APPROACHES TO ACCOUNTING THEORY FORMULATION

Theory construction and verification:

Although accounting is a set of techniques that can be used in specified fields, it is
practiced within an implicit theoretical framework composed of principles and
practices that have been accepted by the profession because of their alleged
usefulness and their logic. These “generally accepted accounting principles” guide
the accounting profession in the choice of accounting formulation theory and in the
preparation of financial statements in a way considered to be good accounting
practice. In response to changing environments, values, and information needs,
generally accepted accounting principles are subject to constant reexamination and
critical analysis, which describes the principles as follows:
Present generally’ accepted accounting principles are the result of an evolutionary
process that can be expected to continue in the future. Changes may occur at any
level of generally accepted accounting principles. Generally accepted accounting
principles change in response to changes in the economic and social conditions, to
new knowledge and technology; and to demands of users for more serviceable
financial information. The dynamic nature of financial accounting — its ability to
change in response to changed conditions — enables it to maintain and increase
the usefulness of the information it provides.
The process of accounting theory construction should be completed by theory
verification or theory validation. Machlup defines this process as follows:
Verification in research and analysis may refer to many things, including the
correctness of mathematical and logical arguments, the applicability of formulas and
equations, the trustworthiness of reports, the authenticity of documents, the
genuineness and paraphrases, the accuracy of historical and statistical accounts, the
corroboration of reported events, the completeness in the enumeration of
circumstances in a concrete situation, the reproducibility of experiments, the
explanatory or predictive value of generalizations.
Accounting theory formulation therefore, should be the result of both a process of
theory construction and a process of theory verification. A given accounting theory
should explain and predict accounting phenomena: when such phenomena occur,
they should be regarded as verification of the theory. If a given theory is unable to
produce the expected results, it is replaced by a “better” theory.

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Scientific theories provide certain “expectations” or “predictions” about phenomena
and, when these expectations occur, they are said to “confirm” the theory. When
unexpected results occur, they are considered to be anomalies which eventually
require a modification of the theory or the construction of a new theory. The purpose
of the accounting theory formulation or the modified theory is to make the unexpected
expected, to convert the anomalous occurrence into an expected and explained
occurrence.
To date, this line of thinking has not been strictly’ followed in accounting. Instead, two
approaches have been used. In the traditional approach to accounting formulation
theory construction, accounting practice and verification are considered synonymous;
in the new approaches to accounting theory construction, attempts are made to
logically or empirically verify the theory.

The nature of an accounting formulation theory:

The primary objective of accounting formulation theory is to provide a basis for the
prediction and explanation of accounting behavior and events. A theory is defined as
“a set ‘of interrelated constructs (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.
It must be recognized at the outset that no comprehensive theory of accounting exists
at the present time. Instead, different theories have been and continue to be proposed
in the literature. Many of these theories arise from the rise of different approaches to
the construction of an accounting theory or from the attempt to develop theories of a
middle range, rather than one single comprehensive theory. Accounting theories of a
middle range result from differences in the way researchers perceive both the “users”
of accounting data and the “environments” in which the users and preparers of
accounting data are supposed to behave. These divergences led the American
Accounting Association’s Committee on Concepts and Standards (or External
Financial Reports) to conclude that:
1. No single governing theory of financial accounting is rich enough to
encompass the full range of user-environment specifications effectively;
hence,

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 2. There exists in the financial accounting literature not a theory of financial
accounting, but a collection of theories which can be arrayed over the
differences in user-environment specifications.
METHODOLOGIES FOR THE ACCOUNTING FORMULATION THEORY:
We have now established that an accounting theory is possible if(1) it constitutes a
frame of reference, (2) it includes three elements: encoding of phenomena to
symbolic representation; manipulation or combination according to rules; and
translation back to real-world phenomena
As in any other discipline, a methodology is required for the formulation of an
accounting theory. The divergence of opinions, approaches, and values between
accounting practice and accounting research has led to the use of two
methodologies; One is descriptive; the other normative.
In the professional world of accounting, the belief is widely held that accounting is
an art that cannot be formalized and that the methodology traditionally used in the
formulation of an accounting theory is an attempt to justify what is by codifying
accounting practices. Such a theory is labeled descriptive accounting or a
descriptive theory of accounting.
The descriptive accounting approach has been criticized by proponents of a
normative methodology. Normative accounting formulation theory attempts to justify
what ought to be, rather than what is. Such a theory is labeled normative accounting
or a normative accounting formulation theory.

