Accounting Theory: Role, Levels and Methodology

In this article we will discuss about Accounting Theory:- 1. Definition of Accounting Theory 2. Role of Accounting Theory 3. Classification 4. Research Methodology 5. Approaches 6. Methodology 7. Other Approaches.

Definition of Accounting Theory:

The term ‘accounting theory’ has been defined by many.

Hendriksen defines accounting theory as:

Logical reasoning in the form of a set of broad principles that:

(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.

Accounting theory is that branch of accounting which consists of the systematic statement of principles and methodology. However, theory cannot be divorced from practice. The theory underlies practices, explains and attempts to predict them. There is not and cannot be any basic contradiction between theory and facts.

A theory is an explanation. However, every explanation is not a theory in the scientific meaning of the word. The objective of accounting theory is to explain and predict accounting practice. Explanation provides reasons for observed practice. For example, an accounting theory should explain why certain firms use LIFO method of inventory rather than the FIFO method.

Prediction of accounting practices means that the theory can also predict unobserved accounting phenomena. Unobserved phenomena are not necessarily future phenomena; they include phenomena that have occurred but on which systematic evidence has not been collected.

It is significant to observe that accounting theory may be based on empirical evidence and practices as well as accounting theory may be formulated using hypothetical and speculative interpretations.

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.

Classifications (Levels) of Accounting Theory:

At present, a single universally accepted accounting theory does not exist in accounting. Instead, different theories have been proposed and continue to be proposed in the accounting literature.

The following are the main classifications of accounting theory:

(a) ‘Accounting Structure’ Theory.

(b) ‘Interpretational’ Theory.

(c) ‘Decision Usefulness’ Theory.

(a) ‘Accounting Structure’ Theory:

‘Accounting structure’ theory, known by different names such as classical theory, descriptive theory, traditional theory, attempt to explain current accounting practices and predict how accountants would react to certain situations or how they would report specific events.

This theory relates to the structure of the data collection process (accounting) and financial reporting. Thus, this theory is directly connected with accounting practices, i.e., what does exist or what accountants do.

The principal contributors to the accounting structure theory are identified chronologically as follows:

William A. Paton, Accounting Theory with Special Reference to Corporate Enterprise (1922).

Henry Rand Hatfield, Accounting—Its Principles and Problems (1927).

Henry W. Sweeney, Stabilized Accounting (1936).

Stephen Gilman, Accounting Concepts of Profit (1939).

W. A. Paton and A. C. Littleton, An Introduction to Corporate Accounting Standards (1940).

A. C. Littleton, Structure of Accounting Theory (1953).

Maurice Moonitz, the Basic Postulates of Accounting (1961).

Robert R. Sterling and Richard E. Flaherty, “The Role of Liquidity in Exchange Valuation,”

Accounting Review (July 1971).

Robert R. Sterling, John O. Tollefson, and Richard E. Flaherty,

“Exchange Valuation: An Empirical Test,” Accounting Review (Oct. 1972).

Yuji Ijiri, Theory of Accounting Measurement (1973).

This theory, basically concerned with observing the mechanical tasks which accountants traditionally perform, is based on the assumption that the objective of financial statement is associated with the stewardship concept of the management role, and the necessity of providing the owners of businesses with information relating to the manner in which their assets (resources) have been managed.

In this view, company directors occupy a position of responsibility and trust in regard to shareholders, and the discharge of these obligations requires the publication of annual financial reports to shareholders. Ijiri explains traditional accounting practice; however, he does place emphasis on the historical cost system.

Sterling advises “to observe accountants’ actions and rationalise these actions by subsuming them under generalized principles.” Theories explaining traditional accounting practice are desirable to obtain greater insight into current accounting practices, permit a more precise evaluation of traditional theory and an evaluation of existing practices that do not correspond to traditional theory.

Such theories relating to the structure of accounting can be tested for internal logical consistency, or they can be tested to see whether or not they actually can predict what accountants do.

Limitations:

(1) The ‘accounting structure’ theory concentrates on accounting practices and the behaviour of practising accountants. The accounting practice begins with observable occurrences (transactions), translates them into symbolic form (money values) and makes them inputs (e.g., sales, costs) into the formal accounting system where they are manipulated into outputs (financial statements).

Accounting practices followed in this way may not reflect the real business situation and real world phenomena. The traditional theory is not concerned with judging the usefulness of the output of accounting practice, but concentrates upon judging the means of manipulation of input into output.

(2) Inconsistencies in traditional theory have given rise to alternative accepted principles and procedures which give significantly divergent reported results. Accrual accounting results in allocations which provide a variety of alternative accounting methods for each major event—e.g., LIFO and FIFO valuations of stock—and different accountants may prefer different methods depending upon how they are affected. Moreover, the traditional approach is inconsistent with theories developed in related disciplines. For example, the historical cost concept of valuation is externally inconsistent with current value concepts.

Finally, good theory should provide for research to assist advances in knowledge. The conventional approach tends to inhibit change, and by concentrating upon generally accepted accounting principles makes the relationship between theory and practice a circular one.

(b) ‘Interpretational’ Theory:

Truly speaking, ‘accounting structure’ and ‘interpretational’ theories are part of the classical accounting theory (model). The principal writers under ‘accounting structure’ such as Hatfield, Littleton, Paton and Littleton, Sterling and Ijiri are mainly positivist, inductive writers, concerned with traditional accounting practice in terms of historical cost system, with some deviations such as the lower of cost or market.

Accounting practices under accounting structure theory are the result of recording business events as they take place. Such practices lack application of judgement and consequences. Interpretational theory attempts to give some meaning to accounting practice.

The theory based on ‘accounting structure’ only, although logically formulated, does not require meaningful interpretation of accounting practices and analysis of accounting activities.

Interpretational theory emphasises on giving interpretations and meaning as accounting practices are followed. This theory provides a suitable basis for evaluating accounting practices, resolving accounting issues and making accounting propositions.

The principle writers in interpretational theory are the following:

John B. Canning, The Economics of Accountancy (1929).

