In a perfect financial world, there would be no demand for published accounting reports

and hence no accounting theory. Instead, there is a demand for financial information to
fill gaps in our knowledge and to reduce uncertainties about current and future values.

Theory is the logical reasoning underlying a belief, and is accepted by scientists,

professionals and society as a whole.

Accounting theory is a modern concept that first developed as a set of tools to record
activities or transactions. It has not been systematically developed from a structured
theory.

Accounting theory questions around measurement include whether to measure assets and
liabilities by historic cost, by selling price, or by present value of future cash flows.

The historical development of accounting methods is illustrated by the inconsistencies in

practice that have arisen. These inconsistencies include different methods of depreciation
and inventory expensing even within the same industry, and measuring some assets at fair
value whereas others are measured at cost.

Accounting practices have multiple demands from insiders and outsiders, and the
objective problem is one of the issues under intense debate. Conceptual framework
projects have not resolved the inconsistencies in practice, and are often used to justify or
support such inconsistencies rather than resolve them.

PRE-THEORY:

Fra Pacioli wrote the first book to document the double-entry system in 1494. For 300
years, developments in accounting concentrated on refining practice.

Until the 1930s, accounting theory was rather random and ill-defined, evolving as they
were needed to justify particular practices. However, developments in the 1800s led to
the formalisation of existing practices in textbooks and teaching methods, and to
increased government legislation regarding reporting requirements.

PRAGMATIC ACCOUNTING

The period 1800-1955 is often referred to as the 'general scientific period' because it
focused on the use of historical cost transactions and the application of the conservatism
principle.

The Great Wall Street Crash of 1929 led to a degree of logical debate about the merits of
measurement procedures. The Securities and Exchange Commission was created in the
early 1930s to improve financial regulation and reporting.
The 1930s period saw the birth of professionally based conceptual theory and several
notable accounting publications, including a statement of accounting principles and a
series of accounting research bulletins.

Forty-two bulletins were issued during the period 1939 to 1953. Eight were reports on
terminology, and 34 were the result of research.

The AICPA established the Accounting Principles Board in 1959 and appointed a
director of accounting research.

NORMATIVE ACCOUNTING

During the normative period, accounting theorists tried to establish 'norms' for 'best
accounting practice'. These theories adjusted for the impact of inflation and specific
increases in asset prices.

During the normative period, the debate over measuring and reporting accounting
information degenerated into a battle between competing viewpoints. The accounting
profession in Australia failed to issue comprehensive measurement guidelines and instead
adopted the IASB's conceptual framework.

Normative accounting theories adopt an objective (ideal) stance and specify the means of
achieving the stated objective. They are dominated by critics of historical cost accounting
and conceptual framework proponents.

During the normative period, the idea of a conceptual framework gained increased
popularity. These frameworks were meant to encompass all components of financial
reporting and were intended to guide practice.

The normative period began drawing to a close in the early 1970s, and was replaced by
the 'specific scientific theory' period.

Normative accounting theories are based on opinions, and they do not necessarily involve
empirical hypothesis testing. Further, the underlying assumptions of some normative
theories are untested, and it is difficult to obtain general acceptance of any particular
normative accounting theory.

POSITIVE ACCOUNTING

The dissatisfaction with normative theories, combined with increased access to empirical
data sets and an increasing recognition of economic arguments within the accounting
literature, led to the shift to positive theory. Positive theory sought to explain and predict
accounting practice.
If managers are remunerated partly with bonuses based on reported accounting profits,
they will use accounting policies that maximise reported profits to maximise their bonus.
This is important for shareholders, lenders and managers.

Watts and Zimmeiman argue that positive accounting theory has given order to the
apparent confusion associated with the choice of accounting techniques. The approach
has attracted criticisms for being too narrow and focusing on agency theory and
assumptions about the efficiency of markets.

A theory of accounting cannot be developed because of human greed, opportunism,

future uncertainty, and naivety. However, increased disclosures and reporting
requirements may advance the development of new theories.

RECENT DEVELOPMENTS

The academic and professional interests in accounting theory development have tended to
be aligned in the past. In recent times, however, the academic and professional interests
have taken somewhat different approaches.

The transition to IFRS saw the replacement of SAC 3 and SAC 4 with the IASB's
conceptual framework, which also forms the basis for the frameworks of other standard-
setting nations such as the United Kingdom, Canada and New Zealand.

