Chapter 2

Questions

1. ‘A theory that is purely syntactic is sterile.’ Comment. How can this

statement relate to accounting?

A syntactic theory is one that is capable of testing on the basis that it is valid in terms
of its logical consistency. Thus the calculation of accounting profit and determination
of asset valuation can be valid in relation to their conformity with rules prescribing
the measurement of accounting profit and asset valuations. This can be described as
sterile as it does not necessarily relate to the real world. Historical cost accounting
has been represented as being purely a syntactic theory, with the semantic inputs to
the system being the transactions and exchanges recorded in the accounting system,
which are then aggregated and classified on the basis of the premises and
assumptions of historical cost accounting. Examples of ‘rules’ include the duality of
the accounting entry system and assigning costs to assets and liabilities rather than
market values. The output is verified via the auditing process. The sterility of this
approach is based on the lack of imprecision of accounting concepts and the lack of
association between the rules and how they produce output that is relevant to users of
financial statements.

2. A pragmatic theory of accounting involves observing the practices and

techniques of working accountants and teaching these to successive accountants.
(a) Argue the advantages and disadvantages of such an approach.
(b) Do you believe this method of teaching accounting is ‘correct’?

(a) A pragmatic theory is where we observe the behaviour of practising

accountants and then copy their accounting procedures and principles.
Advantages:
 the solutions of practising accountants are related to the requirements of the
business world
 they have developed (and been handed down) over a number of centuries
 it is a pragmatic approach to solving the problems of accounting.

Disadvantages:
 no logical assessment (not deductive)
 does not allow change (or change occurs slowly)
 we perpetuate current practice
 concentrates on pragmatics and ignores the measurement issues (semantics).

(b) Tutors should be aware that this debate is a common one argued between
practising accountants and some normative accounting theorists, and will invoke
a number of responses from students. A number will argue that an approach that
lacks a theoretical component (syntactics) will have the danger of becoming
dogmatic or self-fulfilling. A pragmatic approach may mean that too much
emphasis is placed on the practices and techniques of accountants, and little
emphasis is placed on the meaning of the actual ‘financial statements’.
Accounting then may revert to a procedural art.
 On the other hand, others may rightly argue that accounting theory may become
too obtuse if a completely theoretical approach is taken without regard to the
facts of the real world. Theoretical argument without pragmatic application is
likely to be of little benefit to business and society.

Another point worth noting in this question is the meaning of ‘the facts of the real
world’. Our analysis of testing a theory suggests that the above statement should
be subjected to a number of tests.

Tutors should use this question to point out the problems of taking extreme
positions. To ignore any theoretical framework or to ignore pragmatic
implications may be equally dangerous. Students should be encouraged to
combine analytics with pragmatics.

3. (a) Describe the semantic approach to accounting.

(b) Do you think that the outputs of the accounting system should be
‘verified’? How could this be achieved?

(a) A semantic approach to accounting is the assignment of numbers to the

components of accounting. It has two arms:
 Input semantics — assigning numbers to the transaction inputs of accounting
(for example, assets, liabilities, revenue, expenses). This transactions-based
approach is often criticised as a mathematical system divorced from logical
analysis or output semantics.
 Output semantics — testing the outputs of the accounting system against
some external reference (for example, increases in profits against share price
changes — see also Theory in Action 3.1).

(b) This is a difficult question as there are very few external referents other than the
stock market. Further, market prices exist for a minority of businesses. In most
cases the financials determined by accountants are the sole determinant of a
firm’s financial health. Many students, recognising this problem, will revert to a
‘reasonableness test’.

4. Give two examples of accounting ‘doublethink’. How do traditional

accountants counter this criticism?

 The practice of summing together assets using different valuation methods and believing that the sum (total assets) is an
exact measure of asset ‘value’
 The practice of using conservative accounting techniques and different allocation techniques to derive net income, which
is then compared across different industries
 See also the examples on p. 54.

Accountants counter by arguing that the purpose of accounting is to match (allocate)

historical costs, and is not a measurement system. Also, accountants argue that
diverse techniques are required to account for different business situations.

5. (a) What is normative accounting? Give two examples of the major issues
debated in this area.
 (b) Do you think that the effects of inflation on financial statements are
important? Why or why not?

(a) Normative accounting research is more concerned with policy recommendations

and with what should be done in contrast to explaining why current practice is
carried out in the manner that it is.

Normative theorists usually attempt to derive either the ‘true income’ or adopt
the ‘decision-usefulness’ approach whereby accounting reports are an input into
users’ decisions (for example, to buy or sell shares, and management decisions
on the financial wealth of firms).