Sidney S. Alexander, Income Measurement in a Dynamic Economy (1950).

Edgar O. Edwards and Philip W. Bell, The Theory and Measurement of Business Income (1961).

Robert T. Sprouse and Maurice Moonitz, A Tentative Set of Board Accounting Principles for Business Enterprises (1962).

The above writers in interpretational theory are more analysts and explicators than advocates and preachers. They analyse and assess what accountants do and seek to do, they undertake to explain a phenomenon to accountants, and help in understanding the implications of using accounting concepts in the real business situation. For example, Sprouse and Moonitz suggest that the assets valuations should be made in terms of their future services.

In ‘accounting structure’ theory, accounting concepts are un-interpreted and do not reflect any meaning except actual data resulting from following specific accounting procedures. Asset valuations, for example, are the result of following a specific method of inventory valuation and depreciation.

Similarly, specific rules are followed for the measurement of these revenues and expenses. Interpretational theory gives meaningful interpretations to these concepts and rules and evaluate alternative accounting procedures in terms of these interpretations and meanings. For example, it can be said that FIFO is the most appropriate if objective is to measure current value of inventories.

In this case, selection of FIFO in interpretational theory is made with a view to suggest specific result and interpretation. It is argued that empirical enquiry should be made to determine whether information users attach the same interpretations and meanings which are intended by producers of information.

Items of information vary as to degree of interpretation; some items by nature reflect higher degree of interpretation and some items are subject to many interpretations. For example, the item cash in balance sheet is fairly well understood by users to mean what prepares intend it to mean.

On the contrary, the items like deferred expenses and goodwill may not reflect any specific interpretation. The role of interpretational theories is to build a correspondence between the interpretations of producers and users as to accounting information.

This theory attempts to find ways to improve the meaning and interpretations of accounting information in terms of experiences about human behaviour and information processing capacity.

‘Accounting structure’ and interpretational theories both are known as classical accounting models. The writers (mentioned above) under both the theories are, in every sense, reformers. Interpretational theorists differ from ‘accounting structure’ theorists more in degree than in kind; the former are motivated less by missionary zeal than by a desire to analyse, criticize, and suggest, and are primarily deductivists.

Many of the prominent interpretational theorists advocate current cost or values. It is said that interpretational theorists may have observed the behaviour of investors and other economic decision makers and concluded with a validated hypothesis that such decisions-makers seek current value, not historical cost, information.

In spite of the difference in emphasis of ‘traditional’ and ‘interpretational’ theorists, broadly, both are concerned with designing financial reports that communicate relevant information to users of accounting information.

(c) ‘Decision-Usefulness’ Theory:

The decision-usefulness theory emphasises the relevance of the information communicated to decision making and on the individual and group behaviour caused by the communication of information.

Accounting is assumed to be action-oriented—its purpose is to influence action, that is, behaviour; directly through the informational content of the message conveyed and indirectly through the behaviour of preparers of accounting reports.

The focus is on the relevance of information being communicated to decision-makers and the behaviour of different individuals or groups as a result of the presentation of accounting information. The most important users of accounting reports presented to those outside the firm are generally considered to include investors, creditors, customers, and government authorities.

However, decision usefulness can also take into consideration the effect of external reports on the decisions of management and the feedback effect on the actions of accountants and auditors. Since accounting is considered to be a behavioural process, this theory applies behavioural science to accounting.

Due to this, decision-usefulness theory is sometimes referred to as behavioural theory also. In the broader perspective, decision-usefulness studies analyses behaviour of users of information. A behavioural theory attempts to measure, and evaluate the economic, psychological and sociological effects of alternative accounting procedures and modes of financial reporting.

In adopting the decision usefulness theory or approach, two major aspects or questions must be addressed.

First, who are the users of financial statements? Obviously, there are many users. It is helpful to categorize them into broad groups, such as investors, lenders, managers, employees, customers, governments, regulatory authorities, suppliers etc. These groups are called constituencies of accounting.

Second, what are the decision models or problems of financial statement users? By understanding these decision models preparers will be in a better position to meet the information needs of the various constituencies. Financial statements can then be prepared with these information needs in mind and in this way financial statements will lead to improved decision making and are made more useful.

1. Decision Models:

Most of the earliest research on decision-usefulness implicitly adopted the decision model emphasis although the assumed decision model was often not specified in detail. The decision model emphasis has now achieved professional recognition and broad exposure through publications of different accounting bodies all over the world.

For instance, the American Institute of Certified Public Accountants (AICPA) Study Group on the Objectives of Financial Statements, also known as Trueblodd Report, stated that “the basic objective of financial statements is to provide information useful for making economic decisions.”

The Financial Accounting Standards Board (USA) has also formulated the similar objective:

“Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions. The information should he comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.”

The decision model approach first began to appear in the literature in the 1950s. Prior to 1950s, a number of carefully prepared works on accounting theory did refer to users of accounting information but the theoretical structures in those works were not demonstrably based on the alleged information needs of users.

For example, the 1937 “Tentative Statements” of the American Accounting Association (AAA) included but did not build upon, this paragraph:

“The most important applications of accounting principles lie in the field of corporate accounting, particularly in the preparation of published reports of profits and financial position. On the interpretation of such reports depend so many vital decisions of business and government that they have come to be of great economic and social significance.”

Patton and Littleton gave user needs even more prominent attention, including them in their statement of the purpose of accounting: “The purpose of accounting is to furnish financial data concerning a business enterprise, compiled and presented to meet the needs of management, investors, and the public.”

During the 1950s there was a strong user-oriented movement in the managerial accounting literature. That movement may have served as the stimulus for the initial acceptance of the decision-usefulness objective in external reporting at that time.

For instance, Chambers’ articles, “Blueprint for a Theory of Accounting,” published in 1955 stressed that “the basic function of accounting…(is) the provision of information to be used in making rational decisions.” Staubus emphasised that “accountants should explicitly and continuously recognise an objective or objectives of accounting, and “that a major objective of accounting is to provide quantitative economic information that will be useful in making investment decisions.”

