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LECTURE 1: HISTORICAL DEVELOPMENT OF ACCOUNTING THEORY

LECTURE 1: HISTORICAL DEVELOPMENT OF ACCOUNTING THEORY. Prepared by: MS NARIMAH HASHIM Jabatan Perakaunan & Kewangan Fakulti Ekonomi & Pengurusan Universiti Putra Malaysia. IS THERE A NEED FOR A THEORY OF ACCOUNTING?.

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LECTURE 1: HISTORICAL DEVELOPMENT OF ACCOUNTING THEORY

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  1. LECTURE 1: HISTORICAL DEVELOPMENT OF ACCOUNTING THEORY Prepared by: MS NARIMAH HASHIM Jabatan Perakaunan & Kewangan Fakulti Ekonomi & Pengurusan Universiti Putra Malaysia NHashim....UPM....12.7.2005

  2. IS THERE A NEED FOR A THEORY OF ACCOUNTING? • Theory in accounting is a relatively new concept compared to theories in mathematics and physics • Many years the profession has gone without a theory, so why is it needed at all? • The reasons = numerous problems have arisen due to the lack of a general theory of accounting NHashim....UPM....12.7.2005

  3. 1. PERMISSIVENESS IN PRACTICE • Accounting practice has been accused of being too permissive by allowing a number of alternative procedures • The AICPA (1934) once reported to the New York Stock Exchange the following: “The more practical alternative would be to leave every corporation free to choose its own methods of accounting within the very broad limits to which reference has been made” NHashim....UPM....12.7.2005

  4. 2. SOLUTIONS WERE AD HOC • Such freedom has resulted in so much confusion! • Then AICPA issued numerous resolutions to establish order, but their attempts were unsuccessful • The resolutions were seen as mere distillation of practice supported by ad hoc arguments rather than by a a set of consistent principles NHashim....UPM....12.7.2005

  5. 3. INFLUENCED BY OTHERS • The practice then continued to be influenced by law, rules set by government agencies and pressures from business executives • The APB (Statement No. 4 paragraph 139) admitted as such: “The accepted accounting principles are conventional, they become generally accepted by agreement (or often lack of agreement) rather than by formal derivation from a set of postulates or basic concepts. NHashim....UPM....12.7.2005

  6. 4. CONVENTIONAL PRACTICES • The principles were developed on the basis of “experience, reason, custom, usage and to a significant extent practical necessity” • Do what has been done – by those in practice & by acceptance NHashim....UPM....12.7.2005

  7. 5. Too many sources of authority in accounting • The Internal Revenue Service • The professionals/practitioners accepts LIFO for costing inventory and the accelerated depreciation method • Business executives expect accountants to minimize their tax expense or increase their reported incomes within “acceptable” schemes NHashim....UPM....12.7.2005

  8. PRESSURES NOT PRINCIPLES • Professor Paton (1938) argued against the lower of cost or method for inventory valuation. His opinion: “The enthusiasm for the device was not a tribute to the merit of the scheme as a worthwhile accounting mechanism, but as an immediate method of reducing taxable income. It is far removed from the development of sound accounting!” NHashim....UPM....12.7.2005

  9. Oscar Gellien (1980) • A former member of both the APB and the FASB argued: • If a method does not originate in the accounting sector or because other motives were behind it, it does not necessarily be objectionable. • However, it does lead to inconsistency of practices and this was the problem. • In the absence of a conceptual framework, he believes “Bad practices will triumphant over good practices” NHashim....UPM....12.7.2005

  10. ACCOUNTING THEORY DEVELOPMENT • When faced with a particular problem, without any clear-cut existence of a general theory of accounting, recommendations made by authoritative bodies can only be viewed as ad hoc solutions to pressing problems of the moment with no lasting / long-term effect NHashim....UPM....12.7.2005

  11. ACCOUNTING THEORY DEVELOPMENT • In reviewing the history of formulating accounting principles, Reed Storey (1980) observed: “The ad hoc solution resulting from the play-by-the-ear approach have rarely turned out to be lasting solutions” NHashim....UPM....12.7.2005

