Varied Theories of Accounting - Literature review Example

Accounting Theories Introduction Accounting is not only a fundamental process for modern firms and institutions, but also, an imperative one for those organizations that seeks to establish its past financially and it’s present financial standing in order to effectively and efficiently plan for the organization’s future success as highlighted by Porwal (2001). Primarily, accounting entails the process of documenting, categorizing and summarizing various business transactions. It also encompasses the establishment, calculation and communication of financial information meant to allow informed choices and judgments by users of accounting information as discussed by Coetsee (2010). Accounting is not an option for organizations because they help them in sustaining full and orderly documented records of economic events and transactions, it helps in determining net outcomes in terms of profit and loss margins and depicting the financial positions of organizations through compilation of balance sheets on what the organization owns and owes (Needles et al. 2010). In addition, accounting helps managers in evaluating whether the business is moving to the anticipated financial and economic direction, it helps investors in making informed choices on present and future prospects on where and when to invest and most of all, it furnishes the internal and external environments of an organization with information on the condition of the organization as noted by Schroeder et al. (2010). Categorically, accounting information derived from the accounting process helps the top management in strategizing and making sound financial and economic decisions by understanding the available valuable resources, how, when, and where they should be allocated as highlighted by Deegan (2009). Owing to the significant role accounting plays in market and corporate environments, varied theories and models have been established and suggested to explain the concept, structure and process of accounting. This forms the basis of this study which is to analyze how varied accounting theories can be evaluated and how one can prove the theories since none of them is universally accepted. In addition, analyze how one can demonstrate that one accounting theory is superior to others, what impact internationalization of accounting regulation has or will have and suggest the most superior theory of all accounting theories. What is an accounting theory? According to Deegan & Unerman (2011), an accounting theory is a set of interlinked concepts, definitions and recommendations, which illustrate systematic perspectives and analysis of accounting events by identifying correlations among varied accounting variables, with the view to explain and predict present and future accounting phenomena. Accounting theories provides rational reasoning in form of broad standards, which generates frameworks of reference, by which accounting processes can be examined and help in establishment of new accounting practices and procedures (Kakani, 2007). Varied theories of Accounting In order to effectively and efficiently analyze how accounting theories can be evaluated and how one can prove varied theories and demonstrate their superiority, it is vital to discuss the existing accounting theories. Among major theories of accounting includes normative theories or prescriptive approaches, pragmatic theories, syntactic and semantic theories and positive accounting theory. Normative accounting Theory/ prescriptive approach The Normative theories are prescriptive in nature in that they are founded on developing recommendations on what should be done and prescribes how accounting should be carried out (Schroeder et al. 2010). The approach is founded on subjective views and judgments of how to report and record accounts and how best to carry it out as highlighted by Needles et al. (2010). The theory focuses on determining accounting information which is essential to decision making. More often, assumptions made using this theory are not empirically tested and are based on analytical and empirical recommendations (Deegan, 2009). In addition, the assumptions made in normative theory on the nature of operations of an organization are based on the observations made. Pragmatic theories There are two approaches adopted in pragmatic theories of accounting which includes descriptive pragmatic approach and psychological pragmatic theory. Descriptive pragmatic theory is an inductive framework where the conduct of accounting personnel such as accountants and auditors are observed with the intent to emulate their accounting practices, standards and procedures (Schroeder et al. 2010). The main criticism for this approach is that it lacks analytical opinions on the quality of actions of accountants and it does not challenge accounting techniques or permit change (Deegan & Unerman, 2011). The theory is limited because it puts more emphasis on the character and conduct of the accounting personnel and less on measuring the nature of the firm (Porwal, 2001). On the other hand, psychological pragmatic theory is concerned with observing the response of users of accounting information about the outputs of accountants, where the response observed is considered as verification that financial statements are crucial and relevant (Schroeder et al. 2010). The main criticism to the approach is that users are more likely to respond irrationally, they may have pre-conditioned responses and the users of accounting information may fail to respond when required to (Porwal, 2001). Syntactic and semantic theories The syntactic and semantic theories are theoretical frameworks of accounting that is linked to conventional historical cost accounting and theories that have semantic content depending on its inputs respectively. The main limitation of the approaches is that the approach lacks autonomous