounting practices
o Concerned mainly with :
 Explaining the reasons for current practices
 Predicting the role of accounting and associated information in the
economic decision making of individual, firm and other parties.
o Referred as positive methodology/ empirical methodology , which means
testing theories or hypotheses back to facts of the real world
o Main focus :
 Empirically testing some of the assumptions made by normative
accounting theorists
o Important :
 Explain the economic, or wealth, effect of accounting and why
accounting is important to various parties such as shareholders, lenders
and managers
 Important in assisting in the design of contracts based on accounting
numbers that control behavior
 Helps predict the reaction of investors in the market to the action of
management and to report accounting information.
 Enables regulator to assess the economic consequences of the various
accounting practices they consider.

PAT aims to explain why financial statements are produced and audited voluntarily, why
accountants choose the particular accounting methods over others and why accountants or
manager lobby for or against a particular accounting methods.

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1.3 Approaches of accounting theory

Nature of accounting theory approach

Primary objective of accounting theory is to provide a basis for the prediction and
explanation of accounting behavior and events. Due to the complex of human behavior
(opportunism, human greed, future uncertain and degree of shareholder naivety) no single
comprehensive theory of accounting exists at present

Definition of theory

Belkaoui :
A set of interrelated constructs, definitions and propositions that present a systematic view of
phenomena by specifying relations among variables with the purpose of explaining and
predicting the phenomena , if the theory is unable to produce the expected results, it is
replaced by a better theory which is more relevant

Definition of Process

Machlup
 Theory should be subject to a logical or empirical testing to verify its accuracy
 If the theory is mathematical based , the verification should be predicted based on
logical consistency
 If the theory is based on the physical and social phenomena , the verification is based
on deduced events and observation in the real world

Approaches of Accounting Theory*

1. Traditional Approach
a. Non-theoretical approach
i. Practical/ pragmatic
ii. Authoritarian approach
b. Theoretical approach
i. Deductive approach
ii. Inductive approach
iii. Ethical approach
iv. Sociological approach
v. Economic approach
2. Regulatory Approach

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 a. Public interest approach
b. Capture theory
c. Economic interest group theory
3. Positive Approach
4. Behavioral Approach
5. Paradigm Approach
TRADITIONAL APPROACHES

Non-theoretical approach (There is no attempt made to verify the theory)

1. Pragmatic /practical
 Construction of a theory is in line with what happened in the real world and
suggests practical solutions
 Primary objective is to find a workable solution to a problem
 The accounting principles are chosen as they are useful for the different types
of users in making decision
 Pragmatic approach is also an important part of the theory in accounting
because it enables the theory to have operational utility, based on
understanding of relations between business phenomena, of constraints on the
measurement system , and of the needs of users of accounting information
 Advantages
 Accounting serves a function only if it is useful
 Criticism
 There are no basis criteria to determine what is meant by useful

2. Authoritarian Approach
 Constructed by professional bodies and government.
 Mostly used by professional bodies and government to issue pronouncements
(公告)for regulations of accounting practices
 Could be viewed as a variation of the pragmatic approach and it sometimes
equated as pragmatic approach because of the common methodology of its
theoretical grounding which is based on operational utility after the approval
of the regulatory bodies.
 Lack of theoretical foundation and it focuses on accounting practices and
logical conclusion because the theory is derived from practice.

Both pragmatic and authoritarian approach assume that accounting theory and practices must
be predicated and have useful function for the user of accounting information because the
theory without practical consequence is assumed a bad theory. Both theories largely fail to
achieve satisfactory conclusion in their effort to develop accounting theory.