The major issues are the impact of the changing price environment (prices) and
the impact on income, assets, liabilities and equity. As a consequence many
normative theorists are measurement theorists who attempt to incorporate the
effects of inflation into accounting reports. In this sense they take a semantic
viewpoint — relating the figures in the accounting reports to actual objects
(assets, liabilities) or events (changes in inflation).

Whether accounting should be purely a semantic science (or a syntactic or

pragmatic science) is in itself a normative statement, and whichever way students
answer this point should be brought to their attention.

Inflation may matter to some accountants but not to others. For example, a
management accountant who is trying to control costs or projects may have to
pay a great deal of attention to the inflation rates in various sectors; an accountant
who is responsible for hedging money market funds will be interested in the real
rate of return on funds or look to inflation induced hedges (for example, in real
assets). On the other hand, taxation accountants, auditors or record keepers may
have very little interest in the effects of inflation.

(b) Tutor should lead discussion on this issue.

6. (a) Describe the decision-usefulness approach and its relation to accounting

data.
b) Provide three examples of decisions that require accounting data. Do you
need to know if the values of assets have changed for any of your
decisions?

(a) The decision model approach is an instrumentalist approach (see diagram on p.

57). In a narrower sense, one direct test of an overall theory of accounting would
be to determine whether the output data of the accounting systems, which are
constructed on the basis of the overall theory, are useful to users. The data of the
accounting systems are utilised by users in their prediction models, and the
conclusions (predictions) are then used in their decision models. The problem is
that if the prediction is verified, it verifies the prediction model, not the
accounting system and its output. There are other variables besides accounting
data that affect the prediction. We do not know how the accounting data were
utilised. Also, if the decision turns out to be right, it verifies the decision model,
not the accounting system.
 Interpreting the evidence on decision making is extremely difficult. We do not
know how to interpret the evidence to determine that accounting information is
useful. Thus, a direct test is virtually impossible. Accounting standard setters
usually determine usefulness with the weaker, more direct tests that are usually
advanced by accounting committees and include: relevance, verifiability,
freedom from bias, timeliness, comparability, reliability and understandability.

(b) Decisions:
 to invest in a firm’s stock
 to loan funds to a firm
 to purchase or buy an asset.

Yes, inflation is important in these decisions.

7. In general, what is ‘positive theory’?

Positive accounting theory was a reversion to testing or relating accounting theories

back to the ‘facts’ or ‘experiences’ of the real world. Examples of such research were
questionnaires and surveys of bank officers or investors regarding their use of
financial reports for decision making; or whether inflation-adjusted accounting
reports actually aided decision making. Current positive accounting research is aimed
at explaining the reasons for actual accounting practices and in predicting the role of
accounting data in economic, political and social decision making. Positive theory
has expanded accounting theory from the purely decision-making focus of normative
theorists into analysis of political and economic factors.

8. How does an ontological assumption affect an accounting theory?

An ontological assumption is the way we see the world. Using the Morgan and
Smircich six-way classification, we may assume reality as being anything from a
concrete structure (realist-objectivist viewpoint) down to reality as a projection of
human imagination (unstable, human specific).

If we have an ontological viewpoint that the accounting world is relatively concrete

and stable then it is more appropriate to choose a scientific approach to accounting
theory. That means that we are more likely to have a structured, prior theoretical base
and use empirical validation. On the other hand if we view the world of accounting
as being a product of human imagination we are more likely to have an unstructured
research methodology with no prior theory.

9. What is the difference between scientific and naturalistic research?

The difference between scientific and naturalistic research is set out in table 3.2 on
page 63. The tutor should aid students’ understanding by briefly categorising
accounting research into scientific and naturalistic.

10. What type of a theory is historical cost? How has it been derived? Do you
have any criticisms of historical cost accounting?
Historical cost is usually described as a pragmatic theory whereby premises are
determined by observing the practice of accountants. Criticisms include:
 no logical analysis of accountants’ actions
 does not allow for change
 does not focus on measurement
 circularity of logic in the rules
 outputs not verified
 doublethink
 conventions not subject to falsification.