empirical evidence to validate the calculated outputs as echoed by Deegan & Unerman (2011). Positive accounting theory According to Watts and Zimmerman (1986), positive accounting theory explains the accounting practice. The theory is based on explaining and predicting which organizations will or will not utilize a specific accounting technique. The theory puts more emphasis on correlations among different variables and how accounting is utilized to help in the performance of these correlations (Schroeder et al. 2010). Among such correlations include shareholders and managers and managers and the creditors among others. Primarily, the positive or financial accounting theory elucidates on the how, what and give predictions on accounting procedures and practices and it assist regulators to determine the economic impact of varied accounting procedures and practices (Watts & Zimmerman, 1978). The assumptions of the theory are that the accounting information is a political and an economic product and more often than not, people especially managers, act and react in their own self interests (Deegan, 2009). There are numerous accounting theories that relate to the accounting for changing prices and to the measurement of the elements of accounting – assets, liabilities, revenues, expenses, and owners’ equity. None of them is universally accepted. None of them is totally proven. The question therefore is, how can we then evaluate these theories and how can one prove any of the theories How can we evaluate various accounting theories? How can we prove one or other of those theories? The main aim of a good accounting theory is to offer a conceptual framework for observing and understating accountancy, which means that an accounting theory is either functional or not. A good theory of accounting is vital in guiding and focusing attention, establishing and defining critical accounting variables and postulating the correlations between the accounting variables as discussed by Needles et al. (2010). Important to note is that an effective accounting theory is founded on empirical evidence, which makes it relevant and sufficient for present time and holds up under all known standards. Having said that, knowing how to evaluate accounting theories and how to prove any of these theories since they are not universally accepted is vital in establishing which accounting theory is best suitable to apply in any given situation. Effectively evaluating various accounting theories entails examining the ability of the theories to measure up to particular aspects which includes measurement, operationality, parsimony, usability, generativity, importance, scope, internal consistency, empirical support, and falsifability Measurement Kakani (2007) defines measurement as the instrumentation utilized to acquire empirical data. In relation to measurement, evaluating a good accounting theory involves determining the level of measurement of all data be it nominal, ratios, ordinal or intervals and establishing that the findings founded using the level of measurement are justified (Schroeder, et al., 2010). Moreover, establishing if the measurement format permit variability alongside significant dimensions, examining how the measured constructs are defined and if they are consistent with the specific theory, establishing on whether the statistics for processing the data and describing the findings are suitable and examining whether the reliability and validity of the measurement are sufficient to draw conclusions (Swenson, 1999). Therefore, an effective accounting theory must at least possess these attributes in regards to measurements. Operationality An effective accounting theory must have operationally defined terms and concepts that allow the theory to be testable. Being operationally defined allows varied researchers to carry out similar researches and draw similar conclusions (Deegan, 2009). For this reason, evaluating an accounting theory involves assessing whether the theory have clear definitions and if its able to establish important central accounting variables and their correlations as suggested by Swenson (1999). Parsimony (Swenson, 1999) defines parsimony as the criteria for evaluating theoretical frameworks under the assumptions that among the aims of a theory is to elucidate reality through simplification. Therefore, an accounting theory should generate frugal explanations with assumptions in generally accepted parameters (Kakani, 2007). This means, assessing the theory by establishing whether the theory utilize unconventional assumptions and if it in fact does utilize unconventional assumptions, whether they can be empirically or logically justified. Moreover, establishing if the theory contributes to the understanding of the phenomena or it merely reiterates concepts and ideas already accounted for by a different theory (Swenson, 1999). Usability Usability entails a theory’s capacity to explain events more accurately and with enhancing utility (Swenson, 1999). This means, an accounting theory should be assessed based on its capacity to generate distinctions in accounting variables and their correlations. This helps explain what the phenomena is, its ability to highlight how the phenomena operates by focusing on the correlation between accounting variables and its capacity to predict the future by establishing anticipated outcomes by observing correlations between accounting variables under varied conditions and across time (Deegan & Unerman, 2011). In addition, its ability to propose effective responses, by fully comprehending the accounting variables, how they correlate in varied situations and over time and the outcomes, which help in allowing interventions to alter the outcomes (Swenson, 1999). Generativity (Swenson, 1999) suggest that a good theoretical framework must develop hypothesis concerning events within the scope of the theory. In addition, it should not