ACCOUNTING THEORY

According to Hendrickson (1982), Accounting Theory may be defined as logical reasoning

in the form of a set of broad principles that:

i) provide a general frame of reference by which accounting practice can be evaluated;

and
ii) guide the development of new practices and procedures.

Accounting theory may also be used to explain existing practices to obtain a better
understanding of them. But the most important goal of accounting theory should be to
provide a coherent set of logical principles that form the general frame of reference for the
evaluation and development of sound accounting practices.

RELATIONSHIP BETWEEN ACCOUNTING THEORY AND ACCOUNTING

PRACTICES
Unlike other natural sciences, the role played by theory in accounting is very different. In
the natural sciences theories are developed from empirical observations. The converse is
the case in accounting, since practice may be changed to accommodate theory. According to
Ijiri (1971), contrary to the fields of linguistics, meteorology, medicine or chemistry,
accountants can change their practices relatively easily. Therefore, it becomes an essential
problem for accountants to know how accounting practices should be developed in the
future. The sanctions by which accounting practices have become implemented are quite
essential in understanding the field of accounting since it is possible to change practices to
fit theories!! This is unthinkable for scientists in other fields for whom phenomena are
almighty. No matter how beautiful and elegant the theory may be, if it does not fit the
empirical phenomena it is replaced by one which fits better!!

ILLUSTRATION OF ACCOUNTING THEORY AND ACCOUNTING PRACTICE

RELATIONSHIP
Accounting Value Judgements Accounting
Theories Policies

Recommendations
NonUsers Accounting
Users Reports (Fs) Practices

Other info
sources
The above illustration shows how the form of accounting information reported to decision
makers depends on accounting practices adopted. These practices are imposed by
accounting policymakers (policies) who, having knowledge of accounting theories have
the responsibility of responding to the needs of users of accounting information.

It is clear from the above illustration that deficiencies in the four (4) key areas namely,
accounting theory, policymaking (by the profession and the government), accounting
practice (transactions/concepts/etc.) and the use of accounting information impair the
usefulness of an accounting information service. In view of this it is expected that at the
policymaking level, accounting policy makers include the related research findings in the
policies they generate so as to enhance the potential usefulness of the consequent
accounting information.

APPROACHES TO THE DEVELOPMENT OF ACCOUNTING THEORY

Several approaches to the development of accounting theory have emerged and these
include:

1. Descriptive
2. DecisionUsefulness
i) Empirical
ii) Normative
3. Welfare
THE DESCRIPTIVE APPROACH
Using this approach, the theory developers are essentially concerned with what
accountants do. The descriptive theories rely on a process of inductive reasoning, which
consists of making observations and drawing generalised conclusions from those
observations. In essence, the objective of making observations is to look for similarity of
instances and to identify a sufficient number of such instances as will induce the required
degree of assurance needed to develop a theory about all the instances which belong to the
same class of phenomena.

Relating this approach to the construction of accounting theory, the descriptive approach
emphasises the PRACTICE OF ACCOUNTING as a basis from which to develop theories. In
other words, under this approach the practices of accountants are related to a generalised
theory about accounting. Precisely, accounting theory is to be discovered by observing the
PRACTICES OF ACCOUNTANTS. According to Littleton and Zimmerman (1962), accounting
theory is primarily a concentrate distilled from experienceit is experience intelligently
analysed that produces logical explanationandilluminates the practices from which it
springs.

This approach results in descriptive or positive theories of accounting which explain what
accountants do and enable predictions to be made about behaviour, for example, how a
particular matter will be treated. Therefore, it is possible to predict that the payment of
cash will be recorded in the credit side of the cash book. This is also suggestive that the
descriptive approach is concerned with observing the functional tasks which accountants
have traditionally performedthat is, to prepare annual accounts of a business to
shareholders (stakeholders) showing how resources have been utilised and the profits as
well as the position derived from such use. In other words, underlying the descriptive
approach is the belief that the objective of financial statements is associated with the
stewardship concept of the management role which enjoins them to provide the owners of
businesses with information relating to the manner in which their assets have been
managed. However, with the growth of large corporate enterprises, the weakening of the
links between ownership and management created a need for a more elementary notion of
stewardship, in which the disclosure of financial information was aimed at protecting
shareholders form fraudulent management practices. You would recall that managers are
hired by the shareholders of a company to administer the firms activities thereby
establishing an agency relationship. Fact is that the objectives of managers and
shareholders may not be in perfect agreement but a relevant conclusion suggested by
agency theory is that mutual benefits are perceived by management and shareholders from
the disclosure of audited FSs and that routine financial reporting (as audited) is a means by
which shareholders can monitor the actions of managers.
FRAMEWORK FOR DEVELOPING DESCRIPTIVE ACCOUNTING THEORY