  12. CONCLUSION • Therefore, to find answers to questions, answers that can give us confidence, there need to be a rationale for every practice, there need to be a theory behind this rationale • A good answer is based on a good theory. • Once a good theory is formulated, good practice will automatically follow NHashim....UPM....12.7.2005

  13. HISTORICAL DEVELOPMENT OF ACCOUNTING THEORY AND PRACTICE BACKGROUND • Historically development has not been systematic but rather in an ad hoc fashion • Many accounting prescriptions have developed to resolve ad hoc problems as they arose, so the theory underlying those prescriptions have also developed in a largely ad hoc manner too NHashim....UPM....12.7.2005

  14. Chambers, R.J. (1963) • Commented: “ Accounting has frequently been described as a body of practices that have been developed in response to practical needs rather than by deliberate and systematic thinking” NHashim....UPM....12.7.2005

  15. PERIOD BEFORE 1494 • Very little was written regarding the theory underlying accounting practices • However lots of evidences in history about accounting practices • Examples, in civilizations of Assyrian-Sumerian – oldest surviving business records; Chineseduring Zhou dynasty-government accounting; Greek – Zenon, manager of Appolonious introduced responsibility accounting & Roman- laws requiring tax payers to prepare statements of financial position NHashim....UPM....12.7.2005

  16. SIGNIFICANCE of 1494 • A book “Summa de Arithmetica, Geometria, Proportioni et Proportionalita” (The review of arithmetic, geometry and proportions) • By a Franciscan monk, Luca Pacioli • He documented the existence of the double entry bookkeeping system as practiced by the merchants in Venice during that time in 2 chapters of the book NHashim....UPM....12.7.2005

  17. C. Littleton’s 7 Preconditions For the birth of Bookkeeping • The art of writing • Arithmetic • Private property • Money • Credit • Commerce • Capital NHashim....UPM....12.7.2005

  18. PERIOD AFTER 1494 TILL 1800’s • From 1494 till three hundred years later, the development in accounting is said to concentrate on refining practice “No theory of accounting was devised from the time of Pacioli down to the opening of the nineteenth century • Henderson, Peirson & Brown (1992) called this period as “THE PRE-THEORY PERIOD”: NHashim....UPM....12.7.2005

  19. THE PRE-THEORY PERIOD • Suggestions of theory appear here and there, but not to the extent necessary to place accounting a systematic basis” • If any theory development existed, it was ad hoc and ill defined, • Evolving as needed to justify particular practices NHashim....UPM....12.7.2005

  20. PERIOD 1800’s TO 1955 • Contributing factors to the development of a theory for accounting: • Growth of the business sector, construction of the railroad network & rapid expansion in technology in the United States and United Kingdom increased the demand for detailed accounting information, improved techniques and an explanation of the basisfor these improvements • Stimulated demand for accounting information NHashim....UPM....12.7.2005

  21. Called - THE GENERAL SCIENTIFIC PERIOD 2. The government & corporate bodies were beginning to use accounting figures as the basis for their economic policies 3. During this period, economic theories were progressing rapidly • Giving rise to growth in accounting theories especially in United Kingdom • Theories were developed to explain practices to deal with any new issues and to explain to students why certain procedures were adopted NHashim....UPM....12.7.2005

  22. THE GENERAL SCIENTIFIC PERIOD • Existing practices were formalized into textbooks and teaching methods in the United Kingdom. • In the United States, most theory development were also concerned with providing explanations of practices • But greater emphasis was given to formulatingan overall framework to explain and develop accounting practices NHashim....UPM....12.7.2005

  23. SCIENTIFIC METHOD • Theories were developed largely on the basis of empirical analysis, the method that is adopted in the physical sciences • Empirical analysis relies on real-world observations, thus accounting theory development was based on what was observed NHashim....UPM....12.7.2005

  24. GENERAL SCIENTIFIC PERIOD • In the earlier stages of the period, the approach to theory development was sporadic, later it gained momentum • Theories were focused on the existing viewpoints and those that were published to explain practice became more detailed and complex NHashim....UPM....12.7.2005

