Question

It’s a general perception by accounting professionals, that there is a solution to every accounting
problem. It’s like living in a denial, but actually there are many issues that remain unresolved after
having the knowledge of mere accounting. Salim gets admission in a college and advised by his
close friends to take a major in accounting. Accounting will help Salim to acquire knowledge about
the laws that govern business, the ethics of accountancy, statistics, and accounting theory. He will
learn how to prepare the key documents that his job will involve, including business proposals,
financial statements and tax returns.
Like accounting, accounting theory also provides a basis for prediction and explanation of
accounting behaviors and events. It guides the development of new practices and procedures and
help to understand current development in accounting practice. The accounting theory also
provides the knowledge of Generally Accepted Accounting Principles, Contemporary issues and
other developments in the field. Salim, being an accounting student is well aware about all the
latest developments according to the particular guidelines.
a. In your opinion, why Salim should focus on understanding the problems of accounting practices
and profession. Why is there a need of construction of accounting theory? Explain your answer.
(5 Marks)
b. Accounting theory serves as a frame of reference which is used to judge a particular technique
of accounting. As per your understanding, explain how frame of reference would be structured in
accounting theory? (5 Marks)
Your answer should be around 400 words for each question.

Answer 1

Definition of Accounting Theory:

(1) Provide a general frame of reference by which accounting practice can be evaluated, and

(2) 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.

Role of Accounting Theory:

Accounting theory has great utility for improving accounting practices, resolving complex accounting issues and contributing in the formulation of a useful accounting theory. Accounting theory has many advantages.

  

Some of them are listed below:

(1) Accounting theory has a great amount of influence on accounting and reporting practices and thus serves the informational requirements of the external users.

In fact, accounting theory provides a framework for:

(i) Evaluating current financial accounting practice and

(ii) Developing new practice.

Whenever the need for a new application of practice arises, the accounting theory should provide accountants with guidance on the most appropriate procedures to adopt in the circumstances. If accounting practices emerges from the application of rigorously constructed accounting theory, then practice has been tested for logic, consistency and usefulness.

The corporate managements and accountants, after having knowledge of accounting theories, may respond to the needs of users of accounting information. Many users, especially external, use annual reports to make investment and other decisions. Investors, creditors, lenders have to assess the earnings prospects of companies by examining the implications of the different accounting procedures.

All the users are interested to know the effect of alternative reporting methods, on their decisions (welfare). For example, corporate executives want to know how straight-line method of depreciation affects their welfare vis-a-vis accelerated depreciation.

Similarly, if a company is concerned about the market value of its shares, the accounting methods effects on share prices are to be analysed. The corporate executives search accounting theory which better explain the relationship between external annual reports and share prices.

However, determining the relationship between accounting procedures and users benefits is very difficult. For example, the relation between accounting alternatives and company share prices is complex and cannot be determined just by observing whether share prices change when accounting procedures change.

Likewise, the effects of alternative accounting procedures and reporting methods on business profit and other variables are complex and cannot be determined by mere observation. For example, share price changes may not be necessarily due to changes in accounting procedures or vice versa, that is, changes in both could be result of some other event.

In such a case, changing accounting procedures would not necessarily produce a share price effect. Such situations and other similar experiences require accounting theory that explains the relation between the variables and determine the significance of a particular variable.

Nevertheless, there are good reasons why certain things (practices) rather than others, should be done; and there are reasons why certain ways are superior to other ways. These reasons make up the theory. Whether we are conscious of them or not, there are reasons beneath everything we do. Knowing what are, will provide a better understanding of our aims and thus help us to discriminate among possible actions.

To conclude, accounting theory aims to serve practice even when it advances reasons against a familiar practice. A knowledge of accounting theory equips a person to exercise independent judgement with confidence besides enabling him to react according to the circumstances.

(2) Secondly, accounting theory literature is useful to accounting policy makers who are interested in making the accounting information useful. The researches, empirical evidence and investigation can be used and incorporated by the policy makers in formulating accounting policies. Theories are helpful as they apprise policy makers of the underlying issues and clarify the trade-offs implicit in various theory approaches.

According to Taylor and Underdown:

“….The system of financial accounting and reporting is not static but responds to the characteristics of the environment in which it operates. It must be stressed, however, that all changes in financial accounting and reporting do not occur in a random way. It is one of the functions of accounting policy-makers such as the accountancy profession, accounting standards setting bodies, the formulators of company law, and bodies like the Stock Exchange to evaluate current practice and formulate and implement proposals for its reform. They are guided in this by accounting theory. Although there is no single, generally accepted body of accounting theory, much work has been done by academics and policy-makers to develop accounting theory in ways which might facilitate the improvement of financial accounting and reporting.”

However, according to American Accounting Association’s Committee on Accounting Theory and Theory Acceptance (1977), the primary message to policy makers is that until consensus is available, the utility of accounting theories in aiding policy decisions is partial.

Competing theories merely provide a basis for forming opinions on what must remain inherently conflicting and subjective judgements. While it is true that consensus will frequently develop on certain points, usually this consensus only narrows the range of disagreement; it often does not resolve the basic issue that gives rise to the underlying problem.

In the absence of consensus acceptance, it is unrealistic to expect accounting theory to provide unequivocal policy guidance. Different theories will point to different policies. These theories arise from different sets of situations (paradigms). Since there is no rigorous analytical means for choosing between paradigms, there is similarly no rigorous means for choosing between theories or their derivative policy implications.

In fact, in accounting theory debate there is no ultimate theoretical truths. Therefore, it is difficult to impose theory consensus. Whatever future influences theory have on policy-making will be achieved by continued argumentation, new theory development, and debate, not by fiat.

Accounting theory or theories are formulated as a result of both theory construction and theory verification. A given accounting theory explains and predicts accounting phenomena, and when such phenomena occur, they prove and verify the theory.

If a given theory does not act in practice and fails to produce the expected results, it is replaced by a (new) better or more useful theory. The purpose of the new theory or the improved theory is to make the unexpected expected, to convert the anomalous occurrence into an expected and explained occurrence.