The current status of the decision-usefulness, decision model approach to accounting theory may be summarised as follows:

(i) The objective of accounting is to provide financial information about the economic affairs of an entity to interested parties for use in making decisions. This objective statement is a premise which most people seem to find acceptable, subject to slight variations.

(ii) To be useful in making decisions, financial information must possess certain normative qualities such as relevance, reliability, objectivity, verifiability, freedom from bias, accuracy, comparability, under-stand-ability, timeliness, and economy. A set of such desirable qualities is used as criteria for evaluating alternative accounting methods.

The relevance criteria is used to select the attribute(s) of an object or event to be emphasised in financial reporting. Information about an attribute of an object or event is relevant to a decision if knowledge of that attribute can help the decision-maker determine alternative courses of action or to evaluate an outcome of an alternative course of action.

(iii) The decision-usefulness approach provides for the development of the theory on the basis of knowledge of decision processes of investors, taxing authorities, labour union, negotiators, regulatory agencies, and other external users of accounting data, as well as managers. To date, however, only the decision of investors (in the broad sense) have served as the basis for fairly complete theories of external reporting.

2. Decision-Makers:

The previous section has dealt with decision models; this section focuses on decision makers and review certain empirical research bearing upon various issues of financial reporting. Such research can be classified according to the level at which the behaviour of decision-makers is observed: the individual level or the aggregate market level.

Individual User Behaviour:

Empirical research involving observation of individual behaviour as it relates to accounting information has ordinarily been associated with the term behavioural accounting research (BAR). The objective of BAR is to understand, explain, and predict aspects of human behaviour relevant to accounting problems. Behavioural accounting research is relatively new.

Devine’s critical remarks in 1960 expose the failure of accountants to examine user behaviour empirically before that time:

“Let us now turn to … the psychological reactions of those who consume accounting output or are caught in its threads of control. On balance, it seems fair to conclude that accountants seem to have waded through their relationships to the intricate psychological net-work of human activity with a heavy handed crudity that is beyond belief. Some degree of crudity may be excused in a new discipline, but failure to recognise that much of what passes as accounting theory is hopelessly entwined with unsupported behaviour assumption as unforgivable.”

BAR studies ordinarily lack any agreed upon basis by which their results may be assessed. Instead, BAR has been primarily concerned with studying the techniques of data collection and analysis; there has been little attempt to develop a theoretical framework that would support the problems or hypotheses to be tested. Instead, the studies generally have focused on the behavioural effects of accounting information or on the problems of human information processing.

BAR studies may be divided into five general classes according to financial statement disclosure and the usefulness of financial statement data:

(i) The adequacy of financial statement disclosure,

(ii) Usefulness of financial statement data,

(iii) Attitudes about corporate reporting practices,

(iv) Materiality judgements, and

(v) The decision effects of alternative accounting procedures.

In testing for the adequacy of financial statement disclosures, researchers have used many different strategies. For example, one strategy develops a description of user’s approach to financial statement analysis in order to evaluate the reasoning underlying that approach; it then assesses the implications of that approach reasoning for various disclosure issues.

Another strategy focuses on certain interest groups and surveys their perceptions and attitudes about disclosures. A third strategy has been to determine the extent to which specific items of important information are disclosed in corporate annual reports, using a normative index of disclosure as a basis for assessment.

The research on adequacy of financial disclosure showed a general acceptance of the adequacy of available financial statements, a general understanding and comprehension of these financial statements, that the differences in disclosure adequacy among the financial statements were due to such variables as company size, profitability, size of the auditing firm and listing status.

A second set of studies has focused on the usefulness of financial statement information to investors in making resources allocation decision. In this regard, three approaches have been used. The first approach examined the relative importance to investment analysis of different information items to both users and preparers of financial information.

The second approach examined the relevance of financial statements to decision-making using laboratory experimentation. The third approach examined the effectiveness of the communication of financial statement data in terms of readability and meaning to users in general.

The overall conclusion of these studies are:

(i) That some consensus exists between users and preparers on the relative importance of the information items disclosed in financial statements, and

(ii) That users do not rely solely on financial statements for their decisions.

A third set of studies has attempted to measure the attitudes and preferences of various groups toward current and proposed corporate reporting practices. Two approaches have been used in this regard.

The first approach examined preferences for alternatives accounting techniques.

The second approach examined the attitudes about general reporting issues, such as about how much information should be available, how much information is available, and the importance of certain items.

A fourth set of studies has focused on materiality judgements that affect financial reporting. Two approaches were used to examine the materiality judgements. The first approach examined the main factors that determine the collection, classification, and summarisation of accounting data. The second approach focused on what people consider material.

This second approach sought to determine how great a difference in accounting data is required before the difference is perceived as material by the users. These studies indicate that several factors appear to affect materiality judgements and that these judgements differ among individuals.

Finally, in fifth set of studies, the decision effects of various accounting procedures were examined primarily in the context of the use of different inventory techniques, of price-level information, and of non-accounting information.

The results indicate that alternative accounting techniques may influence individual decisions and that the extent of influence may depend on the nature of the task, the characteristics of the users, and the nature of the experimental environment.

Evaluation of Behavioural Accounting Research (BAR):

Most of the BAR attempts to establish generalisations about human behaviour in relation to accounting information. The implicit objective of all these studies is to develop and verify the behavioural hypotheses relevant to accounting theory, which are hypotheses on the adequacy of disclosure, the usefulness of financial statement data, attitudes about corporate reporting practices, materiality judgements, the decision effects of alternative accounting procedures, and components of an information processing model—input, process, and output.

This implicit objective has not yet been reached, however, because most of the experimental and survey research in behavioural accounting suffers from a lack of theoretical and methodological rigour.

BAR has been done mostly without explicit formulation of a theory. This lack of a theory imposes limitations on an acceptable and meaningful evaluation and interpretation of the results. Laboratory experimentation is generally favoured in BAR because it can isolate variables and effects to provide unambiguous evidence about causation and allow better control over extraneous variables.

The failure to ensure validity, however, causes significant problems with laboratory experiments. In general, students have been used as surrogates of business people.

