Accounting Theory

Dr. Amr Abdel-Gawad Mohammed

Ph.D In Accounting and Auditing

Faculty of commerce – Ain Shams Uni.
 Accounting Assumptions

Economic Entity – company keeps its activity

separate from its owners and other businesses.
Going Concern - company to last long enough to fulfill
objectives and commitments .Not to liquidate
Monetary Unit - money is the common unit of
measurement. Inflation rates are not recorded in
accounting.
Periodicity - company can divide its economic
activities into time periods. Accountants must close
records at least one time per year.
LO 6 Describe the basic assumptions of accounting.
 Accounting Assumptions

Historical Cost – is the acquisition cost. Historical cost

provides a reliable measurement to record transactions.
We do not use Fair Value.

Revenue Recognition – revenue is recognized when

realized.
Revenue is Realized at point of sale

LO 7 Explain the application of the basic principles of accounting.

 Accounting Assumptions

Matching - (expenses) should be matched with

generated (revenues)
“Let the expenses follow the revenues.”

Materiality– providing information that is of great

importance to affect the decisions of users.
Information is material if its omission affect the
decision
Conservatism – record losses when they are probable
and record gains only when they happen.

LO 7 Explain the application of the basic principles of accounting.

 Principles and Assumptions
C4

of Accounting

Revenue Recognition Principle

1. Recognize revenue when it is earned. Cost Principle
2. Proceeds need not be in cash. Accounting information is based on
3. Measure revenue by cash received actual cost. Actual cost is
plus cash value of items received. considered objective.

Full Disclosure Principle

Matching Principle A company is required to report the
A company must record its expenses
details behind financial statements that
incurred to generate the revenue reported.
would impact users’ decisions.
C4

Accounting Assumptions
Now Future
Going-Concern Assumption Monetary Unit Assumption
Express transactions and events in
Reflects assumption that the business
monetary, or money, units.
will continue operating instead of being
closed or sold.

Business Entity Assumption Time Period Assumption

A business is accounted for Presumes that the life of a company can
separately from other business be divided into time periods, such as
entities, including its owner. months and years.
 Definition of theory
The word ‘Theory’ has originated from the Greek word,
‘Theoria’. It means to behold or view.
 A theory is a confirmed hypothesis. A ‘hypothesis’ is an idea
or explanation that you then test through study and
experimentation.
Theory is defined as asset of interrelated concepts, definitions
and propositions that present a systematic view of
phenomena by specifying relations among variables with the
purpose of explaining and predicting the phenomena.
▪ Simply stated, a theory is a systematic statement of the rules
or principles which underline or govern a set of phenomena.
 Accounting Theory
Accounting theory is set of hypothetical, conceptual
and pragmatic principles forming a general frame of
reference for enquiring into the nature of accounting.
It will be seen that accounting theory has been defined
as a coherent set of logical principles that provides for:
 Conceptual framework;
Better understanding of present accounting practice;
Evaluation of existing accounting practices; and
Guideline for future development and research
 Accounting Theory
Accounting theory is that branch of accounting which
consists of the systematic statement of principles and
methodology, as distinct from practice. Moreover, it
refers to a generally accepted logical explanation of
Accounting Practices. It is that branch of Accounting
which develops and enhance a set of logical principles
for the evaluation and development of effective
accounting practices.
 Needs for Accounting Theory
Below is given some of the clearly identified need for
accounting theory:
(1) Identification of problem area
(2) Conceptual framework for the study of accounting
problems
(3) Summarization about the subject and current accounting
practices.
(4) One of the goals of accounting theory is to provide
uniformity in practice.
(5) Predictability about further facts.
(6) Development of new practice
Methodology of development of accounting theory
Accounting Theory is the organized body of knowledge which
deals with order, reasons, relationships, objectives and
methods involved in the practice of accounting. The concept
of accounting theory provides the use of theory as a guide to
accounting practices.
▪ However, the fact is that there has been a concurrent
development in accounting. While accounting was
developing as a practical art, it was also evolving a body of
theoretical premises. ( theoretical and practical
development)
The theoretical evolution of accounting is of recent original,
though its practical development can be traced back five
hundred years ago..
Methodology of development of
accounting theory
▪Both the theoretical and practical approaches have
contributed to the existing organized body of knowledge,
presently known as accounting theory. Their approaches are
different, but the purpose is the same: to develop systematic
accounting practices. Under the practical approach,
accountants have frequently relied on trial and error as a
means to improving accounting practices whereas, the
theoretical approach relied on logical, conceptual structure
to develop meaningful pattern of accounting practices. But
both the theoretical approach and practical approach are
interested in developing some general principles and
procedures for dealing with the same real world phenomena
of business transactions and events .
Methodology of development of
accounting theory
From the foregoing it appears that accounting theory can be
extracted from the practice of accounting (i.e., the practical
approach) or it can result from a logically derived process
through the deductive approach. The difference in not one of
purpose, rather the difference is due to adoption of different
methodologies. The diversity of opinions approaches and
values between accounting practice and accounting research
have led to the use of two methodologies , one descriptive and
the other normative. On that basis Accounting theories are:
o Descriptive theories
o Normative theories
 Descriptive Theories
A descriptive theory describes a particular
phenomenon as it is, without any value judgment. A
descriptive theory will not inform whether it’s right or
wrong; rather the process of ascertaining results.