Theoretical Approach
1. Deductive approach

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 2. Inductive approach
3. Ethical approach
 Primarily emphasis on the concept of fairness, justice, equity and truth.
 Justice (equitable treatment of all interested parties)
 Truth (reporting of true and accurate accounting statements without
misrepresentation)
 Fairness (dealing with true and fair, unbiased, and impartial presentation of the
Financial Reports.)
 Accounting theory is required to be constructed based on ethical approach to
ensure that reporting is not subject to any bias or undue influence.
 Disadvantages:
 Fail to provide a sound of basis for the industry, government and
individuals
4. Sociological approach*
 Emphasized on the social implications (social effect) of the accounting
techniques
 Accounting techniques and principles are evaluated for acceptance after
considering all effects on all group in society
 The accounting reporting is expected to be useful for the users to make social-
welfare judgment.
 The social approach has contributed to the evolution of a new accounting
discipline which is called socio-economic accounting.
 The main objective of the new accounting discipline is to encourage business
entities to account environment through measurement and disclosure in
financial statements.
5. Economic approach
 Focused on the concept of general economic welfare
 Emphasis the controlling behavior of macroeconomic indicators that result
from the adoption of various accounting techniques.
 The choices of different accounting techniques depend on their impact on the
national economic good.
 Accounting policies and techniques should reflect economic reality and
depend on economic consequences
6. Eclectic approach (不拘一格的)
 Combination of approaches in developing accounting theory
 It is mainly the result of numerous attempts by individuals, government and
professional bodies to participate in establishment of concepts and principles
in accounting.
 Resulted in the formulation of new approaches, such as the regulatory
approach, behavioral approach and positive approach.

REGULATORY APPROACHES

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1. Public interest theory
 Is based on assumption that economic markets are subject to a series of market
imperfections or transaction failures, which, if left uncorrected, will result in
both inefficient and inequitable outcomes.
 Mainly to correct the market failure due to the demand from the public.
 Regulatory body is assumed to serves the best interest of public, and
government is a neutral arbiter
 Public interest theory is also based on further assumptions
 First, the interest of consumers is translated into legislative action
through the operation on the internal market place.
 Second, there are agents who will seeks regulation on behalf of the
public interest
 Third, government is a neutral arbiter
 Criticism
 Complex task in deciding the right amount of regulations
 Regulation carries substantial costs (ex: compliance cost)
 Regulator will operate to serve his benefits rather than operate on
behalf of the best interest of the public

2. Capture theory
 Origin of the regulation is to protect the public interest, however this purpose
is not achieved because in process of regulation, the regulatee comes to
control the regulator
 Assumption on capture theory:
 People are economical rationally. Each person will pursue his self-
interest to the point where the private marginal benefit from lobbying
regulators just equals the private marginal costs.
 Regulation has the potential to redistribute wealth; therefore, people
lobby for regulations that increase their wealth.
 Government has no independent role play in the regulatory process,
and that interest groups battle for control of the government’s coercive
powers to achieve their desired wealth distribution.
 Capture theory is said to occur when regulated entities:
 Control the regulation and the regulatory agency
 Succeed in coordinating the regulatory body’s activities with their
activities, so that their private interest is satisfied.
 Regulatory decisions usually have major effects on the interests of regulated
industries. Therefore, they generate intense activity aimed at influencing the
regulatory agency.
 Regulatory capture theory suggest that professional bodies or the corporate
sector will seek as much control as possible over the settling of accounting
standards governing the reporting by their members. This involves :

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  Formal control over standard setting representation on the relevant
standard setting bodies.
 Significant control over the decisions made by the relevant standard
setting bodies.
 Criticism
 No reason suggest that regulated industry is the only group able to
influence the regulator
 No reason why regulated couldn’t prevent creation of the regulatory
agency

3. Economic interest group theory (Private interest theory)

 Regulation of an industry mainly set to take care of particular special interest
group to maximize their interests.
 Regulation is more competition for power rather than to protect the public
interest
 Government is not neutral arbiter, they owned power to coerce (强迫), and it
is a potential resource or threat to every business firm.
 For future electoral (选举) success, government sells aspect their right in the
form of supplying regulatory program and legislation. Example, industry may
demand regulation to be protected from foreign price competition.
 The interest group theorists believe that there is a market for regulation with
similar supply and demand forces operating as in capital market.
 Within the political market there are many bidders, however, only one group
that makes the highest bid will successful.
 Regulation serves the private interest of politically effective groups, those
groups with insufficient power will not be able to effectively lobby (游说) for
regulation to protect their own interest.