But do students and business people react similarly to stimuli? Several have examined the subrogation problem without any conclusive results. Similarly, the experiment as a social contract implies a role relationship between the subject and the experiment. Some aspects of this relationship may threaten the validity of the experiment.

Aggregate Market Behaviour:

The decision-usefulness accounting theory emphasises not only, ‘Individual User Behaviour’, but ‘Aggregate Market (User) Behaviour’ also. In fact, aggregate market behaviour is a manifestation of individual action.

However, according to proponents of market level research, there are factors that are difficult to stimulate in individual level research (such as competing information sources, incentives, and user interactions) that are important in study of groups; those factors thus prohibit a simplistic extension from the individual to the aggregate.

Indeed, they may be so significant that theories about individual behaviour and theories about market behaviour becomes, in fact, theories about distinctly different things. Therefore, some researchers believe that aggregating individual users responses may not provide an apt description of market-wide user behaviour.

The early research regarding relations between accounting information and market behaviour has been based on the theory of capital market efficiency. This theory implies that an alteration in the information set will result in a prompt transition to a new equilibrium.

The theory is not specific with respect to the information set, and technical problems arise when it is admitted that the price actually reflects the underlying information.

The prompt adjustment to a new equilibrium in conjunction with the dissemination of accounting data is consistent with the notion that those data are useful or possess pragmatic information content. Following that logic, researchers have assessed the pragmatic information content of various accounting data by studying the timing of the incidence of abnormal returns.

A number of studies have been conducted along these lines. Ball and Brown, Beaver, and Gonedes consistently observed abnormal returns in conjunction with the announcement of the annual earnings number. May observed similar reactions to the quarterly announcement of firm earnings. In other words, these studies are consistent with the notion that financial reports are useful.

However, the mere presence of an abnormal return coincidental with the publication of accounting earnings provides a somewhat tenuous basis from which to infer that the observed price movement was caused by the earnings signal.

In some cases, users of accounting information react when they should not react or should not react the way they did. Also, users’ aggregate behaviour may not be due to any information content. These fears, however, are not real and lose their validity in view of the theory of Efficient Market Hypothesis.

The above classifications of accounting theory indicates differences in problems addressed, assumptions made, and research methods used, by the various writers. While the differences in these theories are fundamental and issues and conclusions are often inconsistent, theorists have had little success in reconciling their differences or in persuading critics that their theory is superior to others.

In future, the debate on (appropriate) accounting theory will continue and no closure appears to be nearer in construction of accounting theory at this time. The existence of continuing disagreement (recognising at the same time that competing theories exist) is noticed in almost all disciplines and not only in accounting. This proves that theory progress in accounting as well as in other disciplines is a difficult task.

Watts and Zimmerman rightly comment:

“We cannot find a theory that explains and predicts all accounting phenomena. The reason is that theories are simplifications of reality and the world is complex and changing. Theorists try to explain and predict a class of phenomena and, as a consequence, try to capture in their assumptions the variables common to that class. The result is that facts particular to a given observation or subset of observations and not common to the whole class are ignored and are incorporated into the theory’s assumptions. Ignoring these facts (or omitted variables) necessarily leads to a theory not explaining or predicting every observation…the mere fact that a theory does not predict perfectly does not cause researchers or users to abandon that theory.”

Research Methodology used in Formulating Accounting Theory:

The terms deductive and inductive indicate the type of research methodology or reasoning used in formulating an accounting theory.

(i) Deductive Approach:

The deductive approach first establishes the objectives of accounting and then derives principles and procedures for recording consistent with these objectives. The deductive approach begins with basic accounting objectives or propositions and proceeds to derive by logical means accounting principles that serve as guides and bases for the development of accounting techniques.

The deductive approach includes the following steps:

(i) Determining the objectives (general or specific) of financial reporting.

(ii) Selecting the postulates of accounting.

(iii) Developing a set of definitions.

(iv) Formulating principles of accounting or generalized statements of policy.

(v) Applying the principles of accounting to specific situations, and

(vi) Establishing procedures, methods and rules.

In deductive approach, all subsequent steps (mentioned above in points (ii) to (vi)) follow the objectives formulated. Therefore, the development of objectives is first and prime task as different objectives might require logically different sets of postulates, principles, techniques etc. For example, principles and rules for determining income may vary between the objectives of determining taxable income and business income.

Although there is a demand to apply the same set of rules for tax accounting and financial accounting to avoid confusion, but, since the basic objectives are different, it is not likely that the same principles and techniques will meet the different objectives equally well.

Similarly different income concepts are found in accounting and therefore the differing income concepts require different principles and procedures to be developed in conformity with respective income concepts.

In spite of the existence of different income concepts (and concepts relating to different accounting issues), it has been argued that there is a need for a single all pervasive concept of income which could serve different objectives and different users.

A single income concept and its ability to meet the requirement of different users, is still a debatable question in accounting. On the other hand, it would not be beneficial to have different sets of principles for different purposes accepted in accounting.

Some compromises must be made, but there should also be some freedom to serve different objectives as well. Thus, accounting theory should be flexible enough to satisfy the needs of different objectives, but rigid enough to provide for some uniformity and consistency in financial reports to shareholders and the general public.

The accounting writers who have primarily followed deductive process are Paton, Canning, Sweeny, MacNeal, Alexander, Edwards and Bell, Moonitz, and Sprouse and Moonitz (Table 3.1).

These deductive theorists unanimously suggest that users should use current cost or value information in their economic decisions. Some deductive writers have used mathematical, analytical representations and testing. Known as the exiomatic method, it is found in the writings of Mattessich and Chambers.

Approaches of the Deductive TheoriesApproaches of the Deductive Theories

Many of the deductive writers cite particular users (generally shareholders, creditors, and managers) and occasionally suggest the information that users would find useful.

Except in the case of Alexander, who proposes different models for different users, each writer offers his policy recommendations as a universally valid proposal, as if the entire hierarchy of users would be sufficiently well served by a single set of resulting information. It is also found that the deductive writers operated independently of one another, rarely comparing their work with that of predecessors or contemporaries.