Such descriptive theories are concerned with the

behavior of the practicing accountants and what they
do. This approach emphasizes accounting practice as
the basis from which to develop theory.
 Normative Theories
Concept
o The word, ‘normative’ means it is related to rules, or make
people to obey rules, especially rules of behavior.
o Normative accounting is a branch of accounting theory that is
concerned with the differences between different accounting
systems and the ways in which one system might be better than
another.
o The people, who are developing and using normative
accounting theory, seek to understand the objectives of
accounting in practice and compare its ability to meet those
objectives with other systems. Normative accounting theory is
generally more prescriptive than other ways of approaching
accounting theory.
 Normative Theories
Purpose
Normative accounting theorists tend to advocate not only for a standardized
system of accounting, but also for a particular system that is thought to be
superior to others.
▪ Feature
The essential feature of Normative Theory is the existence of value
judgment . Normative Theories tend to justify what ought to be, rather than
what it is. It imposes on the accountants responsibility of determining what
should be reported rather than reporting what some one else has requested.
▪ Challenges
Normative accounting theory is subject to critique from accounting and
business professionals. Under this approach, theorists tend to rely heavily
upon circumstances evidence (e.g., examples of fraud) that generally fails to
meet tests of academic consistency .
Approaches to the Formulation of
Accounting Theory
New theories are formulated and existing ones are
remodelled with the help of accounting theory. In different
time phases for explaining accounting practices , different
theories have been formulated. Some of these theories have
been put to storehouse in subsequent period while some
others have raised . New theories are always formulated on
the basis of new opinions or concepts. Such opinions or
concepts are identified as approaches. So approaches to the
formulation of accounting theory stand for the different
opinions or concepts on the basis of which new accounting
theories are invented. The approaches to the formulation of
accounting theory are shown in the following chart:
Formulation of Accounting Theory
1. Traditional Approaches 2. Modern or New Approaches
a) Non-theoretical or Pragmatic
Approach a) Events Approach
b) Theoretical Approaches b) Decision Model Approach
o Deductive Approach c) Behavioral Approach
o Inductive Approach d) Predictive Approach
o Ethical Approach
o Sociological Approach
o Economic Approach
o Eclectic Approach
 Traditional Approaches:
The traditional approaches discussed mainly aim at
construction of theories. These approaches may be
divided into two categories:
a) Non-theoretical or Pragmatic Approach; and
b) Theoretical Approach.
a) Non-theoretical or Pragmatic Approach
▪ The approach that speaks in favor of formulation of theory in
conformity with the real world needs and problems and aims at
finding out their solutions may be identified as pragmatic or non-
theoretical approach to accounting theory.
▪ This is also called practical approach. Here those concepts and
principles are emphasized upon which are effective to meet the
practical problems and useful to the users of accounting
information in taking relevant decisions.
▪ 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.
▪ This approach takes into consideration not only the interest of the
owners but the need of all the users of accounting information as
well.
(b) Theoretical Approach
The theory based approaches to the formulation of
accounting principles may be divided into six
categories as follows :
Deductive Approach
Inductive Approach
Ethical Approach
Sociological Approach
Economic Approach
Eclectic Approach
1- Deductive Approach
▪ This approach is used to construct normative theories.
▪ Normative theory is that theory which consists of principles based on standard or
ideal logic. So, deductive approach helps formulation of those principles of
accounting that explain the standard or ideal happenings with logic.
▪ In other words deductive approach is that outlook which follows logically and ideally
correct concepts, opinions, bases and principles for formulation of accounting theory.
▪ The steps required for development of theories under deductive approach are:
o Objectives: to determine the general and specific objectives of financial statements.
o Postulates: to select the basic accounting concepts or postulates relating to
economic, political and sociological environment.