POSITIVE APPROACH*

Development of a positive theory of accounting which will explain why accounting is what it
is, why accountants do what they do, and what effects these phenomena have on people and
resource utilization.
PAT aims to explain why financial statements are produced and audited voluntarily, why
accountants choose the particular accounting methods over others and why accountants or
manager lobby for or against a particular accounting methods.
 This approach is based on the proposition that managers, shareholders and regulators
are rational and that they attempt to maximize their utility.
 Completely opposite to the normative approach and attempts to explain why
accounting procedures and policies are as they are, whereas the normative attempts to
prescribe the accounting procedures and policies to be implemented.

Positive Accounting Theory (PAT)*(chapter 4)

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 Concerned on predicting and explaining the choices of accounting policies by the
manager and how the manager will respond to the new accounting standards.
 PAT assumed the manager is rational and will choose the accounting policies that
attempt to maximize his own best interest, not the firm’s profit.
 Under PAT, firm can be view as a nexus ( 链 接 ) of contract, such as contract with
employees, suppliers and capital provider are central to the firm’s operation. Firm will
want to minimize various contract cost (contract efficiency).
 Management has the ability to choose from a set of accounting policies which opens
up possibility of opportunities behavior, managers choose accounting policies from
the set for their own purposes there by reducing contract efficiency. For example, if
manager’s remuneration is based on reported income, thereby manager may choose
accounting policies to smooth out income, even though this may affect firm taxes and
possibly damage the firm’s interest.
 PAT does not attempt to tell individuals what they should do, this theory is known as
normative
 3 hypotheses(猜测) of PAT
1. Bonus Plan hypothesis
 Managers are tend to use accounting method that shift reported earnings
from future period to current period as this will increase manager bonus
(maximize utilities).
 Managers are predicted to choose less conservative ( 保 守 ) and less
volatile (易变) accounting policies.
 Managers will prefer accounting policy that smooth reported earnings,
they will opposed (反对) proposed accounting standards that may lower
report net income
 Compensation contract as one of the major focuses in PAT provides
insight for opportunistic driven Earning Management (EM)
 They are more likely to choose opportunistic manipulation to increase
reporting earning thus increase their expected bonus. Manage is said to
doing Real Earning Management (boost income by reducing R&D
expenses) to get more bonus.

2. Debt Covenant hypothesis

 The closer a firm is to violation of accounting based debt covenant (合
同 ), the more likely the manager is to select accounting policies that
shift reported earnings from future to the current period.
(The existence of debt-contract provides manager incentives to
manipulate accounting numbers, by shifting future earnings to present
to avoid violation of debt-contracts.)
 The reasoning is that the increasing net income will reduce the
probability of technical default.
 A borrowing firm may covenant to maintain specified level of interest
coverage, debt-to-equity and working capital. If such covenants are

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 violated, the debt agreement may impose penalties. To avoid penalties,
managers will try to maintain its current earnings at a satisfied level
 Managers with high debt-equity ratio are predicted to choose less
conservative accounting policies, and oppose new standards that limit
their liabilities.
 In order to avoid violation of debt contracts, managers usually engaged
in earnings management to boost income for current period. Managers
may be acting opportunistically and not for the benefit of the debt
holders.

3. Political Cost hypothesis

 Large firm with high profit more likely to choose income-decreasing
manipulation to reduce political costs be deferring earnings from
current to future to minimize political cost such as taxes and other
regulations
 This hypothesis predict that manager of very large firm will choose
more conservative accounting policies than managers of smaller firms,
and will be less likely to oppose new standards that may lower
reported net income.
 Criticism :
a. Concept from PAT is drawn from an obsolete (过时) philosophy of science as the
theories of empirical science make no positive statement of “what is”
b. Rochester School’s assertion that the kind of positive research are undertaking is s
prerequisite for normative is based on a confusion phenomenon domains at the
different level and is mistaken.
c. A theory may be used merely for prediction even it is known to be false

BEHAVIOURAL APPROACH

 Behavioral approach exists because most traditional approaches to the construction of

an accounting theory have failed to take into consideration of user behavior.
 To create the accounting theory, we must consider individual’s behavior because the
behavioral analysis is also important for developing the accounting theory
 Accounting method that considered on behavioral approach is known as behavioral
accounting
 Behavioral accounting is used in accounting world as a method in which takes into
account key decision makers as part of the value of a company
 Behavioral approach is concerned on human behavior tat relates to accounting
information and problems.
 The basic objective of behavioral accounting is to explain and predict human behavior
in all possible accounting contexts.

