Accounting Theory

Chapter 1

Definition of theory:

 A belief guiding actions or behaviour

 An idea explaining something
 A set of principles suggesting an explanation to a fact or event
 Generally: an opinion

The accounting principles are based on opinions (mostly because of political lobbying – paying or
supporting government candidates to pass or implement a specific principle)

Definition of accounting theory:

 ‘A description, explanation or a prediction [of accounting practice] based on observations

and/or logical reasoning’
 ‘Logical reasoning in the form of a set of broad principles that
o provide a general framework of reference by which accounting practice can be
evaluated and
o guide the development of new practice and procedures’.
 Or: describes accounting, prescribes solutions and gives reference to the conceptual
framework

Why is theory helpful?

 Describe and explain current accounting practices e.g. capital market theory
 Predict accounting practice e.g. agency theory or manager behaviour
 Providing principles to guide making decisions e.g. theories of capital budgeting
 Improve accounting principles by identifying problems and deficiencies with current
accounting practice e.g. the conceptual framework

Types of theory:

 Positive theory – (empirical theory)

o Describe/explain what is actually happening
o Make predictions about what will happen
o E.g. theories that explain why managers choose one accounting method over the
other
o Developed from observation and induction (specific to general) and deduction
(general to specific)
o Makes no judgements about outcomes
 Normative theory
o Make suggestions/recommendations as to what should happen
o Aim to achieve a goal or objective
o E.g. theories that propose fair value should be used to measure assets instead of
historical cost with the aim to ensure more relevant data
o Prescribe a course of action

Evaluating and testing theories:

  Reasons to accept a theory without being an expert about it:
o Authority of the source of the theory
o If it makes sense and fits in with personal beliefs and experiences
o If other people accept the theory
 An expert must apply legitimate, independent and justifiable methods when assessing and
evaluating theories including:
o Examining logical construction of the theory (do all parts of the theory make sense?)
o Considering evidence that confirms or disproves the theory

Relationship between research and theory:

 Come up with a theory and conduct research to prove it

 Or do research to come up with a theory
Chapter 2

Definition of conceptual framework:

A conceptual framework is a group of ideas or principles used to plan or decide something. It is a

set of guiding principles — that is, those ideas or concepts that influence and direct decisions being
made in a particular area.

The role of a conceptual framework:

 The conceptual framework is a set of general principles that help take a course of action or
make a decision. They are not specific enough to be interpreted in the same way by
everyone.

The conceptual framework theory:

 It is a normative theory
 It prescribes the basic principles that need to be followed
 The accounting conceptual framework is “a coherent system of concepts, which are
guidelines to the accounting standards used for financial reporting.”

How the conceptual framework differs from accounting standards:

 Conceptual framework is general, designed to provide guidance, and applies to a wide range
of decisions e.g. defines what is an asset and when it should be include in the FS
 Accounting standards provide specific requirements for a particular area e.g. outlines
definition of inventory and the costs included, how to measure the value of inventory etc.
 Standards are generally mandatory, whereas the framework is just a set of principles that
don’t have to be followed.
 If the framework conflicts with the standards, then the standards must be followed

Since the accounting standards are based on the framework, then:

 The standards do not contradict each other

 Work towards one collective goal
 Have the same general guidelines

Structure and components of the conceptual framework:

 The conceptual framework answers the following questions:

o What are the reports? -general purpose financial reports
o Who are they for? -users who may provide resources
o What id their purpose? -to provide the needed information for users to make a
decision
o What are the assumptions made when preparing them? -going concern
o What type of information must be included? -must be relevant and faithfully
representative, and preferably be comparable, verifiable, timely and understandable
o What are the elements of the FS? -assets, liabilities, equity, income and expenses
o When should these elements be included? -when they are probable and can be
measured reliably
 The conceptual framework does not answer the following questions:
o What measurement basis should be used
o What capital concept should be used
Reporting focus:

 The CF is concerned with general purpose reports (financial reports intended to meet the
needs of users who are not able to require an entity to prepare reports tailored to their
particular information needs)
 Small shareholders, or anyone who are not the owner of the company do not have the right
or ask for additional information to the FS provided publicly.
 CF does not need to be used when preparing special purpose financial reports (reports to
meet the needs of particular users); they contain special information for those who have
the right to ask for them e.g. significant lenders, taxation authorities, management