only propose a different outlook but also, rouse controversy and even resistance as a way of broadening the inquiry (Swenson, 1999). Therefore, an accounting theory should be evaluated by establishing its ability to stimulate thinking, provide justifications that account for events, permits development of new hypothesis, generate and extend discussions and even develop more research and research questions on accountancy. Importance Primarily, a theory should account for fundamental and relevant phenomena (Swenson, 1999). For this reason, an accounting theory should be evaluated based on what impact the theory makes and the difference made by the justifications generated from the theory’s utilization Scope Various theories differ in their span, capacity and breadth to which they imply to account for varied phenomena as noted by Swenson (1999). When evaluating accounting theories it therefore entails analyzing what each theory implies to account for, whether the theory’s propositions encompasses all relevant factors within the purported scope and analyzing whether the theory function within its scope of convenience or if it unsuitably operating outside its range (Deegan, 2009). Internal consistency Consistency is a key element in evaluating a theory. The concept and the suggestions within a theory should be rationally consistent with each other. The suggestions and concepts of the theory must be correlated and constructed on each other (Swenson, 1999). Thus, evaluating accounting theories in order to prove any of them entails examining whether the concepts of each theory correspond to each other, with justifiable explanation for any contradiction observed, assessing whether the concepts generate logical explanations of accounting events and if the constructs used to develop conclusions are rationally consistent and justifiable. Empirical support Swenson (1999) implies that a good theory must permit for it to be tested in a manner which generates evidence on whether its explanations and suggestions should be embraced or discarded. When evaluating accounting theories, it means establishing if empirical studies have been carried out that supports the accuracy and utility of each theory, understanding how each theory handle contradictory evidence and determining if the research design used by each theory is suitable for drawing conclusions on the sufficiency of each theory and if there is any evidence which reinforces the propositions and explanations made by each theory (Porwal, 2001). Falsifiability An important feature of a good theory is it should be well defined and generates propositions which are questionable enough to permit tests to disprove it (Swenson, 1999). Therefore, when evaluating accounting theories it entails assessing whether each theory is open to change and disapproval. This means that an effective accounting theory should not only be testable and challenge its primary constructs but also, have clear criteria that justifies rejection of the constructs (Deegan & Unerman. 2011). Each one of the accounting theories can be proved by establishing the accounting theory’s ability to incorporate the important constructs, aspects and relationships between accounting variables. In addition, the ability of any of the model to answer key questions about the phenomena which includes what is this? How do relationships between accounting variables operate and function? What happens next? And conclusively, what can we do about the phenomena or how can we influence it? How can we demonstrate that one theory is superior to the others? Demonstrating that one accounting theory is superior than the other is easier said than done since, different accounting theories provide different explanations and diversity which is required to explain accounting events and practices and predicting future accounting processes, procedures and practices. By evaluating the different theories of accounting namely normative theories or prescriptive approaches, pragmatic theories, syntactic and semantic theories and positive accounting theory, one is able to assess which of the theories of accounting incorporates and contains majority of the aspects and elements needed to develop a good accounting theory as suggested by Swenson (1999). This means the most superior accounting theory not only generate assumptions and justifications within generally accepted parameters, rely on empirical evidence to justify unconventional assumptions, generate questionable and violate constructs, systematically constructs on and broaden exiting knowledge but also, enable itself to be appraised and its measurements levels are well defined. In addition, a superior accounting theory should be able to account for events with enhanced accuracy and utility by offering a language that make distinctions, highlighting the relationship between accounting variables and effectively and efficiently predicting anticipated outcomes to be able to influence outcomes or change the outcomes (Deegan, 2009). A superior accounting theory should not only prescribe directions but base its assumptions not only on reason but also on empirical evidence. In addition, it should stimulate controversy, generate more hypothesis and questions and generate more research. What impact on these questions do you think the internationalization of accounting regulation has had, or will have? Owing to the impact of globalization in contemporary business and market environments, organizations are increasingly exchanging information, products, services, systems and processes over great distances. With easy access to information and more and more organizations trading across borders, developing accounting standards, policies, regulations and systems that effectively and efficiently meet the accounting needs of each organization regardless of its location is integral (McGregor, 1999). Accounting regulations constitute laws, regulations