o Constraints: to set out the constraints or regulations this will guide the theory.
o Structure: to build up the framework of theoretical ideas.
o Definitions: to develop the definitions to explain the related ideas.
o Principles: to fix up the accounting principles on the basis of logic.
o Application: to develop the process of application or the techniques and methods
of accounting based on the principles framed.
Continued Deductive Approach
The first step of developing accounting theory following
deductive approach is setting up objectives of accounting. In the
deductive process, the formulation of objectives is most
important because different objectives might require entirely
different structures and result in different principles. Due to this
reason deductive approach is also called ‘objectivity approach’.
▪As deductive approach follows ideally right principles, from the
viewpoint of justification it is identified as the best approach.
But if there exists any defect in the postulates or concepts
selected, the theory formulated on the basis of deductive
approach may mislead the accounting activities.
▪ This approach has also been recognized and used by the
Financial Accounting Standards Board (FASB) of AICPA.
ii) Inductive Approach
This approach is used to formulate descriptive theory.
The main objective of inductive theory is to arrive at a
generalized decision to the logic, reasons and
assumptions acting behind the occurrence of events
through observation and analysis.
▪ So, the inductive approach to the formulation of
accounting theory may be defined as that outlook which
emphasises on developing generalized decisions and
principles through observation, measurement and analysis
of the events occurred.
▪ The process of induction consists of drawing generalized
conclusions from detailed observations and measurements.
ii) Inductive Approach
The steps required for development of theories under deductive approach are:
o To observe and to keep records of all observations.
o To find out recurring relationships, similarities and differences among these
observations by analysis and classification.
o To formulate generalised principles of accounting on the basis of recorded
observations.
o To test and apply these generalised principles.
▪ The main advantage of this approach lies in its independence. It is not
influenced by any predetermined norm or standard model. This helps the
researchers to work independently and to arrive at decisions which they think as
the best outcome of their observations and analysis.
▪ The main disadvantage of the inductive approach is that the researchers in
studying relationship among the data collected from observations may be
influenced by previous principles or ignorace . Another problem of inductive
approach is that the financial data collected through observations may vary from
firm to firm. This creates difficulty in arriving at meaningful and generalized
principles.
iii) Ethical Approach
D. R. Scott, had used the ethical approach for the first time.
▪ The approach to the formulation of accounting theory that puts
emphasis on fairness, justice and truth and considers these attributes as
centres of focus for framing the theories is known as ethical approach.
▪ The concept of ethics is also used more or less in all other approaches to
accounting theory. For this reason the ethical approach is not treated as a
separate and independent approach.
▪ The object of this approach is to prepare the accounting statements
accurately and in an unbiased manner not giving any favour to any of the
interested parties.
▪ At present the financial statements must explore the true and fair view
of the state of affairs of the concern. The main disadvantage of ethical
approach is that it does not provide a sound and independent basis for
the development of accounting principles. It also fails to form the basis
for the evaluation of existing accounting principles.
iv) Sociological Approach
The approach that emphasises on the social aspect of accounting is known as
sociological approach. It is the outcome of ethical approach that takes into
consideration fairness and justice for the construction of accounting theory.
▪ As fairness equates social welfare Glautier and Underdown have identified this
approach as 'welfare approach'.
▪ As per this approach the accounting principles or techniques are to be evaluated on
the basis of their reporting effects on the people of the society. Here it is assumed
that the information supplied by accounting will be useful for social welfare.
▪ The object of sociological approach is to provide information to make possible an
evaluation of the effect of a firm's activities on society.