Entity focus:

 There is no definition of a reporting entity in the CF

 The CF only states that the framework applies to the FS of all commercial, industrial and
business reporting entity of public or private sectors
 Definition of reporting entities in the new development of the CF:
o A reporting entity is a circumscribed area of economic activities whose financial
information has the potential to be useful to existing and potential equity investors,
lenders, and other creditors who cannot directly obtain the information they need in
making decisions about providing resources to the entity and in assessing whether
the management and the governing board of that entity have made efficient and
effective use of the resources provided.
o Reporting entity is seen as a set of economic events and transactions with a group of
users relying on the financial information, instead of a legal entity
o The CF is not aimed at NPOs
o The CF does not specify who must prepare FS, only provide guidelines for them (the
government imposes this upon companies)

The objective of financial reporting:

 Stewardship/accountability
o Focuses on the duty of managers as they are entrusted with the resources of the
entity.
o Requires managers to provide a report to those who provide the resources to show
how the resources were managed
o This was the main purpose of financial reports and accounting
o The CF does not include accountability as a separate objective, focusing mainly on
decision usefulness
o According to the CF: The objective of general purpose financial reporting is to
provide financial information about the reporting entity that is useful to existing and
potential investors, lenders and other creditors in making decisions about providing
resources to the entity (involving buying, selling or holding equity and debt
instruments)
o Or in simpler words: the financial statement should provide information that is
useful to users in decision making
o Information is needed to:
 Help us predict what may happen in the future
 Provide feedback on previous decisions
 o To investors, stewardship and decision usefulness are parallel objectives with
different emphasis but do not contradict each other
 Users and their information needs
o Primary users of FS:
 Existing and potential investors
 Lenders
 Other creditors
o Other users may also be: customers, employees, governments, the public
o However, the CF states the information is directed at the primary groups
o The aim is to provide the information that met the common needs of all the users
(not every single need or objective) and meet the needs of the maximum number of
primary users
o Non-financial information, like ethical issues, are not required to be provided in the
FS by the CF (only limited to financial information)
 Usefulness of financial reporting
o Financial information must be relevant and reliable
o Relevant information enhances the user’s ability to make informed decisions
o Some economic resources, such as intangibles, innovations, ideas, etc, are not
recorded, therefore the FS do not fairly represent the value of the entity

Underlying assumption

 The underlying assumption is the assumption that is used by the entities, which is the going
concern assumption
 It states that ‘the financial statements are normally prepared on the assumption that an
entity is a going concern and will continue in operation for the foreseeable future. (basically,
the assumption that the company will continue to exist in the near future)
 Going concern directly impacts recognition and measurement of items, if the company is
going to close down:
o Prepaid insurance will not be received, therefore will not be recorded
o Inventory will not be expected to sell at its “normal” price
o Etc.

Qualitative characteristics of useful financial information

 To be useful for decision making, information must be relevant and faithfully represented.
 These characteristics are not essential but improves usefulness of the information.
 Relevance:
o Aims to ensure that only financial information that could make a difference in
decisions is included
o This explains why financial information is needed (linked directly to purpose of FS –
to provide info useful to users in making decisions)
o If it cannot be used to make predictions or provide feedback, it is not useful
o Relevance is used as the first “test” applied to financial information to measure its
usefulness (faithful representation must also be met)
o Materiality is related to relevance – the quality of info that could influence decisions
of users if it is left out or misstated.
o Materiality is entity specific (differs from one company to the other), related to the
size and amount of the item and the nature of the item
  Faithful representation:
o The purpose is to make sure users trust the financial information provided
o It replaces reliability
o Faithful representation requires making sure that what is shown in the financial
reports corresponds to the actual events and transactions that are being
represented
o Standards require we consider substance over form (comply with legal form and
economic reality)
o 3 characteristics considered when determining faithful representation:
 Complete depiction – users require all relevant info about an event be
included
 Neutrality – free of bias, no attempt to promote a particular view
 Freedom from error – estimates may be incorrect or inaccurate, but if they
are reasonably based, they still meet the requirements of faithful
representation
 Enhancing qualitative characteristics
o Comparability – reasons for changes or differences must be clear when comparing
financial info to previous years or other entities
o Verifiability – info can be supported or confirmed by anyone
o Timeliness – providing info on a timely basis
o Understandability – info must be understood to be useful, it is not a requirement to
simplify the info so that everyone can understand it
 Determining relative importance of qualitative characteristics
o Ideally, info should have all characteristics
o In reality, trade-offs are more common (giving up one characteristic over the other
e.g. relevance over understandability)
o E.g. historical cost is most objective and understandable but not relevant to all users
who look for PV or FV.
 Cost constraint on financial information
o Cost sometimes limits the company from meeting all the characteristics
o Benefit of obtaining one characteristic may not be greater than the cost needed to
obtain it
o Cost-benefit analysis takes place