and guidelines that accountants and auditors and the organizations they work for need to comply with in order to safeguard against accounting malpractices as defined by McGregor (1999). Primarily, accounting plays a significant role in market economies particularly with the rapid globalization of capital markets, which necessitates for organizations to embrace comparable, consumer centred and transparent accounting systems, practices and processes. By fully understanding which accounting theory is superior to the others through proper evaluation of the theories of accounting and proving the worth of each, develops a solid ground for developing and implementing internationalization of the accounting regulations where accountants across the globe are compelled to rely on one superior accounting theory which helps in generating consistency in accounting decisions despite the jurisdictions where the accountant is (McGregor, 1999). Consistency is crucial in enforcing laws and limiting loop holes in the accounting practice and processes. Internationalization of accounting regulations means developing standards, policies and guidelines for accountants that are applicable globally. This has a positive impact of enhancing the integrity of accountants and improving the perceptions the public has about the accounting industry/ fraternity. Implementing a superior accounting theory based on the evaluation of the existing theories of accounting, provides an effective framework for ensuring current differences that exists in the accounting practice and procedures are addressed (Swenson, 1999). Nevertheless, enforcing an internationalized accounting regulations are difficult to implement and sustain since accounting regulations and standards are unique to varied nations and are therefore, designed in an environment characterized by different social, political, economic, cultural and educational processes and systems constructed over histories, geopolitical structures and cultures as indicated by McGregor (1999). Therefore, generating answers to the questions on how one can evaluate varied accounting theories, how one can prove one theory over the other and how to demonstrate the superiority of one theory over others is only the first step to realizing a unified accounting regulatory system. The answers to these questions should be coupled with establishing elements and features that generates differences or variations between accounting systems and regulations and make efforts to standardize the regulations for them to be applied internationally/ universally. This will then help realize a situation where all business organizations globally prepare and carry out their accounting duties, and practices in agreement with one cohesive systems of accounting rules (Deegan & Unerman, 2011). As it stands, varied streams of accounting principles and regulations such as the IAS and the GAAP in UK among others are the main threats for effective and efficient accounting practices and systems since although indirectly, they operate contrary to coordination of accounting practices. McGregor (1999) notes that internationalization of accounting regulations and systems has or will enhance cross-border portability and movement of accounting practices and systems needed by organizations and accounting institutions. Developing accounting practices and systems that are not only reliable, but also transparent and comparable help in efficient running of market economies universally (Porwal, 2001). This is necessitated by the growing numbers of multinational companies and the advance in reach, scope and size of foreign direct investments and international trade in securities. The reliability and integrity of existing accounting practices and systems which are influence by existing theories of accounting is criticized especially when similar business transactions and financial activities are accounted for in varied ways in diverse nations as noted by Porwal (2001). Internationalization of accounting regulations based on superior accounting theory enhances comparability among accounting standards by setting restrictions on the options permitted for similar transactions and permits room for options especially for cases where economic realities varies (McGregor, 1999). Interestingly, internationalization of accounting regulations impact on the questions by ensuring accounting theories that generate harmony, which enhances transparency and foster comparability are advocated and recommended for usage as point of reference on accounting issues and events. Internationalization of accosting regulations is beneficial to investors as they allow comparability of financial information and hence allows them to make informed investment choices, multinational companies have an added advantage in that they are not compelled to make varied financial reports for different countries where they operate and stock markets profit from increase in security listings and volume of securities trade (Deegan & Unerman, 2011). Which theory is the most superior of them all and what are the reasons In my personal opinion, the most superior of the theories of accounting is the positive / financial theory of accounting. Unlike the normative theory that operates on working to create an ideal accounting system and structures, the positive accounting theory create accounting standards and concepts based on scientific methodology of explaining accounting events and practices and predicting future anticipated outcomes based on observed and analyzed relationships of accounting variables over time and in different conditions (Deegan, 2009). Based on the information earlier highlighted on how to evaluate the accounting theories and how to prove any of them in order to determine which is superior, the positive accounting theory is the only on that is able to effectively incorporate majority of the elements discussed. That