Approaches to the accounting formulation theory

Although there is no single comprehensive theory of accounting, various accounting
theories of a middle range have resulted from the use of different approaches.

Traditional Approaches to Accounting Theory Formulation

The traditional approaches are:
1. Non-theoretical, practical, or pragmatic (informal).
2. Theoretical.
1. Non-theoretical approaches:
The non-theoretical approaches are a pragmatic (or practical) approach and
authoritarian approach.

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The pragmatic approach consists of the construction of a theory characterized by its
conformity to real-world practices that is useful in terms of suggesting practical
solutions. According to this approach, accounting techniques and principles should
be chosen on the basis of their usefulness to users of accounting information and
the; relevance to decision-making process. Usefulness, or utility, means “that
property which fits something to serve or to facilitate its intended purposes”.
The authoritarian approach to the accounting formulation theory, which is employed
primarily by professional organizations, consists of issuing pronouncement 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 predicated on
the basis of the ultimate uses of financial reports, if accounting is to have a useful
function, In other worlds, a theory without practical consequences is a bad theory.
The pragmatic and authoritarian approaches have been largely’ unsuccessful in
caching satisfactory conclusions in their attempts to construct an accounting theory.
For instance, Skinner claims that:
In essence, the pragmatic approach to the development of accounting principles
has been followed by accounting authority in the past, and attempts to reduce
conflicting practices have until recently been extremely cautious and tentative. It is
apparent on the basis of experience that this approach will never, by’ itself, come
close to solving the problem of conflicts in accepted accounting principles.
Utility is cited as a main objective of accounting various writers in the literature,
including Fremgen and Prince. Mueller also argues that accounting principles
should be developed through a pragmatic approach. The practical attempts should
not be discarded simply because they are basically non-theoretical. Practical
approaches are necessary to any theory’ with an operational utility In fact, pragmatic
considerations permeate the field of accounting through the generally accepted
standard of relevance.

2. THEORETICAL APPROACHES
Theoretical approaches to the development of an accounting theory are many such
as:
a. Deductive approach

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 b. Inductive approach
c. Ethical approach
d. Sociological approach
e. Economic approach
f. Eclectic approach
Deductive approach:
The deductive approach to the construction of any theory begins with basic
propositions and proceeds to derive logical conclusions about the subject under
consideration. Applied to accounting, the deductive approach begins with basic
accounting propositions or premises and proceeds to derive by logical means
accounting principles development of accounting techniques. This approach moves
from the general (basic propositions about the accounting environment) to the
particular second). If we at this propositions about the accounting consist of both
objectives and postulates, the steps used to derive the deductive approach will
include:
 Specifying the objectives of financial statements.
 Selecting the “postulates” of accounting.
 Deriving the “principles” of accounting.
 Developing the “techniques” of accounting.
Inductive approach:
The inductive approach to the construction of a theory begins with observations and
measurements and moves toward generalized conclusions. Applied to accounting,
the inductive approach begins with observations about the financial information of
business enterprises and proceeds to construct generalizations and principles of
accounting from these observations on the basis of recurring relationship. Inductive
arguments are said to lead from the particular (accounting information depicting
recurring relationships) to the general (postulates and principles of accounting). The
inductive approach to a theory involves four stages:
1. Recording all observations.
2. Analysis and classification of these observations to detect recurring
relationships ( likes and similarities )
3. Inductive derivation generalizations and principles of accounting from
observations that depict recurring relationships.
4. Testing the generalizations.