ACCOUNTING PARADIGM (pattern)

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Paradigm is a fundamental image of the subject matter of science. It serves to define what
should be asked and what rules should be followed in interpreting the answer obtained.

a. Anthropological (人类学)
 Use descriptive-inductive approach to the construction of an accounting theory
 The basic subject matter is regarding the existing accounting practices, and
management’s attitudes toward those practices.
 Paradigm is evaluate the significance of historical cost in term of accountability and
decision making (Littleton)
 Paradigm is more concern of accounting to be functioning of accountability
relationship among interested parties. (Ijiri)
 4 theories considered as part of anthropological :
o Information economics
o The agency model
o The income smoothing hypothesis
o PAT
 Methods:
o Techniques used in income smoothing research
o Techniques used in earning management research
o Techniques used in Positive Theory research

b. True-income
 Use normative-deductive approach to the construction of an accounting theory
 The basic subject matter is the construction of an accounting theory on the basis of
logical and normative reasoning , and concept of ideal income based on some
other method than the historical cost method
 True income theorists concentrated on deriving a single measure for assets and a
unique (correct) profit figure
 Deductive method begin with basic accounting premises and proceeds to derive
logical means accounting principles that serve as guides for the development of
accounting technique. If the premises are false, the conclusion may also false.

c. Decision usefulness (informativeness of price)

 Primary objective is to provide economic information which is useful in decision-
making process.
 The accounting system cannot supply all information desired by all decision-
makers due to different user required different information. Thus, we must decide
what information is important while what information is not.

d. Aggregate market behavior

 The extended from decision usefulness from individual user response to the
aggregate market response.

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  The aggregate market paradigm implies that accounting procedures numbers have
informational content dictated by market response.
 The theory states that the market for securities is deemed efficient in market prices
“fully reflect” all publicly available information and market prices are unbiased
and respond instantaneously to new information

e. Decision maker
 The information that provides decision usefulness is very important for the
decision maker
 The basic subject matter is the individual-user’s response to accounting variables
 This paradigm is to determine how the decision maker influenced by the
information
 The objective of this paradigm is to understand, explain and predict human
behavior within accounting context.

ACCOUNTING STRUCTURE

The structure of an accounting theory contains 4 elements:

a. A statement of the objectives of financial statements

b. A statement of accounting postulates and the theoretical concepts
c. A statement of accounting principles based on both the postulates and theoretical
d. A body of accounting techniques derived from the accounting principles

A. Objectives

Specific Objective  Present fairly and conform with GAAP

General Objective  Provide reliable information about economic resources and
obligations of business enterprise
 Provide reliable information about changes in the net resources
from profit-directed activities
 Provide financial information to estimate the earning potential of
a firm
 Provide other needed information about changes in the economic
resources and obligation
Qualitative Objective  Prepare FS with relevance, understandability, verifiability ,
timeliness, comparability and completeness

B. Postulates
Defines as a basic assumption or fundamental proposition regarding the economic, politic
or social environment that accounting operates in.

1. The entity postulate  Entities are separated from its owners and other
firms
 Enables accountant to distinguish between
business and personal transaction , because

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 only business transaction will be reported in
the FS
 Recognized the fiduciary responsibility of
management to stockholders.
a. Firm-oriented approach
 Defined as the economic unit (sole
proprietorship, partnership)
responsible for the economic activities
and administrative control of the unit
b. The user-oriented approach
 Define an accounting entity in terms
of the economic interest of various
users
 The interest of the users will define
the boundaries of the accounting entity
and the information to be included in
the FS
2. The going-concern postulate  Business entity will continue its operations
long enough to realize its project and ongoing
activities
 The entity is not expected to be liquidated in
the foreseeable future
 Assumes the entity will continue for an
indefinite period of time
 Justifies the valuation of assets on non-
liquidation basis and provide the basis for
depreciation accounting.
 Encourage managers to be forward-looking and
motivate investors to commit capital to an
enterprise
3. The unit-of-measure postulate  Defined accounting is a measurement and
communication process of the activities of the
firm that are measurable in monetary term
 It records the outflow and inflow of the firm
resources in monetary term
 Monetary unit was chosen in accounting as
common denominator to account for
transactions of firm to ensuring comparability
 Limitation:
 Limited to the information express in
monetary term. Accounting does not
record other relevant but non-monetary
information
 Unit of measure. The value of ten
dollars 10 years ago and today is
different. Means the purchasing power
is subject to change
4. The accounting-period postulate  User needs a information about company
financial position to make decision. Thus, FS
should be disclosed periodically.