ELEMENTS CONCEPTS ACCOUNTING PROCEDURES

Assets Entity Recording transactions

Liabilities Money Measurement Classifying transactions
Capital Going Concern Summarizing transactions
Revenue Cost Reporting transactions
Expenses Realisation [ Interpreting reports ]
Profits Accrual
[Transactions] Matching
Periodicity
Consistency
[ Prudence ]
a) Accounting Elements
Accounting Elements are the main contents of the specified components of the Financial
Statements or Reports that have been recorded and classified based on the transactions
arising within the reporting period. The elements are recorded and classified in the FSs
based on accounting concepts. As a result, the establishment of these elements and
concepts is very important to the development of a theoretical framework since they
are used to describe the events that comprise the existence of business of every kind as
well as provide the essential material of accounting theory.
The term transactions refers to events which require recognition in the accounting
records and they originate when changes in basic concepts are recorded. A transaction
is financial in nature and is expressed in terms of money.
b) Accounting concepts
Accounting concepts determine the rules which are applied to Accounting Procedures.
They are not exhaustive and are continually being adapted to meet the changing
demands and dynamism of business situations. It should be noted that at any point in
time there may be more than one accepted way (concept) of treating a particular class
of transaction.
An example of a relationship between accounting elements and concepts:
Assets are things of value which are processed by a business but in order to be
classified as an asset the money measurement concept demands that a thing must have
the quality of being measurable in terms of money.
c) Accounting Procedures
There are several procedures in accounting. These procedures are associated with the
periodic or routine production of Financial Statements as well as their performance
evaluation. Accounting Procedures include recording, classifying, summarizing and
reporting of transactions as well as interpreting or evaluating the Financial Statements
(reports).
For example, Recording is the process by which financial transactions are
systematically placed in accounting records. The recording may be in the form of pen
markings by hand or it may be accomplished by various mechanical or electronic
devices. Again, the recorded transactions are analysed so that they can be classified
according to a predetermined system (subheadings or terms). Periodically, the
recorded and classified information is summarised in the form of Financial Statements
and reported to managers of the enterprise and to other interested parties
(stakeholders).
 Interpreting basically refers to the use of recorded classified and summarised data
(content of FSs) which reveals and emphasises significant changes, trends and potential
developments in the affairs of a given enterprise.
THE DECISIONUSEFULNESS APPROACH
These theories came about in the 1970s as a result of expansion of behavioural research
into accounting. According to the American Accounting Association (AAA, 1971):

To state the matter concisely, the principal purpose of accounting reports is to

influence action, that is, behaviour. Additionally, it can be hypothesised that the very
process of accumulating information, as well as the behaviour of those who do the
accounting, will affect the behaviour of others. In short, by its very nature,
accounting is a behavioural process.

The two (2) types of DecisionUsefulness Theories of accounting that have resulted from
this approach are Empirical and Normative.

a) The Empirical Approach

This approach emerged with a view to make accounting research more rigorous and to
improve the reliability of results. In views of this in the early 1970s a substantial
increase in empirical research in accounting was witnessed. Sophisticated statistical
techniques became increasingly used in the expansion of university courses in
accounting which consequently increased the number of students with a quantitative
background who could conduct research in this manner. Indeed, the university
departments of accounting, aiming to enhance their status within the universities,
viewed the possibility of empirical research based on the scientific method as a useful
springboard to this end. The implications of the empirical approach to research in
accounting were significant in the development of accounting theory with the primary
focus on how users of accounting information apply this information in decision
making.
b) The Normative Approach
Unlike empirical research which concentrates on how users of accounting information
apply this information in decisionmaking the normative approach to theory
construction is concerned with specifying the manner in which decisions ought to be
made as a precondition to considering the information requirement. As a result, the
normative approach focuses on the decision models which should be used by decision
makers seeking to make rational decisions. This focus is seen as providing insights on
the information needs of decision makers, as a basis for developing accounting theory.
 It works by assessing the information needs of stakeholders for example the
information needs of investors, employees, creditors, etc. it is the approach in recent
attempts to develop conceptual frameworks for financial reporting.
THE WELFARE APPROACH
This approach is an extension of the decisionmaking approaches, which considers the
effects of decisionmaking on social welfare. Clearly, the decisionmaking approaches limit
the field of interest to the private use of accounting information. That is, if accounting
information had a relevance limited to private interests, the decisionmaking approaches
would provide a sufficient analysis of information needs. However it is because of the
external social effects of decisions made on the basis of accounting information that there is
imputed a socialwelfare dimension to accounting theory.

Consequently the theoretical objective of the welfare approach is the maximisation of social
welfare, which is defined as the benefits accruing to all members of society from decisions
made by individuals about the use of resources under their control. The approach attempts
to deal with the situation where accounting is seen to be providing information for
decisionmaking for individuals (parties/stakeholders), without any consideration of
social welfare effects. As May and Soudem (1976) pointed out, such a delineation of WHAT
accounting policy makers should be concerned with precludes the possibility of making
comparisons of alternative policies having different social welfare effects.

The welfare effects associated with the use of Financial Statements may be discussed from
various standpoints.

1. Consistency and comparability of FSs and reports

The effects of financial information on the welfare of individual decisionmakers may
be deemed to be one important standpoint. Since investment decisions imply the
comparison of alternative investments, external users of financial information require
as much consistency and comparability as is practicable between the FSs of enterprises
generally. Indeed the lack of comparability between the FSs of enterprises which lay at
the root of much criticism of the accounting profession in recent years.
2. Possession of superior knowledge
The effects of financial information on social welfare may also be seen from the
standpoint of the distortion arising from the possession of supervisor knowledge by
one segment of a particular group of users, which would have consequential changes in
the distribution of wealth within one group. For example if an investor has access to
inside information about an enterprise and this information is not freely available to
 other investors, he would be able to make decisions which may improve his welfare at
the expense of other investors.
3. Influence resource allocation in the economy
The effects of financial information may also be viewed from the standpoint of the
allocation of resources in the economy. The importance of accounting information as
regards the allocation of scarce resources focuses on the aspect of FSs which are to
provide investors with data to assist in establishing the market price of company
shares. Indeed there is research evidence to show that accounting data have an
important effect on share prices. Ideally, FRs should contain data which make it
possible for investors to evaluate investment opportunities, if the allocation of
resources throughout the economy is to maximise social welfare in accordance with
classical economic theory.