  25. Notable publications • In 1936, the AAA (American Accounting Association) released a TENTATIVE STATEMENT OF ACCOUNTING PRINCIPLES AFFECTING CORPORATE REPORTS • In 1938, the AICPA (American Institute of Certified Practicing Accountants) released A STATEMENT OF ACCOUNTING PRINCIPLES authored by Sanders, Hatfield & Moore, the professionals at that time NHashim....UPM....12.7.2005

  26. THE ACCOUNTING PRINCIPLES COMMITTEE • In 1938, the Accounting Procedures Committee was established. • Between 1939 to 1953 the committee published a series of accounting research bulletins, 42 issues in all: • 8 were on terminologies • 34 were results of research carried on segments of practices where problems were demanding and which concerned NHashim....UPM....12.7.2005

  27. PERIOD FROM 1955 TO 1970 • Referred to as the “NORMATIVE PERIOD” • Accounting theorists attempted to established norms for best accounting practices • Theories developed not interested with what happened in practice • But more concerned with developing theories that prescribed what should happen • MAINLY for the purpose of policy recommendations NHashim....UPM....12.7.2005

  28. NORMATIVE THEORIES PUBLICATION • Prior to 1956, some preliminary normative works have been carried out. • Among the most notable is by MacNeal, K (1939) regarding TRUTH IN ACCOUNTING and Sweeney, H (1936) regarding “STABILIZED ACCOUNTING” • The major focus of normative theories was on the impact of changing prices on the value of assets and the calculation of income NHashim....UPM....12.7.2005

  29. NORMATIVE THEORIES • Concentration on: • Deriving the ‘true income’ for an accounting period, OR • True income theorists attempted to derive a single measure for assets and a unique (and correct) figure for income NHashim....UPM....12.7.2005

  30. Most of the normative theories 2.Concerned with the type of information useful for making economic decisions • Based on classical economic concepts of income and wealth or economic concepts of rational decision making with adjustments for inflation or the market value of assets NHashim....UPM....12.7.2005

  31. Nature of Normative theories • Proponents of these theories described their derived accounting system as the ’IDEAL’ recommended to replace historical cost and prescribe it for use to everybody NHashim....UPM....12.7.2005

  32. GROUPS OF THEORISTS DURING THE NORMATIVE PERIOD • Two groups of theorists dominated the period: • The critics of historical cost accounting, and • The conceptual framework proponents • It was during this period that the conceptual framework increased in popularity NHashim....UPM....12.7.2005

  33. THE CONCEPTUAL FRAMEWORK • The conceptual framework is considered as the structured theory of accounting. • The framework is supposed to encompassed all components of financial reporting and intended to be used as a guide to practice NHashim....UPM....12.7.2005

  34. THE CONCEPTUAL FRAMEWORK • Among the notable works on the conceptual framework includes: • Goldberg (1965) was commissioned by the AAA to investigate the nature and meaning of accounting • The resultant publication: “AN INQUIRY INTO THE NATURE OF ACCOUNTING” NHashim....UPM....12.7.2005

  35. CONCEPTUAL FRAMEWORK AS GUIDE TO PRACTICE • In 1966, “A STATEMENT OF BASIC ACCOUNTING THEORY” was released with the stated purpose of providing an integrated statement of a basic accounting theory which will serve as a guide to educators, practitioners and others interested in accounting NHashim....UPM....12.7.2005

  36. DEMISE OF THE NORMATIVE PERIOD • The normative period ended in the early 1970’s • Two main factors prompted the demise of the normative theorists: 1. The unlikelihood of acceptance of any particular normative theory - Normative theories prescribed how accounting should be practiced NHashim....UPM....12.7.2005

  37. Theories were subjective • The basis of such theories is subjective opinion of what accounts should report and what is the best way to do it • Thus, opinions regarding the appropriate goals and methods vary between individuals • Their approaches did not provide any means of resolving the differences of opinions NHashim....UPM....12.7.2005