The logic of their analyses is difficult to monitor, as it reflects implicit criteria and judgements. Of their writings, it may be said that they neither proved their points nor were disproven by others.

A common point may be found in their diverse recommendations: the implicit agreement that users seek (or should seek) current cost information in making economic decision. In this important respect, notwithstanding the diversity of their recommendations, their cause was united.

An important limitation of the deductive approach is that if any of the postulates and propositions are false, the conclusions may also be wrong. Also, it is difficult to derive realistic and workable principles or to provide the basis for practical rules as deductive approach may be found far from reality. But it has been contended that these limitations generally stem from a misunderstanding of the purpose and meaning of deductive theory.

It is not necessary that theory be entirely practical in order to be useful in establishing workable procedures. The main purpose of theory is to provide a framework for the development of new ideas and new procedures and to help in the making of choices among alternative procedures.

If these objectives are met, it is not necessary that theory be based completely on practical concepts or that it be restricted to the development of procedure, that are completely workable and practical in terms of current known technology. In fact many of the currently accepted principles and procedures are general guides to action rather than specific rules that can be followed precisely in every applicable case.

(ii) Inductive Approach:

The inductive approach to accounting theory examines observations first and accounting practices and then derives principles and procedures from these observations. This approach emphasises on drawing generalized conclusions and principles of accounting from detailed observations and measurements of financial information of business enterprises.

The inductive approach includes the following steps:

(i) Making observations and recording of all observations.

(ii) Analysis and classification of these observations to determine recurring relationships, similarities, and dissimilarities.

(iii) Derivation and formulation of generalisations and principles of accounting from the recorded observations that reflect recurring relationships.

(iv) Testing of generalisations and principles.

Some accounting writers have followed inductive approach and used observations regarding accounting practice to suggest an accounting theory, accounting principles and generalisations. Inductive theorists include Hatfield, Littleton, Patton and Littleton, and Ijiri. All these theorists emphasise rationalizing and improving accounting practice to draw theoretical conclusions.

The inductive approach has been forcefully supported and defended by Ijiri. Ijiri undertakes to generalize the objectives implicit in current accounting practice and then defends the use of historical cost against current cost and current value.

He rejects current values because they are predicted on hypothetical actions of the entity and, as such, are not verifiable. Ijiri concludes that accounting practice may best be interpreted in terms of accountability, which he defines as economic performance measurement that is not susceptible to manipulation by interested parties.

Ijiri explains forthrightly his preference for inductive approach:

“This type of inductive reasoning to derive goals implicit in the behaviour of an existing system is not intended to be pro-establishment or promote the maintenance of the status quo. The purpose of such an exercise is to highlight where changes are most needed and where they are feasible. Changes suggested as a result of such a study have a much better chance of being actually implemented. Goal assumptions in normative models or goals advocated in policy discussions are often stated purely on the basis of one’s conviction and preference, rather than on the basis of inductive study of the existing system. This may perhaps be the most crucial reason why so many normative models or policy proposals are not implemented in the real world.”

Inductive approach has advantages as it is not necessarily influenced by predetermined objectives, structure or model. The investigators may make any observations they find purposeful. After generalisations and principles are formulated, they are verified using the deductive approach. However, this approach has some limitations too.

The investigators are likely to be influenced by preconceived notions in studying relationships among the accounting data. The collection of data may be influenced by the attitude of the investigators. Another limitation is that financial data (observations) may vary from one firm to another. The diverse nature of the data for different firms creates difficulties in drawing meaningful generalisations and principles.

It may be said that while the deductive approach begins with general proposition and objectives, the formulation of these propositions and objectives are often done by using inductive approach, conditioned by the researcher’s knowledge of and experience with accounting practice.

In other words, the general propositions are formulated through an inductive process, while the principles and techniques are formulated by a deductive process. Therefore, some of the inductive writers sometimes interpose deductive approach, and deductive writers sometimes interpose inductive reasoning. Yu suggests that inductive logic may presuppose deductive logic.

Approaches in Accounting Theory:

(i) Events Approach:

The events approach in accounting theory implies that the purpose of accounting is to provide information about relevant economic events that might be useful in a variety of possible decision models. It is up to the accountant to provide information about the events and leave to the user the task of fitting the events to their decision modela.

It is up to the user to aggregate and assign weights and values to the data generated by the event in conformity with his own decisions The user rather than the preparer of accounts transfers the event into accounting information suitable to the user’s own individual decision model.

Events may be characterised by one or more basic attributes or characteristics and these characteristics can be directly observed with feasibility. The events approach suggests a large expansion of the accounting data presented in financial reports. Characteristics of an event other than just monetary values may have to be disclosed. Under the events approach because of a disaggregation of data provided to users, the data are expanded.

Sorter proposes the following guidelines for the preparation of balance sheet and income statement under the events approach:

(i) A balance sheet should be so constructed as to maximise the reconstructibility of the events to be aggregated. This means that all aggregated figures in the balance sheet may be disaggregated to show all the events that have occurred since the inception of the firm.

(ii) In Income statement, each event should be described in a manner facilitating the forecasting of that same event in a future time period given exogenous changes.

Johnson has emphasised upon ‘normative events theory’ to increase the forecasting accuracy of accounting reports by focusing on the most relevant attributes of events crucial to the users. Johnson observes:

“In order for interested persons (shareholders, employees, manager, suppliers, customers, government agencies, and charitable institutions) to better forecast the future of social organisations (households, business, governments, and philanthropies), the most relevant attributes (characteristics) of the crucial events (internal, environmental and transactional) which affect the organisations are aggregated (temporally and sectionally) for periodic publication free of inferential bias.”

The events approach suffers from the following limitations:

(i) Information overload may result from the attempt to measure the relevant characteristics of all crucial events affecting a firm. This is important as there is a limit to the amount of information an individual can efficiently handle at one time.

(ii) Measuring all the characteristics of an event may prove to be difficult, given the state of the art in accounting.

(iii) The criterion for selecting what information (events) should be presented is very vague, and therefore, it does not lead to a fully developed theory of accounting. Yet, an adequate criterion for the choice of the crucial events has not been developed.

