CHAPTER 1

THE ROLE OF
ACCOUNTING THEORY
Nature of Theory
 The objective of accounting theory is to
explain and predict accounting practice.
 Explanation: providing reasons for
observed practice.
 Prediction: the theory predicts unobserved
accounting phenomena.
Why Accounting Theory is
Important
 Many individuals have to make decisions
about external accounting reports.
 Corporate managers
 Public accountants
 Officers of lending institutions
 Investors and financial analysts
 Individuals in accounting standard-setting
bodies
Why Accounting Theory is
Important (Cont’d)
 All these various parties in act so as to maximize
their own welfare.
 Corporate managers: if corporate manager’s welfare
is dependent on the market value of the corporation,
he/she wants to know the effect of accounting
decisions on stock/bond prices.
 Researchers should be able to provide theories
that are more useful to decision makers in
maximizing their welfare.
 Evolution of Accounting Theory
 After the US Securities Acts of 1933 and
1934: accounting theorists became more
normative – concerned what should be done.
 Empirical tests of hypotheses were facilitated
by the creation of a large computer data base
of security prices (CRSP) and combined with
the availability of computer.
 Led to the development of the efficient
market hypothesis
Evolution of Accounting Theory
(Cont’d)
 Article that had the biggest impact on the
accounting literature was Ball and Brown
(1968).
 By mid 1970s accounting researchers had
observed systematic accounting behavior in
accounting practice, which suggested that a
theory could be developed to explain
accounting practice.
Evolution of Accounting Theory
(Cont’d)
 Another basis for the emerging accounting
theory was the ongoing debate over the
desirability of government regulation of
financial disclosure
Positive and Normative
Propositions
 Positive propositions are concerned with
how the world works.
 Normative propositions are concerned with
prescriptions.
An Outline of Methodology
 Development of a Theory
 A theory consists of 2 parts: the assumptions
and the set of substantive hypotheses.
 If the phenomena the research address are
interesting, others researchers will try to
improve the original researcher’s
methodology, apply it to different
phenomena, find and test alternative
explanations, and so on, and a literature will
develop
An Outline of Methodology
(Cont’d)
 The Nonexistence of Perfect Theories and
the Role of Anomalies
 Theories are simplifications of reality and the
world is complex and changing.
 The mere fact that a theory does not predict
perfectly does not cause researchers or users
to abandon that theory.
 But prediction errors are important, because
investigation of them frequently leads to
improvement in the accepted theory.
 An Outline of Methodology
(Cont’d)
 The Nature of Evidence
 Concern with anecdotal evidence:
 In some circumstances, that evidence is the only
evidence available, and some evidence is better than
none.
 It can suggest ways to improve the theory.
An Outline of Methodology
(Cont’d)
 The Criterion for a Theory’s Success
 The costs of prediction errors.
 The cost of developing the theory’s
prediction.
 Intuitive appeal of the theory’s explanation
for phenomena and by the range of
phenomena it can explain and predict as well
as by the usefulness of its prediction to users.
An Outline of Methodology
(Cont’d)
 The Important Role of Competing Theories
 There is often competition among alternative
theories about the same phenomena.
 If competing theories exists, we have to
investigate the variables that those competing
theories suggest are important.