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Unlike the deductive approach of the propositions does not depend on other
propositions, but must be empirically verified. In induction, the truth of the
propositions depends on the observation of sufficient instances of recurring
relationships.
Similarly, we may state that accounting propositions that result from inductive
inference imply special accounting techniques only with more or less high
probability; whereas the accounting propositions that result from deductive inference
lead to specific accounting techniques with certainty
This type of inductive reasoning to derive goals implicit in the behavior of an existing
system is not intended to be pro-establishment to promote the maintenance of the
status quo. The purpose of such 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. Good 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.
Ethical approach:
The basic core of the ethical approach consists of the concepts of fairness, justice,
equity and truth. Such concepts are D.R. Scott’s main criteria for the formulation of
an accounting theory Scott equates “justice” with equitable treatment of all
interested parties, “truth” with true and accurate accounting statements without
misrepresentation, and “fairness” with fair, unbiased, and impartial presentation.
Accountants since Scott have considered these three concepts to be equivalent. in
contrast, perceives only justice and fairness as ethical norms and views truth as a
value statement. The “fairness” concept has become implicitly ethical; in general,
the “fairness” concept implies that accounting statements have not been subject to
undue influence or bias. “Fairness” generally implies that the preparers of
accounting information have acted in good faith and employed ethical business
practices and sound accounting judgment. “Fairness” is a value statement that is
variously applied in accounting. Patillo ranks “fairness” as a basic standard to be
used in the evaluation of other standards, because it is the only standard that

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implies “ethical considerations”. Spacek goes one step further in asserting the
primacy of the “fairness” concept:
A discussion of assets, liabilities, revenue, and costs is premature and meaningless
until the basic principles that will result in a fair presentation of the facts in the form
of financial accounting and financial reporting are determined. This fairness of
accounting and reporting must be for and to people, and these people represent the
various segments of our society.
Whatever it may connote, fairness has become one of the basic objectives of
accounting. The Committee on Auditing Procedures refers to the criteria of fairness
of presentation” as (1) conformity with generally accepted accounting principles, (2)
disclosure, (3) consistency, and (4) comparability. In an unqualified report, the
auditor not only states compliance with generally accepted accounting principles
and generally -accepted auditing standards but also expresses an opinion with the
words “present fairly”. Thus, the conventional auditor’s report reads as follows:
In our opinion, these consolidated financial statements present fairly the financial
position of the company as of June 30, 2017, and the results of its operations and
the changes in financial position for the year then ended in accordance with IASs/
IFRSs applied on a basis consistent with that of the preceding year.

Sociological approach:
The sociological approach to the formulation of an accounting formulation
theory emphasizes the social effects of accounting techniques. It is an ethical
approach that centers on a – broader concept of’ fairness, social
welfare. According to the sociological approach, a given accounting principle or
technique is 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 in making social welfare judgments. To accomplish its objectives,
the sociological approach assumes the existence of “established social values” that
may be used as criteria for the determination of accounting theory. 5° It may be
difficult to identify a strict application of the sociological approach to accounting
theory construction, due to the problems associated with determining acceptable
“social values” for all people and with identifying the information needs of those who
make welfare judgments.

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Bedford says the plays the role of a lubricant, facilitating the functioning of society in
an operational sense. Specifically, measured income is used as a computed amount
to accomplish objectives necessary for the operation of society-
The sociological approach to the formulation of an accounting formulation
theory has centralized to the evolution of a new accounting sub discipline, known
as socioeconomic accounting. The main objective of socioeconomic accounting is to
encourage the business entities the function 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.
Economic approach:
The economic approach to the formulation of an accounting theory emphasizes
controlling the behavior of macroeconomic indicators that result from the adoption of
various accounting 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 the 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 with other macroeconomic policies. More explicitly
the choice of accounting techniques will depend on the particular economic
situation. For example, the last in, first out (LIFO) method will be a more attractive
accounting technique during periods of continuing inflation than the first in, first out
(FIFO) or average cost methods, because LIFO is assumed to produce a lower
annual net income assuming higher, more inflated costs for the goods sold.
The government contested the use of the deferral method on the basis that the
incentive effect of an instrument of fiscal policy. The economic approach and the
concepts of “economic consequences” and “economic reality” have been revived
since the creation of the Financial Accounting Standards Board. Most of the
questions examined during the short life of the Board have been the subject of a
critical examination in terms of the economic consequences of possible
recommendations. Some examples are accounting for research and development,
self-insurance and catastrophe reserves, development-stage companies, foreign