Elements of FS

 Assets - A resource controlled by the entity because of past events and from which future
economic benefits are expected to flow to the entity.
 Liabilities - A present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying economic
benefits.
 Equity - The residual interest in the assets of the entity after deducting all its liabilities.
 Income - Increases in economic benefits during the accounting period in the form of inflows
or enhancements of assets or decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants.
 Expenses - Decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants.
Recognition criteria

 Recognition is the process of incorporating an item in the balance sheet or income

statement . . . It involves depiction of the item in words and by a monetary amount and the
inclusion of that amount in the balance sheet or income statement totals.
 For the item to be recognised, it must be probable and measurable
 Probability – it is probable that there will be future economic benefit that will flow into the
entity (the event is more likely to continue than not)
 Reliable measurement – the item has a cost or value that can be measured with reliability

Benefits of conceptual framework

 Technical benefits
o to improve the quality of financial statements by providing guidance to standard
setters and for users and preparers
o before, standards were set without a CF, this was the piecemeal approach
o the main technical benefits of having a CF are:
 to improve accounting itself
 to improve the practice of accounting
 to provide a basis for answers to specific accounting questions and problems
o the CF does this by:
 Providing a basis and guidance for those who set specific accounting rules
(providing a set if established and agreed principles and focusing on how to
apply the principles already in the CF)
 Helping individuals involved in preparing/auditing/using the FS
o Political benefits
 Standards affect decisions made by users which have a real economic
impact and affect the wealth and welfare of particular individuals, entities
and industries
 This is why politics interferes with setting standards
 Lobbying often takes place (supporting government candidates to pass or
prevent certain standards from passing according to their personal gain)
 The CF framework prevents political interference by referring to the CF
whenever anyone disagrees with a new standard
o Professional benefits
 The CF protects the professional status of accounting and accountants
 This argument is based on the following:
 Professional status is valuable.
 A profession has a unique body of knowledge; it has expertise in an
area that other groups do not have.
 The historical ‘knowledge base’ of accounting is double-entry
bookkeeping. However, this, at least in a simple form, is practiced
widely in the general community.
 Because of the problems with the historical knowledge base of
accounting, a conceptual framework has been developed to
establish a unique body of knowledge of accounting.
 Although the accounting profession may state that the reason for
conceptual frameworks is to improve accounting, the true reason is
to provide the appearance of having a unique body of knowledge so
 that it can maintain its status as a profession and so that its
members can gain the benefits of professional status.
 However, some argue against this theory in that the professional status of
accountants is developed and maintained through social actions, and that it
provides no explanation why some accounting rules in some countries adopt
parts of the CF.

Problems with and criticisms of the CF

 The criticisms are caused by the nature of the CF as a set of general guiding principles and
specific parts of the current CF
 Criticisms of the CF:
o It is too ambiguous (too general)
 They may be interpreted differently
 Share options do not meet the definition of expense, however they are
expensed
 No definite answer on how to measure the items
 Provides no clear guidance on how to balance/weigh decisions based on
constrained/limited circumstances
 CF is incomplete
o It is too descriptive
 It does not try to improve the practice, only describes it
 Based on historic concepts that may be incorrect
 Some do not agree with the principles included
o The meaning of faithful representation/reliability is problematic
 Realistic view – FS are representationally faithful to the extent that they
provide an objective picture of an entity’s resources and obligations
 Materialistic view - argues that accounting cannot be viewed as a science
whose aim is to discover objective facts that simply exist in the world