▪ For achieving its objective the sociological approach assumes the existence of
certain accepted social values. These social values are used to regulate the
formulation of accounting theory.
▪ However, it is difficult to ascertain those social values which may be accepted by all
concerned. The sociological approach to accounting theory has helped formulation
of a new branch of accounting known as social or socio-economic accounting.
v) Economic Approach
▪ Two conditions are to be satisfied for formulating accounting theory under
this approach are:
o The principles and methods of accounting should reflect the present
economic situation or 'economic reality'.
o Selection of the accounting techniques should depend on the economic
consequences.
▪ The approach that focuses on the concept of 'national economic welfare'
for formulating accounting principles is termed as economic approach.
Under this approach the impact of national economic welfare is the main
determining factor for formulation of accounting principles and techniques.
- The economic approach to the formulation of an accounting theory puts
emphasise on controlling the attitude of macro-economic indicators that
result from the adoption of different accounting techniques.
 Economic Approach
▪ Sweden is the country where the accounting techniques
are adjusted to the macroeconomic situation. Under this
approach the selection of a particular accounting technique
depends on a particular economic situation.
▪ For example, under the condition of continuous increase
in price level it is more reasonable to adopt 'Last in First
Out' method of pricing of materials. So this method of
pricing of materials is to be adopted in times of inflation.
▪ The main disadvantage of this approach is that while
framing theory it relies more on economic conditions rather
than on operational problems of accounting.
vi) Eclectic Approach
The word 'eclectic' refers to form the opinion from different methods.
All the above approaches to the formulation of accounting theory have
some special advantages with limitations as well. In comparative analysis
none of these approaches is identified as the best fit to construct theories
which can match up all the practical needs of the users of accounting
information.
▪ For this reason there lies the need to develop an approach by
combining all the accepted approaches. This combined approach will
assist in framing such an accounting theory that can consider all the
practical problems of different users of accounting information.
▪ This combined approach is known as eclectic approach. So eclectic
approach is that approach which is built up by combining the advantages
of all other approaches for formulating that theory which will assist in
solving the problems of all the users. It is not a new approach but a
mixture of the old ones.
2. Modern or New Approaches
The traditional approaches discussed mainly aim at
construction of theories but not evaluation of the theories
already established. Due to this defect, efforts were made
by the scholars of accounting to develop such approaches
which would not only help in formulating new accounting
theories but in verifying the same as well. These new
approaches are identified as modern approaches. The
important modern approaches are as under:
Events Approach
Decision Model Approach
Behavioral Approach
Predictive Approach
 Events Approach
The events approach for the formulation of accounting theory was first
proposed by George Sorter and it was endorsed by the majority of the
members of the AAA American Accounting association committee
that issued “A statement of Basic Accounting Theory” in 1966.
To formulate accounting theory on the basis of relevant economic
events affecting the users' decisions is known as events approach. The
principal argument used in adoption of the events approach is that,
due to wide ranging use and heterogeneous users of financial
statements, accountants should not direct the published financial
statements to specified ‘assumed’ group.
▪ Events are of two types: Monetary event and Non-monetary event.
Under this approach the main objective of accounting is to supply
information of those monetary events which have relevance in decision
making of the users.
 Events Approach
▪ Advantages: The main advantage of this approach is that it helps
maximization of forecasting accuracy of the accounting statements
because it takes into consideration all probable information of an
economic event which may be useful to the users.
▪ Disadvantages: The limitations of the events approach, however,
are the following:
o Events approach presupposes that the users are knowledgeable
enough to be able to classify and aggregate accounting data for