11. Explain the psychological pragmatic approach to accounting theory. Give an

example of how it can be applied.
The psychological pragmatic approach to accounting theory observes users’
responses to the accountants’ outputs (such as information contained in financial
reports or the presentation of information in financial reports). If the response
suggests that the information is useful and relevant then a theory prescribing the
usefulness of the particular accounting information can be derived. Students should
be able to contrast the psychological pragmatic approach to accounting theory with
that of the descriptive approach, with the latter observing accountants’ behaviour in
contrast to users’ behaviour in deriving accounting theory. An example of the
psychological pragmatic approach would be ascertaining if the presentation of
financial information (such as changing the format of the statement of financial
performance to provide comprehensive earnings in addition to operating earnings) is
more meaningful to a user and enables them to make better decisions. The criticism
of this approach to theory construction is that the response of individuals may be
illogical and not representative. To test users’ responses more systematically,
positive accounting theory development in the form of capital market, contracting or
behavioural research approaches are used.

12. Give an example of an accounting convention usually adopted in historical

cost accounting. Conventions govern the way accounting is practised, and
conventions are, by definition, known from practice.
(a) What theoretical approach is used to derive conventions?
(b) What does your answer to (a) imply about the potential for accounting
theories based on conventions to be innovative in providing useful
information?

The principles underlying the use of historical cost accounting are: (1) the
appropriate unit of measurement is historical cost; (2) the monetary unit is
stable; (3) the matching principle; and (4) the realisation principle. A specific
accounting convention adopted in historical cost accounting is depreciation.
The depreciation expense represents the allocation of an asset’s cost over
the estimated useful life of that asset and is consistent with the matching
principle.

(a) The theoretical approach used to derive the convention of depreciation is the
dogmatic basis. Accountants use historical cost accounting (or a modified
version) on the basis that this is what the accounting rules have traditionally
 required them to use. Similarly, physical assets are depreciated on the basis that
the accounting rules require such assets to be depreciated. Thus accounting
practices gain acceptance as a result of the accepted rules, and in many cases the
rules involve a codification of practice.

(b) In answering this question, it is useful for students to first consider the criticisms
of historical cost accounting. Included amongst these criticisms are the
production of irrelevant financial information and errors in measuring units.
Consider the case of depreciation. This is an accounting entry that involves an
allocation process. Depreciation does not attempt to reflect the diminution in
asset value that has occurred in the reporting period. If rules were simply a
codification of existing accounting practices, the ability of accounting to be
innovative and to produce information that is potentially more relevant would be
minimal.

In recent years the divergence between stalwart accounting practices and

accounting rule prescriptions has increased. For example, historical cost is not the
preferred measurement system in recent standards covering topics such as
SGARAs, insurance companies and financial instruments. Movement to fair
value accounting would see traditional accounting conventions such as
depreciation disappear, as assets would be recognised at their fair value each
reporting period, with movements in fair value from the start to the end of the
reporting period recorded as revenue or expenses. This is intended to be a more
accurate portrayal of the measurement effect of occurrences during the reporting
period and to provide more useful information.

13. How do you think the massive amounts of data now available from
information technologies will affect:
(a) the development of accounting theories?

(b) the testing of accounting theories?

(a) & (b) The technological advances enhancing the capture, extraction, collation and
analysis of data, will assist in accounting theory construction. An important
part in the construction process is the ability to validate or verify the theory
espoused. The availability of financial information databases and analysis
packages will facilitate the verification process. It will be possible to test
theories on data sets and this can be accomplished in a relatively short
period of time. The availability of data has assisted scientific research in
accounting.

14. What are the key differences between normative and positive theories?

‘Normative’ and ‘positive’ are the labels given to the accounting theories. A
normative theory of accounting is a prescriptive theory that specifies what
‘ought’ to be. A normative theory is based on the values, ideas and beliefs of
the theory developer; and, as people have different ideas, values and beliefs,
consensus is unlikely. For example, espousing current cost accounting as the
appropriate measurement system to derive ‘true income’ is a normative
theory. This was not universally accepted as other theorists supported
alternative measurement models to derive ‘true income’ (for example, exit
value accounting, historical cost accounting).

A positive theory of accounting is one that describes, explains or predicts

accounting practices. The theories are developed and tested with reference
to real-world experiences using empirical methodology. The fundamental
differences between positive and normative accounting theories are identified
in the table below. It should be noted that the theories can co-exist.

Normative Theory Positive Theory

 prescriptive  descriptive, explanatory or
predictive
 value laden  non-value laden
 does not involve empirical  empirically based
methodology
15. What are some common criticisms of scientific approaches? Are they valid? Why

or why not?

The criticisms of scientific and naturalistic research stem from the differences
in their ontological assumptions, epistemological approaches, methodology
and methods. It is useful to review these differences with students by
referring to table 3.2 on page 63.