is, the elements of measurability, operationality, parsimony, usability, generativity, importance, scope, internal consistency and empirical support. The theory does not merely generate assumptions but is does so based on empirical evidence (Deegan, 2009). The theory effectively stimulates discussions, generate more research, provide a basis for more hypotheses and fully answer four critical questions which include what is this? In relation to an accounting evens or practices, how do relationships between accounting variables operate and function? What happens next? And what can we do about the phenomena or how can we influence the outcomes? The financial accounting theory or the positive accounting theory analyzes accounting practice from varied dimensions. The two dimensions highlighted by the positive accounting theory includes the efficiency perspective which highlight how different managers of accounts select accounting techniques which offers true demonstration of the performance of the organization (Deegan, 2009). This explains the adoption of accounting procedures and practices implemented by organizations which are usually aligned to giving the true representation of the financial performance of the organization. The other dimension is the opportunistic perspective which suggests that accounting managers act and choose accounting practices and systems that serve their own self interests (Deegan & Unerman, 2011). This means, they adopt accounting principles and policies, which permits them to acquire as the organizations acquires (Watts & Zimmerman, 1978). Among other reasons I perceive positive accounting theory to be superior to other theories of accounting is that it has approaches that highlight important aspects and variables of accounting. Among approaches within positive accounting theory includes the contracting theory, capital market based research and behavioural research as discussed by Deegan (2009). The main limitation of normative theories of accounting which makes the positive accounting theory more effective is that, normative accounting theory prescribes how to carry out a specific accounting practice without putting into considerations that the prescriptions can depart from current accounting practices (Kakani, 2007). According to Deegan (2009), financial theory of accounting concentrates on correlations among varied entities and variables and focuses on how accounting can be utilized to help in effective functioning of the correlations. The positive accounting theory has generated varied options for hypothesis that can be used to effectively, efficiently and accurately explain and predict endorsement or rejection of an accounting practice, system or even technique. The three hypothesis generated by the theory includes the debt hypothesis, the bonus plan hypothesis and political cost hypothesis (Deegan & Unerman. 2011). Nevertheless, positive accounting theory has been heavily criticized for failure to offer prescriptions in relation to what need to occur instead of merely explaining and predicting. In addition, it is perceived that the theory is not value free as it merely explains and predicts what account managers might do and fails to give focus on what they are supposed to do (Deegan, 2009). Its assumptions that all account managers and owners of firms intentions and actions are guided by their self interest to enhance their own wealth without giving thought to the consequence is limited (Deegan & Unerman, 2011). This is because, not all firm owners and accounting managers act on their self interests. Be it as it may, positive accounting theory still remains the most superior of the accounting theories as it considers both logic and empirical evidence, it reaffirms, it is flexible to changes and it does what other theories of accounting fails to do. That is, the weak points of the other accounting theories are the main strong points of positive accounting theory. Primarily, the theory’s assumptions confirm actions and decisions made by accounting managers in the past which are illustrated by real life examples such as the Enron case and the World Com case. Conclusions By aligning positive accounting theory with the concept of internationalization of accounting regulations helps in mediating between differing interests of accounting managers and the investors with investors requiring access to useful information and accounting managers objecting to making this information accessible and available to investors. The two approaches in positive accounting theory namely behavioural and agency theories are crucial to financial accounting, making positive accounting theory the superior of all the other accounting theories. The report has analyzed in detail how to evaluate various accounting theories and how one can prove the accounting theories. Moreover, assessing how one can demonstrate that one accounting theory is superior to others, what impact internationalization of accounting regulation has or will have on the questions and it has suggested the most superior theory of all accounting theories. Among important aspects that one should analyze when evaluating accounting theories includes measurability, parsimony, usability, importance, scope, internal consistency and empirical support. A good accounting theory should stimulate discussions, generate more research, provide a basis for more hypotheses and fully answer four critical questions which include what is this? In relation to an accounting evens or practices, how do relationships between accounting variables operate and function? What happens next? And what can we do about the phenomena or how can we influence the outcomes? 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Retrieved on the 12th Aug 2011. Watts, R. & Zimmerman, J. 1978. Towards a Positive Theory of the Determination of Accounting Standards. The Accounting Review, 53, pp112–134. Read More