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  Most companies issued interim reports for
more timely, relevant and frequent information


C. Theoretical concepts
Portray (描写) the nature of accounting entities operating in a free economy characterized
by private ownership of property.
D. Accounting principles
Principle that governs the current accounting practices which is used as a reference to
determine the appropriate treatment of complex transactions. It is derived from both
objectives and theoretical concepts of accounting that governs the development of
accounting technique.

1. The cost principle  Historical cost or acquisition cost is the appropriate

valuation basis for recognition of the acquisition of all
goods and services
 Item should be recorded and reported at the exchange
price at the date of purchase
 Historical cost as a valuation basis because it is reliable
as it is verifiable
2. The revenue principle  Nature of components
 Interprets what is revenue and its components
 An inflow of net assets resulting from sale of
goods or services
 An outflow of goods or services from the firm to
its customers
 A product of the firm resulting from the mere
creation of goods or services by an enterprise
during a given period of time
 Measurement
 Measured in term of the value of the products or
services exchange an “arm’s length transaction”
 Net cash equivalent or the present discounted value
 Timing
 Revenue should be recognized when it is realized or
is realizable and earned
 Revenue is realized when products are exchanged for
cash or claims to cash while revenue is realizable
when related assets received are readily convertible
to cash or claim to cash
 Revenue is earned when the products are delivered or
services are performed.
 Accrual basis
 Revenues are recognized when a product has
been sold or a service has been performed,
regardless of when the money is actually
received.
 Under the percentage-of-completion method, the

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 revenue is recognized in accordance to the
proportion of work done in each period
3. Matching principle  Expenses should be recognized at the same period with
the recognized revenue
 It reflects cause0and effect relationship
 4 criteria on association between revenue and expenses
 Direct matching of expired cost with a revenue
(COGS)
 Direct matching of expired cost with the period
(salary)
 Allocation of costs over periods benefitted
(depreciation)
 Expensing all other costs in the period occurred
(advertising costs)
4. Objectivity  Emphasizes on free from bias, conflict of interest as well
as undue influence from other parties
 Accounting will be recorded on the basis of objective
evidence, means different people looking at the evidence
will arrive at the same value for the transaction
5. Consistency  Similar economic events should be recorded and reported
in a consistent manner from period to period
 Apply same accounting procedures to similar item over
time, even though there are other acceptable accounting
alternatives
6. Full disclosure  FS should be prepared and presented accurately of all the
economic events that have affected the firm for the
certain period.
 FS must disclose all the facts that may influence the
judgment of the users, and it must not mislead the users.
 No information will be concealed by management
7. Conservatism  Implies that the highest values of the liabilities and
expenses and lowest values of assets and revenues should
preferably be reported
 Because higher expenses lead to lower reported of
income and inventory cost (asset should be measured at
the lower of cost and NRV)
8. Materiality  Materiality provides an important guidance for the
accounting in deciding what should be disclosed in FS.
 The concept is relative in term of size and importance of
an item to a firm.
 What is material for a small company many not be
material for a big company
 2 criteria to determine materiality
 Size of the item
 The impact of the item (significant influence the
firm or not)
9. Uniformity &  Uniformity refers to the use of the same procedures by
Comparability different firms
 To achieve comparability of FS by reducing the diversity

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 created by the use of different accounting procedures by
different firms.

E. Accounting techniques
Specific rule that derived from accounting principles that account for specific transactions
and events faced by the accounting entity

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