International accounting standards aim to harmonise practices across international

reporting boundaries and reduce differences in reported information, particularly for
multinational and listed corporations.

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Accounting Theory and Policy Making

Bodies such as the Financial Accounting Standards Board and the Securities and
Exchange Commission make financial accounting rules. These rules are influenced by
economic factors, political factors, and accounting theory.

The steep inflation of the 1970s in the United States was an economic factor that
impinged on policy making.

Political factors refer to the effect on policy making of those who are subject to the
resulting rules or regulations, including auditors, preparers of financial statements,
investors, and the public.
The management of major firms and industry trade associations are important political
components of the policy-making process. The FASB's initial attempt to solve the
problem of special purpose entities (SPEs) failed because of political interference by the
then Big Five public accounting firms.

Discounted Cash Flows

The discounted cash flow approach is a purely theoretical method with virtually no
operable practicability on a statement-wide basis. It involves estimating future cash flows
and measuring income based on the change in the present value of those cash flows.

In a real situation, it is virtually impossible to apply this method because many assets
contribute jointly to the production of cash flows.

The discounted cash flow approach can only be implemented for a limited group of assets
and liabilities, and a mixed bag of discounted cash flows, net realizable values, and
replacement costs results.

Accounting theory is concerned with governing and making the rules for financial
accounting. It is exclusively developed and refined through the research process, and the
measurement process itself is quite ordinary and routine in virtually all situations.

1.1 WHAT THEORY IS

Accounting theory is an explanation for a phenomenon. It asserts that wherever a set of

circumstances occur, a similar result will be seen.

A theory can be tested against facts, such as the number of accidents recorded in a
particular jurisdiction, the number of cars driving over the limit and also the number
under the limit associated with recorded accidents. If the theory is supported by the facts,
it is correct.

1.4 POSITIVE FACTS AND NORMATIVE OPINIONS

Theories can be normative or positive. Normative theories prescribe behaviour, while

positive theories explain or predict facts, and do not assume we want any particular
outcome.
Positive theories explain, describe and predict behaviour, but do not prescribe it. For
example, positive accounting theory holds that firms manipulate their reported profits
upwards if bonuses are a major part of directors' pay packages, and positive financial
economics theories hold that debt makes no difference to share value.

Normative theories involve value judgments, positive theories are supposed to be value
free, and fact statements must be able to be tested against facts. Opinion statements
cannot be tested against facts, but can be shown to be ineffective or inefficient in
generating the results they claim.

A fact statement is true or false, and a lie is a false statement of fact. A prediction cannot
be a fact statement, because we cannot test it now.

Positive theories assume that there is a set of observable facts that are independent of the
theory itself, but that can be used to verify the truth of the theory. They follow the
philosopher Karl Popper who held that all theories can be disproved but not proved.

Because a theory may be falsified in the future, it does not make it false or invalid in the
present. If a theory explains facts and enables accurate predictions, that is good enough.

1.5 ACCOUNTING THEORY AND LAW

Accounting is the child of law and economics, historically speaking. Assets are things
you legally own, such as a house, a car or a share, and can be bought and sold.

Accounting involves the valuation of assets, liabilities, income, expenditure and equity.
In the early sixteenth century, double entry bookkeeping was spread round the world, and
valuation started to include gains or losses on foreign exchange.

Inflation means that the cost of a long lived asset such as a building is lower than the
price for which it could now be sold. Falsifying historical cost in accounting reports is
illegal, criminal and deceitful.

Current values are not fixed, and can change every second of the trading day. The value
of liquid assets is shown in a balance sheet, but may have changed by the time the
accounting report is published.

1.6 AGENCY THEORY

Accounting has several theories relevant to it, but agency theory is the most important
one and is central to understanding accounting practice, especially financial accounting
practice. Agency theory holds that modern companies are owned by shareholders but run
by managers, and that the economic interests of the two are different.

Managers are assumed to regard shareholders' wants as constraints on their own wants,
and are therefore responsible for making management accountable to shareholders
through accounting reports, audits, good corporate governance and holding the chief
executive accountable to the shareholders.

Bonding costs are much more important than monitoring costs in reducing the agency
problem. These costs are incurred by bonding managers to shareholders through stock
options and tying annual bonuses to profits.

In most large companies, the agency problem is solved by bonding, but in a minority of
companies, managers still pay themselves bonuses even when the firm has made a loss.

Accounting is about valuation, but it is even more about accountability. It is a way of

managing trust between strangers in business and succeeds much more often than it fails.