The scientific approach to theory construction is a very structured approach,

and critics of this approach focus on its rigidity. The criticisms of the scientific
approach to accounting theory construction can be summarised as follows:

 testing environment is not representative of the real environment

 lacks relevance to practitioners
 reliance of large scale statistical testing
 data richness ‘lost’ through the aggregation process
 relies on preconceived assumptions or theories
 it seeks the absolute truth.

Case Study 2.1 — New regime taxing for foreign corporates

1. Explain what you think are the problems described in the article.

The article describes the change in taxation rules for foreign corporations operating
in Australia. The new consolidated tax regime requires groups to lodge a single
income tax return (rather than all entities within the group lodging returns) with one
nominated Australian subsidiary being responsible for all tax obligations. The
problems associated with such taxation treatment, as described in the article, are:
 overseas parent entities losing valuable foreign tax credits
 lack of autonomy of entities within the group operating in Australia
 access to commercially sensitive information by independent firms in
the group operating within Australia
 differences in the substituted accounting periods or financial year ends
of subsidiaries, resulting in grouping benefits between their year end
and tax consolidation date being lost.

2. Do you think a normative approach to regulation led to the problems

described in the article? Explain your answer.

The revised taxation regulation relating to foreign-owned corporate groups is most

likely to be a result of a normative approach to regulation. The regulators have
legislated what they believe the taxation arrangements should be. Presumably this
has been done in consultation with business. The article suggests that most corporate
groups will take up the new taxation arrangements suggesting that their applicability
and relevance to the real world has been duly considered (a case of psychological
pragmatic theory development).

3. What role can positive theory play in resolving the issues described in the
article?

The impact of the new taxation arrangements is only capable of being tested
empirically once the arrangements come into existence and the economic
consequences can be systematically investigated. Investigating the economic
consequences will enhance the theory of how foreign group structures should be
taxed, as it will describe and explain the consequences associated with the new
taxation arrangements.

4. What role can normative theory play in resolving the issues described in the
article?

Normative theory prescribes how the income of foreign-group structures within

Australia should be taxed. When considering the appropriate taxation treatment,
attention would have been paid to issues such as the equitableness of the taxation
rules, their ease of application and level of understandability. Current arrangements
are not necessarily optimal; and by suggesting alternative taxation schemes, the
theory of how foreign group structures operating in Australia should be taxed can be
advanced. It is desirable but difficult to achieve Pareto optimality when proposing
amendments to accounting or taxation rules, and the article gives examples of
situations where individual firms and the group may be worse off.

5. Describe the roles the following approaches to accounting theory can play in
resolving the problems described in the article:
(a) pragmatic
(b) syntactic
(c) semantic.

Taxation theory, like accounting theory, is a social science as well as a measurement

and technical process.

(a) Pragmatic: This relation pertains to the effect of words or symbols on the
behaviour of people. Not all theories have a pragmatic orientation, but the nature
of taxation and accounting makes this relation an important one. One objective of
accounting and taxation affirms that we are interested in how users react to
accounting and taxation information, and how preparers respond to accounting
and taxation rules. For example, the analysis of the reactions of preparers and
investors and other users to the taxation arrangements of firms is an important
area of research in accounting and taxation theory. Also, the study of pragmatics
in accounting and taxation leads us to form political and social theories about the
reactions of people to rules and the output from the system.

Pragmatics, syntactics and semantics are the three types of relationships in the
theoretical structure, although not all relations are required in theory formulation.
The instructor can now pose the question whether all these relations exist in
accounting and taxation theory and how they can be used to resolve the issue
 discussed in the article. The answer is ‘yes’ to varying degrees, and also
according to the perceptions of the student (and the instructor) of the importance
of each relation. Students should then have some understanding of the
complexity of defining and studying ‘accounting theory’.

(b) Syntactic: This represents the logical relations in the theory and concerns the
rules of the language employed — for example, in this case, the taxation rules
related to how foreign structures operating in Australia are taxed. A syntactical
methodology relies on the construction of a syllogism that forms an analytical
proposition and requires a logical test to validate its truth. An example in relation
to this question is the determination of taxable income and the mathematics
associated with aggregating the assessable income and allowable deductions of
entities within the group.

(c) Semantic: Semantics is sometimes referred to as rules of correspondence or

operational definitions. It connects symbols, words, terms or concepts with real-
world objects, events or functions and is seen to make a theory realistic. In
accounting and taxation, semantic theory concerns itself with the correlation of
propositions to objects or events and manifests itself in terms of measurement
theories — for example, measuring the taxable income when the income is
realised. Theorists in this area argue that by applying these adjustments, the
accounts now have semantic content and can be related to the real world.