  38. THEORY TESTING DIFFICULT • The availability of financial economic principles and testing methods • Normative theories do not involve hypothesis testing since theories were based on value judgments • Since theories cannot be empirically tested and almost impossible to demonstrate how “what ought to be” NHashim....UPM....12.7.2005

  39. THEORIES WERE VALUE JUDGMENTS • The underlying assumptions of some of the theories were untested and whether they have strong foundations at all • The fact that they were value judgments increased further dissatisfactions of normative theories in general (Refer pp 249 – 251) NHashim....UPM....12.7.2005

  40. PERIOD 1970’S TILL 2000’s • Referred to as the POSITIVE THEORY period • The objective: To EXPLAIN AND PREDICT practice and tested EMPIRICALLY • Example: A positive theory that was formulated is called ‘The bonus plan hypothesis’ - States that managers being wealth- maximizers would rather have more wealth than less, even at the expense of the shareholders NHashim....UPM....12.7.2005

  41. POSITIVE THEORIES • THE PREDICTION: Managers who are remunerated via bonus plans will use income-increasing accounting methods more than managers who are not remunerated via bonus plans • THE OBSERVATIONS: Managers who were partly remunerated by bonuses based on reported profit in a period, have incentives to use accounting policies that will maximized reported earnings in the period NHashim....UPM....12.7.2005

  42. POSITIVE THEORIES • The advantages of being able to explain and predict practice according to Watt and Zimmerman: • It gives order to the apparent confusion associated with the choice of accounting techniques • It assists in predicting the reactions of ‘players in the market’ – i.e. how they will react to the actions of management and to reported accounting information NHashim....UPM....12.7.2005

  43. POSITIVE ACCOUNTING THEORY • Explain? =providing reasons for observed practice • Prediction? = can expect what will happen even for unobserved phenomena • Unobserved phenomena not necessarily means future phenomena. • It may refer to phenomena that have occurred but no systematic evidence has been collected about it NHashim....UPM....12.7.2005

  44. Example: • A theory is formulated to predict the reactions of firms to a proposed accounting standard • The theory can also be expected to explain why firms would lobby for and against the standard even though the standard has already been released • Testing the theory would provide evidence that can be used to predict the impact of accounting regulations before they are implemented NHashim....UPM....12.7.2005

  45. THEORY USAGE • It has an economic focus, for it seeks to provide answers to questions such as: • What are the costs and benefits of alternative accounting methods? • What are the costs and benefits of regulation and the accounting standard-setting process? • What is the effect of reported financial statements on share prices? NHashim....UPM....12.7.2005

  46. Assumptions of positive theories • To provide the answers, positive theory adopts the following assumptions: • Managers, investors, lenders and other individuals are rational, evaluative utility-maximisers • Managers have discretion to choose accounting policies that directly maximize their utility or to alter the firm’s financing, investment and production policies, to indirectly maximize their utility • Managers usually take actions that maximize value of the firm NHashim....UPM....12.7.2005

  47. POSITIVE THEORY DEVELOPMENT • Initially, positive accounting theory developed in 2 stages: • Research involving the capital markets • Research seeking to explain and predict accounting practices across firms • Research into the capital markets were based on the Efficient Markets Hypothesis (EFM) and the Capital Asset Pricing Model (CAPM) NHashim....UPM....12.7.2005

  48. CONCLUSION • Watts & Zimmerman (1986): Positive theories – able to explain and predict accounting practices - succeeded in giving order to the apparent confusion resulting from the freedom of choice in accounting policies • Developed hypothesis about reality that can be subsequently tested by observations in the real world • It enables regulators to asses economic consequences of the various accounting practices NHashim....UPM....12.7.2005

  49. CRITICISMS AGAINST POSITIVE THEORIES • The positive theorists simply and arrogantly dismissed alternative viewpoints NHashim....UPM....12.7.2005

  50. BEHAVIORAL ACCOUNTING RESEARCH • Behavioral research is sociological IMPLICATIONS & IMPACT of accounting numbers and the associated key players as they react to accounting information NHashim....UPM....12.7.2005

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