(ii) Value Approach:

Value approach in accounting is traditional approach which assumes that “users’ needs are known and sufficiently well specified so that accounting theory can deductively arrive at and produce, optimal input values for user and useful decision models.”

However, it is accepted that input values cannot be optimal for all uses and users. In the value approach, the balance sheet is regarded as an indicator of the financial position of a business enterprise at a given point in time. On the contrary, in the events approach, the balance sheet is regarded as an indirect communication of all accounting events, relevant to the firm since its inception.

Similarly, in the value approach, the income statement is perceived as an indicator of the financial performance of the business firm for a given period. In the events approach, it is perceived as a direct communication of the-operating events occurring during period.

In the value approach, the funds flow statement is perceived as an expression of the changes in working capital. In the events approach, however, it is better perceived as an expression of financial and investment events. In other words, an event’s relevance rather than its impact on the working capital determines the reporting of an event in the funds flow statement.

Events approach assumes the existence of many and diverse users and therefore financial reporting in this approach is not directed towards specific users. It also assumes that the user should be able to select the desired information from a broader list and also to decide the amount of aggregation. A user can generally aggregate accounting data with sufficient detail, but cannot disaggregate data without the detail.

Which approach—event approach or value approach—should be followed, depends on many factors such as decision models, users’ informational requirements, the need to predict specific events etc. Benbasat and Dexter conclude that the psychological type of the decision-maker is an important factor in determining what type of information system to provide.

Structured/aggregate reports are preferable for high analytical decision-makers, and events approach is preferable for low capability decision-makers. In addition to psychological type, the information provider needs to consider the users decision environment as a contributing factor in the design process.

As the uncertainty in the decision environment decreases, the “value” approach seems preferable. On the other hand, as uncertainty about the environment increases or if the decision making process is not well understood, the event approach may be more suitable.

(iii) Predictive Approach:

Predictive approach in accounting theory basically deals with deciding different accounting alternatives and measurement methods. This approach signifies that particular accounting method should be followed which has predictive ability, i.e., which can predict events that are useful in decision making and in which users are interested.

In this way, an accounting measure or option having the highest predictive ability or power with regard to a specific situation or event will be preferred by the preparers of accounting reports as it will be useful to users in predicting the decision making variables.

Predictive approach in accounting theory is based on the concept of relevant information. The assumption is that the relevant information, if communicated, commands greater predictive ability in predicting the future events about a business enterprise.

The predictive approach is useful in evaluating the current accounting practices, evaluating alternative methods of accounting, choosing competing accounting measures and hypotheses. It facilitates the testing and evaluation of accounting choices empirically and the ultimate decision-making.

Predictive ability is a purposeful criterion which is linked with the decision-making purpose of accounting information and within this goal this approach helps in selecting relevant information for the users Prediction is a prerequisite to making decision, i.e., decisions are usually not made without the prediction. However, prediction may not necessarily end into decision-making, i.e., prediction may be made without the goal of decision.

Predictive approach may not be successfully used due to some inherent difficulties such as difficulty in identifying the decision models of different users, difficulty in identifying the events and items which are of interest to users, difficulty in establishing predictive and explanatory relationship between accounting events and information on the one hand and accounting methods and measures on the other hand.

Methodology in Accounting Theory:

A methodology is required for the formulation of an accounting theory. In accounting it is true that many theories, approaches, opinions, have been proposed and supported.

These theories and approaches have led to the use of two methodologies:

(i) Positive Methodology

(ii) Normative Methodology

(i) Positive Methodology:

Positive methodology, often known as Descriptive Methodology, Positive Accounting Theory, attempts to set forth and explain what and how financial information is presented and communicated to users of accounting data.

Positive theory yields no prescriptions and norms for accounting practices. It is concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method of valuing assets, but it says nothing as to which method a firm should use.

The concept of positive theory was introduced into the accounting literature relatively recently during 1960s. The best defence of positive accounting theory has been provided by Watts and Zimmerman through their various writings, the most recently being Positive Accounting Theory (1986). Watts and Zimmerman find that prescriptions and proposed accounting objectives and methodologies in the form of ‘should be’ fail to satisfy all and not accepted generally by all standard setting bodies.

Prescriptions require the specification of an objective and an objective function. For example, to argue that current cost values should be the method of valuing assets, one might adopt the objective of operating capability and specify how certain variables affect operating capability (the objective functions). Then one could use a theory to argue that adoption of current cost values will increase operating capacity.

However, a theory (which suggest the specification of objective) does not provide a means for assessing the appropriateness of the objective(s) which frequently differ among writers and researchers. The decisions on the objective is subjective and there is no method for resolving differences in individual decisions.

The differences in objectives are reflected in many statements on accounting theory. For example, Chambers apparently adopts economic efficiency as an objective while the American Institute of Certified Public Accountants (AICPA) Study Groups on the Objectives of Financial Statements decided that “financial statements should meet the needs of those with the least ability to obtain information….”

Not only are the researchers unable to agree on the objectives of financial statements, but they also disagree over the methods of deriving prescriptions from the objectives. Thus, choosing an objective amounts to choosing among individuals and, therefore, necessarily entails a subjective value judgement.

Positive methodology or theory is important because it can provide those who must make decisions on accounting policy (corporate managers, auditors, investors, creditors, loan officers, financial analysts, company law authorities) with explanations and predictions of the consequences of their decisions.

An important test of the value of an accounting theory is how useful it is. For example, a user will use the accounting theory that increases his welfare the most, through making decisions. Therefore, all users are interested in predicting the effects of decisions.

Positive accounting theory attempts to make good predictions of real-world events. This theory is concerned with predicting such actions as the choice of accounting policies by firms and how firms will respond to proposed new accounting standards.

It should be noted that this theory does not go far as to suggest that firms (and standard setters) should completely specify the accounting policies they will use. This would be too costly. It is desirable to give managers some flexibility to choose accounting policies so that they can adopt to new or unforeseen circumstances.