Case Study 2.2 — Rough Guide

1. What is EBITDA?

EBITDA is the acronym for earnings before interest, tax, depreciation and
amortisation. It is used as an earnings measure that excludes asset diminution
charges, financing costs and tax expense.

2. How can a pragmatic approach lead to an explanation of the use of EBITDA

and why should it be used?

EBITDA is a financial measure that is extensively accepted and utilised in financial

markets. It has applications in the areas of financial statement analysis, credit
analysis and valuation. A pragmatic approach explaining its use is that EBITDA was
initially used as a more accurate measure of the debt-servicing capacity of highly
levered firms in the late 1980s when leveraged buyouts were popular. The use of
EBITDA as a financial indicator of operating earnings, debt-servicing capacity and
operating margins has continued (despite cash flow information now being publicly
available), as analysts pass on their analytical skill base and tools (including the use
of EBITDA) to new industry entrants.

3. Give the main arguments in a normative theory explaining why EBITDA

should be replaced by a different measure in analysing firms’ financial
performances.
(a) Where does ‘decision-usefulness’ feature in this theory?
 (b) What is the role of positive accounting theory in this normative theory
development?

(a) There are numerous reasons why EBITDA should be replaced with an alternative
metric for analytical and valuation purposes. The strengths of EBITDA include:
 provides a benchmark against which the quality of a firm’s reported earnings
can be assessed by reconciling this metric to the firm’s gross cash flows from
operations
 is a comparable figure, as it is not distorted by different depreciation methods
and rates, effects of financial leverage and taxation effects
 provides the commencement point in determining a firm’s free cash flow
 is respected as a metric to be used in assessing a firm’s debt capacity
 is a key input to valuation analysis.

The weaknesses of EBITDA include:

 does not reflect the actual cash flow generation capacity of a firm, as it fails
to capture capital requirements and there are other non-cash items for which
EBITDA makes no corrections
 calculation is susceptible to ‘earnings management’, as it is based on accrual
accounting (but less so than other measures such as net profit)
 is not an all-encompassing measure of corporate earnings and financial
performance
 does not incorporate working capital requirements.

These weaknesses provide the normative arguments as to why EBITDA is not the
most useful metric to use in performance and valuation assessment. Warren
Buffet, one of the world’s most successful investors, provides the following
normative statement in relation to the use of EBITDA:

…we do not think so-called EBITDA is a meaningful measure of performance.

Management that dismisses the importance of depreciation — and emphasises
cash flow or EBITDA — are apt to make faulty decisions, and you should keep
that in mind as you make your own investment decisions.

(b) Positive theory can be used to test the validity of the usefulness of EBITDA in
valuation and liquidity assessments. The ability of EBITDA, relative to an
alternative metric, to more accurately predict financial distress can be empirically
tested. Similarly, the usefulness of EBITDA in forecasting future cash flows and
firm value can be assessed via empirical testing. As discussed in previous
questions, this illustrates the simultaneous role played by normative and positive
theories in advancing accounting theory.

4. Can a naturalistic research approach apply to the debate about the

usefulness of EBITDA? If so, how? If not, why not?

The difference between scientific and naturalistic research is set out in table 3.2 on
page 63. The naturalistic research approach to theory formulation is based on the
ontological assumption that reality is socially constructed and a product of human
imagination. When viewed as such, individuals will have different beliefs as to the
appropriateness of one metric versus an alternative metric in financial analysis and
valuation. The naturalistic research approach accommodates individuals’ perceptions
and preferences with respect to valid metrics. If decision makers genuinely believe
that EBITDA is an appropriate measure of financial performance based on the
strengths of this metric then its use is justified and valid.

5. Can a scientific approach apply to the usefulness of EBITDA? If so, how? If

not, why not?

The scientific approach would test the validity of EBITDA as a suitable metric in
financial analysis and valuation decisions in a structured empirical manner. The
approach would involve hypothesis development (for example, developing the
hypothesis that EBITDA is positively correlated with a firm’s future cash flows or
EBITDA discriminates between financially distressed and healthy firms) and
hypothesis testing based on statistical analysis of the data collected. Compared to
naturalistic research, scientific research is highly structured and based on large data
sets making it generalisable and resulting in general theories of accounting. Critics of
this approach argue that the research is conducted in the absence of its natural real-
world setting.