their own use.
o Events approach does not mention which data are to be selected
for the financial statements.
o There is definite limit to the amount of data a person can handle
at a time. The expansion of data may cause information overload to
the users.
 2- Decision Model Approach
▪ The accounting approach, where an ideally adequate decision model
is pre-determined on the basis of anticipated needs of the users of the
financial statements, is identified as decision model approach.
▪ In this approach, the information need of different users for making
decisions is emphasised upon. Keeping an eye to this need all
probable information which may be helpful to the users is presumed
with care.
▪ On the basis of such anticipated information standard or ideal
decision models are pre-fixed.
▪ Advantages: Such accounting principles or techniques are
formulated which may be the best fit for meeting information need of
the users.
3- Behavioral Approach
In most of the approaches to the formulation of accounting theory,
how the accounting practice should be done that is emphasized
upon. But how is the accounting theory applied or used in practice
that question is not considered at all.
▪ The behavioral approach is concerned with user’s reaction to
accounting reports as a basis for descriptive generalization about the
behavioral aspects of particular accounting techniques and problems
such as:
o The adequacy of disclosure;
o The usefulness of financial statement data;
o Attitudes about corporate reporting practices;
o Materiality Judgment; and
o The decision effects of alternative accounting valuation bases.
3- Behavioral Approach
- In behavioral approach, the behavioral aspect of accounting theory is
accepted as the basis for formulation of theory. So the approach, where the
need and behavior of the users of accounting information are taken as the
primary consideration for the formulation of accounting theory, is
identified as behavioral approach.
▪ Accounting is practice oriented work which directly and indirectly affects
human behavior. This behavior orientation of accounting paves the way of
introducing the concept of behavioral science in developing its principles
and techniques. Under this approach it is accepted that accounting should
be done keeping an eye to the objectives and behavior of the users of
accounting information. For this purpose, the choice of accounting
principles should be based on what information the users need and what
would be their behavior in relation to that information. As accounting is
identified as a behavioral process the behavioral approach makes
accounting ideas nearer to behavioral science.
▪ This approach is on the process of continuous research. It has not yet
been finished and no theory has yet been formulated following this
approach.
3- Predictive Approach
▪ Like other modern approaches this approach is also decision oriented;
but here decision is not the primary goal, primary goal is prediction for
decision. Under the traditional approach accounting measures are
generally used for non-predictive purposes e.g., In the predictive approach
however, accounting measures are not just considered as real exercise.
This approach is based on predictive forecasting to take future decisions
on the basis of data supplied by accounting. Under predictive approach
the principles are formulated taking into consideration the predictive
capacity of accounting information.
▪ According to this approach, when accountant confronted with the choice
between different measurement alternatives, they will select that measure
alternative, which provide the greatest predictive power in respect to a
given event. The predictive approach is directly related to the predictive
ability of financial data and is to provide a standard that relate the
function of collecting financial data to the task of decision-making
Comparison between Descriptive Theory
and Normative Theory
• Concept: The descriptive theory is predictive model whose validity
is independent of the acceptance of goal structure. normative theory
requires a commitment to goals and therefore requires a policy maker
to make value judgments.
• Purpose: Descriptive theories are concerned with how the world
works, e.g., if a business enterprise changes from FIFO to LIFO and
the share market has not anticipated the change, the share price will
rise. On the other hand, normative theories are concerned with
prescriptions, goal setting. E.g., the statement, ‘if prices are rising,
choosing a LIFO system will maximize the value of the firm’ is
refutable by evidence. Thus given an objective, a researcher can turn a
prescription into a conditional prescription and assess the empirical
validity.