However, giving management flexibility to choose from a set of accounting policies opens up the possibility of opportunistic behaviour. That is, this theory assumes that managers are rational (like investors) and will choose accounting policies in their own best interests if able to do so.

Scott Comments:

“The optimal set of accounting policies for the firm then represents the best trade-off between tightly prescribing accounting policies so as to minimise contracting costs under current circumstances and giving managers flexibility to change accounting policies in the face of changing circumstances, including resulting costs of opportunistic behaviour. PAT (positive accounting theory) emphasises the need for empirical investigation to determine just what these accounting policies are and how they vary from firm to firm depending on its organisational structure. Ultimately, the objective of the theory is to understand and predict accounting policies choices across different firms.”

(ii) Normative Methodology:

Normative methodology, popularly known as normative theory also, attempts to prescribe what data ought to be communicated, and how they ought to be presented; that is, they attempt to explain ‘what should be’ rather than ‘what is.’ Financial accounting theory is predominantly normative (prescriptive).

Most writers are concerned with what the contents of published financial statements should be; that is, how firms should account. Normative methodology and accounting, with more than half a century of research in its area, has got support from many writers and accounting bodies, notably Moonitz, Sprouse and Moonitz, AAA’s Statement of Basic Accounting Theory, Edwards and Bell, Chambers.

It has been found that government regulations relating to accounting and reporting has acted as a major force in creating a demand for normative accounting theories employing public interest arguments, that is, for theories purporting to demonstrate that certain accounting procedures should be used, because they lead to better decisions by investors, more efficient capital market, etc. Further, the demand is not for one (normative) theory, but rather for diverse prescriptions and suggestions.

According to Scott:

“Whether or not normative theories have good predictive abilities depends on the extent to which individuals actually make decisions as those theories prescribe. Certainly, some normative theories have predictive ability—we do observe individuals diversifying their portfolio investments, for example. However, we can still have a good normative theory even though it may not make good predictions. One reason is that it may take time for people to figure out theory. Individuals may not follow a normative theory because they do not understand it, because they prefer some other theory or simply because of inertia. For example, investors may not follow a diversified investment strategy because they believe in technical analysis, and may concentrate their investments in firms that technical analysts recommend. But, if a normative theory is a good one, we should see it being increasingly adopted over time as people learn about it. However, unlike a positive theory, predictive-ability is not the main criterion by which a normative theory should be judged. Rather it is judged by its logical consistency with underlying assumptions of how rational individuals should behave.”

Comparison between Positive Theory and Normative Theory:

The positive theory is a predictive model whose validity is independent of the acceptance of any goal structure. Though assumed goals may be part of such a model, research relating to a theory or model of accounting does not require acceptance of the assumed goals as necessarily desirable or undesirable.

On the other hand, accounting policies as made in normative theory, requires a commitment to goals and, therefore, requires a policy maker to make value judgements. Policy decisions presumably are based on both an understanding of accounting theories and acceptance of a set of goals.

In spite of the existence of positive and normative methodologies in accounting theory, theorists and writers have to be very careful in discriminating between positive and normative propositions. Positive theories are concerned with how the world works.

For example, the following is a propositions made in positive accounting: “if a business enterprise changes from FIFO to LIFO and the share market has not anticipated the change, the share price will rise.” This statement is a prediction that can be refuted by evidence.

Normative theories are concerned with prescriptions, goal setting. For example, “given the set of conditions A, alternative D should be selected,” is a normative proposition. The other normative proposition can be, “since prices are rising, LIFO should be adopted.” These (normative) propositions are not refutable. Given an objective, it can be made refutable.

For example, the statement, “if prices are rising, choosing LIFO will maximise the value of the firm,” is refutable by evidence. Thus, given an objective, a researcher can turn a prescription into a conditional prediction and assess the empirical validity. However, the choice of the objective is not made by the theorists, but by the users of theory.

It is difficult to say which methodology—positive or normative—should be used in the formulation and construction of accounting theory. It is argued that, given the complex nature of accounting, accounting environment, issues and constraints, both methodologies may be needed for the formulation of an accounting theory.

Positive theory may be used in justifying some accounting practices. At the same time, normative theory may be useful in determining the suitability of some accounting practices which ought to be followed in terms of normative theories.

Watts and Zimmerman observe:

“We emphasise that positive theory does not make normative propositions unimportant. The demand for theory arises from the users’ demands for prescriptions, for normative propositions. However, theory only supplies one of the two necessary ingredients for a prescription: the effect of certain actions on various variables. The user supplies the other ingredient: the objective and the function that provides the effect of variables on that objective (the objective function).”

Similarly Scott Comment:

“….it is sufficient to recognise that both normative and positive approaches to theory development and testing are valuable. To the extent that decision-makers proceed normatively, both positive and normative theories will make similar predictions. By insisting on empirical testing of these predictions, positive theory helps to keep the normative predictions on track. In effect, the two approaches complement each other.”

Other Approaches in Accounting Theory:

In the previous section, many theories (approaches) of accounting have been discussed. It is also clear that there is no single comprehensive theory of accounting. Besides the theories discussed earlier, some more traditional approaches to formulation of an accounting theory are found.

They are listed as follows:

(1) Pragmatic Approach,

(2) Authoritarian Approach,

(3) Ethical Approach,

(4) Sociological Approach,

(5) Economic Approach and

(6) Eclectic Approach.

1. Pragmatic Approach:

The pragmatic approach aims to construct a theory characterized by its conformity to real world practices and that is useful in terms of suggesting practical solutions.

According to this approach, accounting techniques and principles should be chosen because of their usefulness to users of accounting information and their relevance to decision making processes. Usefulness, or utility, means that attribute which fits something to serve or to facilitate its intended purpose.

2. Authoritarian Approach:

The authoritarian approach to the formulation of an accounting theory, which is used mostly by professional organizations, consists of issuing pronouncements for the regulation of accounting practices. Because the authoritarian approach also attempts to provide practical solutions, it is easily identified with the pragmatic approach.

