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Financial Accounting Theory & the Reporting Environment Essay

5. Researchers who develop positive theories and researchers who develop normative theories often do not share the same views about the roles of their respective approaches to theory construction. (a) How do positive and normative theories differ? (b) Can positive theories assist normative theories, or vice versa? If yes, give an example. If not, why not? Normative accounting research makes policy recommendations and is concerned with what should be done in contrast to explaining why current practice is carried out in the manner that it is (positive theory). Normative theorists usually attempt to derive either the ‘true income’ or adopt the ‘decision — usefulness’ approach whereby accounting reports are an input into users’ decisions (e.g., to buy or sell shares, management decisions on the financial wealth of firms, etc.). The major issues are the impact of the changing price environment (prices) and the impact on income, assets, liabilities and equity. As a consequence many normative theorists are measurement theorists who attempt to incorporate the effects of inflation into accounting reports. In this sense they take a semantic viewpoint — relating the figures in the accounting reports to actual objects (assets, liabilities) or events (changes in inflation). To some extent the approach of the IASB is a normative approach. Positive accounting theory was a reversion to testing or relating accounting theories back to the ‘facts’ or ‘experiences’ of the real world. Examples of such research were questionnaires and surveys of bank officers or investors regarding their use of financial reports for decision making; or whether inflation adjusted accounting reports actually aided decision making. Current positive accounting research is aimed at explaining the reasons for actual accounting practices and in predicting the role of accounting data in economic, political and social decision making. Positive theory has expanded accounting theory from the purely decision making focus of normative theorists into analysis of political and economic factors. Using the normative recommendation of IFRS, that fair values should be used in financial statements, a positive theorists would first undertake a number of empirical tests to see if they are actually useful/used by decision makers
in their valuation models. In this sense they complement each other – normative theory the deductive analysis with positive theory the empirical verification.


Classify the following hypotheses according to whether they are conclusions of positive or normative theories. Explain your answers. (a) Historical cost accounting should be replaced by a market value system. (b) Historical cost accounting provides information used by creditors. (c) Historical cost accounting is used by many managers to allocate costs in determining divisional performance. (a) normative (b) positive (c) positive

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The decision-usefulness approach to theory development can be used to develop theories of accounting. a) Explain what is meant by the decision-usefulness approach to theory development. b) How can the decision-usefulness approach relate to accounting theory formulation? c) Give two examples of decisions that require data obtained from accounting reports.

The decision-usefulness approach is an instrumentalist approach (see diagram p.25). In a narrower sense, one direct test of an overall theory of accounting would be to determine whether the output data of the accounting systems, which are constructed on the basis of the overall theory, are useful to users. The data of the accounting systems are utilised by users in their prediction models, and the conclusions (predictions) are then used in their decision models. The problem is that if the prediction is verified, it verifies the prediction model, not the accounting system and its output. There are other variables besides accounting data that affect the prediction. We do not know how the accounting data were utilised. Also, if the decision turns out to be right, it verifies the decision model, not the accounting system. Interpreting the evidence on decision-making is extremely difficult. We do not know how to interpret the evidence to determine that accounting information is useful. Thus, a direct test is virtually impossible. Accounting standard setters usually determine usefulness with the weaker, more direct tests which are usually advanced by accounting committee setting bodies and include: relevance, verifiability, freedom from bias, timeliness, comparability, reliability and understandability. Some decisions: To invest in a firm’s stock (i) (ii) To loan funds to a firm (iii) To purchase or buy an asset. GHTHH Chapter 4 1. How do conceptual frameworks of accounting attempt to create a theory of accounting? Describe the components of the IASB Framework and how they contribute to a theory of accounting.

Conceptual frameworks (such as those developed in the United States, Australia and at the IASC/IASB) do not employ the term ‘theory’ because of the difficulty of demonstrating logical consistency and in gathering empirical evidence to corroborate the theory. However, by following a structured program of inter-related concepts, accounting regulators aim to use the conceptual framework to achieve consistent accounting standards that will replace ad hoc solutions to specific problems. In this context, the components of the conceptual framework can be viewed as the building blocks of a theory of accounting. The components of the IASB/Australian Framework are: objectives of financial statements; qualitative characteristics of financial information (such as relevance, reliability, comparability, timeliness and understandability); and definitions of the basic elements of accounting reports (such as assets, liabilities, equity, revenue, expenses and profit) and principles and rules of recognition and measurement of the basic elements, and the nature of the information to be displayed in financial reports. (Refer page 55 of text) 3. What does the IASB Framework describe as the basic objective of accounting? What are its implications? Stewardship looks primarily to the past, asking the question: What happened? Decision making looks to consequences in the future, asking the question: What will happen? A decision-making approach sees accounting information as inputs for the decision-making prediction models of users. If so, then we are concerned about what kind of accounting information is relevant to decision makers. Some believe that current value is implied. Also that statement of financial position accounts and their amounts are as important as those in the income statement. Traditional
accounting emphasises income.

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6. Explain the role of accounting in relation to: (a) individuals (b) firms (c) the Australian economy. Accounting information helps to efficiently allocate capital in the economy. The successful operation of a free economy depends, to a large extent, on the good judgements made by individuals about their investment opportunities and the investment opportunities of firms. People need information to decide where to invest or lend, and at what price. In relation to firms, accounting information forms the basis for many contracts, such as debt contracts that include covenants specifying that the firm will not allow its leverage ratio to exceed a certain level, or management compensation plans that provide managers with bonuses based on reported corporate earnings. As such, the firm’s cash flows are tied to accounting numbers. Since the value of the firm is the present value of all future cash flows and those cash flows are tied to accounting numbers, accounting numbers determine the value of the firm. In relation to the economy, accounting information plays a vital role in the equitable allocation of capital, and it contributes to the effective performance of the price system. The effective operation of our economy means that efficient and inefficient companies must be identified, so that resources are channelled to the former and away from the latter in order to have a ‘successful’ economic system. What would happen, after a long period of time, if ‘incorrect’ information is reported? The economic system would become inefficient (because of the existence of many inefficient firms), causing serious economic problems to all. 7. Can accounting ever provide an unbiased map of economic reality? Why or why not? Yes.

Criticisms of neutrality or freedom from bias take two forms. First, some argue it is a state of mind that is not attainable, because all of us are affected by personal values that have been shaped by our particular beliefs, traditions, environment, background and personality. Granted that this is true, it is still meaningful to speak of neutrality or freedom from bias. We recognise the existence of these influences on our perceptions. The idea is to control them within an acceptable range. Second, some contend that neutrality or freedom from bias is not operational, because we cannot be expected to read other people’s minds. However, it is possible to translate neutrality or freedom from bias into operational terms by establishing specific control devices that are external and subject to examination. Control devices are the means by which the notion of objectivity receives operational meaning. Control devices have to do with making public or external what is essentially internal or introspective. Rules and procedures under the heading of disclosure, consistency, comparability, and materiality as well as GAAP are practical control devices. In the accounting literature, practical control devices under the heading of objectivity have taken the following three forms:  to make specific and precise the concepts and procedures of accounting, and to obtain general agreement on them  to determine a consensus of the measure among a number of experts  to improve the standards of competence and ethics of the profession. Accountants must construct unbiased or neutral financial maps of economic reality. Otherwise, as Solomons warns, ‘If it ever became accepted that accounting might be used to achieve other than purely measurement ends, faith in it would be destroyed’.

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