Both approaches assume that accounting theory and the resulting accounting techniques must be predicted on the ultimate uses of financial reports if accounting is to have a useful function. In other words, a theory without practical consequences is a bad theory.

3. Ethical Approach:

The several approaches to accounting theory are not independent of each other. This is particularly true of the ethical approach; defining it as a separate approach does not necessarily imply that other approaches do not have ethical content, nor does it imply that ethical theories necessarily ignore all other concepts.

The ethical approach to accounting theory places emphasis on the concepts of justice, truth and fairness. Fairness, justice, and impartiality signify that accounting reports and statements are not subject to undue influence or bias. They should not be prepared with the objective of serving any particular individual or group to the detriment of others.

The interests of all parties should be taken into consideration in proper balance, particularly without any preference for the rights of the management or owners of the firm, who may have greater influence over the choice of accounting procedures. Justice frequently refers to a conformity to a standard established formally or informally as a guide to equitable treatment.

Truth, as it relates to accounting, is probably more difficult to define and apply. Many seem to use the term to mean “in accordance with the facts.” However, not all who refer to truth in accounting have in mind the same definition of facts. Some refer to accounting facts as data that are objective and verifiable.

Thus, historical costs may represent accounting facts. On the other hand, the term truth is used to refer to the valuation of assets and expenses in current economic terms. For example, MacNeal stated that financial statements display the truth only when they disclose the current value of assets and the profits and losses accruing from changes in values, although the increases in values should be designated as realized or unrealized.

Truth is also used to refer to propositions or statements that are generally considered to be established principles For example, the recognition of a gain at the time of the sale of an asset is generally considered to be a reporting of true conditions, while the reporting of an appraisal increase in the value of an asset prior to sale as ordinary income is generally thought to lack truthfulness.

Thus, the established rule regarding revenue realization is the guide. But the truthfulness of the financial reports depends on the fundamental validity of the accepted rules and principles on which the statements are based. Established rules and procedures provide an inadequate foundation for measuring truthfulness.

Probably the greatest disadvantage of ethical approach to accounting theory is that it fails to provide a sound basis for the development of accounting principles or for the evaluation of currently accepted principles. Principles are evaluated on the basis of subjective judgement; or, as generally found, currently accepted practices become accepted without evaluation because it is expedient and easier to do so.

4. Sociological Approach:

The Sociological approach to the formulation of an accounting theory emphasizes the social effects of accounting techniques. It is an ethical approach that centers on a broader concept of fairness, that is, social welfare. According to the sociological approach, a given accounting principle or technique will be evaluated for acceptance on the basis of its reporting effects on all groups in society.

Also implicit in this approach is the expectation that accounting data will be useful for social welfare judgements. To accomplish its objectives, the sociological approach assume the existence of “established social values” that may be used as criteria for the determination of accounting theory.

A strict application of the sociological approach to accounting theory construction may be difficult to find because of the difficulties associated with both determining acceptable “social values” to all people and identifying the information needs of those who make welfare judgements.

The sociological approach to the formulation of an accounting theory has contributed to the evolution of a new accounting sub-discipline — social responsibility accounting. The main objective of social responsibility accounting is to encourage the business entities functioning in a free market system to account for the impact of their private production activities on the social environment through measurement, internalization, and disclosure in their financial statements.

Over the years, interest in this sub-discipline has increased as a result of the social responsibility trend espoused by organizations, the government, and the public. Social-valise-oriented accounting, with its emphasis on “social measurement,” its dependence on “social values,” and its compliance to a “social welfare criterion,” will probably play a major role in the future formulation of accounting theory.

5. Economic Approach:

The economic approach to the formulation of an accounting theory emphasizes controlling techniques. While the ethical approach focuses on a concept of “fairness” and the sociological approach on a concept of “social welfare,” the economic approach focuses on a concept of “general economic welfare.”

According to this approach, the choice of different accounting techniques depends on their impact on the national economic good. Sweden is the usual example of a country that aligns its accounting policies to other macroeconomic policies.

More explicitly, the choice of accounting techniques will depend on the particular economic situation. For example, last in first out (LIFO) will be a more attractive accounting technique in a period of continuing inflation. During inflationary periods, LIFO is assumed to produce a lower annual net income by assuming higher, more inflated costs for the goods sold than under the first in, first out (FIFO) or average cost methods.

The general criteria used by the macroeconomic approach are:

(1) Accounting policies and techniques should reflect “economic reality,” and

(2) The choice of accounting techniques should depend on “economic consequences.” “Economic reality” and “economic consequences” are the precise terms being used to argue in favour of the macroeconomic approach.

Until the setting of standards setting bodies in different countries, the economic approach and the concept of “economic consequences of accounting choices” were not much in use in accounting. The professional bodies were encouraged to resolve any standard-setting controversies within the context of traditional accounting. Few people were concerned with the economic consequences of accounting policies.

However, at present, the economic approach and the concepts of economic consequences and economic reality are being applied while framing accounting standards. Some examples where economic approach has got major consideration are accounting for research and development, foreign currency fluctuations, leases, inflation accounting.

In setting accounting standards, therefore, the considerations implied by the economic approach are more economic than operational. While in the past, reliance has been on technical accounting considerations, the tenor of the times suggests that standard setting encompasses social and economic concerns.

6. Eclectic Approach:

The eclectic approach is basically the result of numerous attempts by individual writers and researchers, professional organisations, government authorities in the establishment of accounting theory and principles and concepts therein. Therefore, eclectic approach comprises a combination of approaches.

For example, in USA, many public accounting firms (like Arthur Anderson and Company; Arthur Young and Company; Coopers and Lybrand; Ernst and Whinney; Price Water House Co.; Peat, Marwick, Mitchell and Co.; Touche Ross and Co.; Deloitte Haskins and Sells), The American Institute of Certified Public Accountants (AICPA), American Accounting Association (AAA), Financial Accounting Standards Board (FASB), Securities and Exchange Commission (SEC), and other professional organisations are involved in the development of accounting theory.

In other countries also including India, many efforts have, although on a lesser degree, been made by individual accounting organisations and government authorities to establish accounting principles and concepts.

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