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 currency fluctuations, leases, the restructuring of troubled debt, inflation accounting
and accounting in the petroleum industry.
The eclectic approach to the accounting theory formulation
In general, the formulation of an accounting theory formulation and the development
of accounting principles have followed an eclectic approach, or a combination of’
approaches, rather one of the approaches presented result of numerous attempts
by individuals and professional and governmental organizations to participate in the
establishment of concepts and principles in accounting. This eclectic approach has
given rise to the new approaches being debated in the literature: the regulatory
approaches, the behavioral approaches, and the event, predictive, and positive
approaches.
Conclusions:
The traditional-approach to the accounting theory formulation has employed a
normative or a descriptive methodology, a theoretical or a non-theoretical approach,
a deductive or an inductive line of reasoning, and has focused on a concept of
“fairness”, “social welfare”, or “economic welfare”. Whatever approach is chosen, it
is important to remember that an accounting theory must be confirmed to be
accepted.

Regulatory approaches

Numerous would regard this as the approach we presently have to accounting theory.
They grip this view because to them it does not look that standards, even those of the
IASB, are based on broad, related theories but are developed as solutions to current
conflicts that arise in our attempts to provide beneficial information to manipulators.
Certainly, they might argue that new standards are only developed when a specific
manipulator complains about misrepresentation or non-information. But there are
questions to consider if we do adopt this approach to the development of accounting
theory. In the main these queries center on whether we should accept a free market
approach to the regulation, a private sector regulatory approach or public sector
regulatory approach. This regulatory approach is also one that tends to recognize
solutions to difficulties that have occurred in our reporting rather than providing us with a
theory that anticipates the issues.

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New approaches

These efforts to use both conceptual and empirical reasoning to formulate and verify an
accounting framework. The approaches are:

 Events approach

 Behavioral approach

 Human Information Processing approach

 Predictive approach

 Positive approach

Events approach

The events approach was developed in 1969 by George Sorter and was defined as
‘providing information about relevant economic events that might be useful in a variety
of decision models’. The events approach leaves the manipulator to aggregate and
allocate weights and values to the event. The accountant would only provide information
on the economic event to the user, he would not undertake a decision model. Thus, for
example, the event approach income statement would not specify financial performance
in a period but would transfer events that occurred during the period without any attempt
to determine a bottom line.

Behavioral approach

The behavioral approach attempts to take into account human behavior as it narrates to
decision making in accounting. Devine (1960) stated the following:

On balance it seems fair to conclude that accountants seem to have waded through
their relationships to the intricate psychological network 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 recognize that much of what passes as accounting theory is
hopelessly entwined with unsupported behavior assumptions is unforgivable.

This to us seems fair remark. Given that financial reporting is about communicating
information to users to permit them to make decisions, a lack of attention of how that
information influences their behavior is certainly unforgivable. Studies in this area have
tended to concentrate on:

o The adequacy of disclosure

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 o Usefulness of financial statement data

o Attitudes about corporate reporting practices

o Materiality judgements

o Decision effects of alternative accounting practices

In one of these areas, materiality, it was discovered that manipulators’ assessment of

materiality was individualistic and that the provider of the information was not in the
finest position to determine materiality for a manipulator. There is much work still to do
within the behavioral approach.

Human information processing approach

This is comparable to a behavioral approach in that it focuses on how manipulators

interpret and use the information provided.

Predictive approach

This approach attempts to formulate an accounting theory by focusing on the analytical

nature/ability of a particular method of reporting an event that would be of use to the
manipulator. Such approaches are most predominant in what could be regarded as
management accounting. Efficient market hypothesis, Beta models, chaos theory are all
examples of this approach.

Positive approach

This can be best clarified by quoting Jensen (1976), who called for thebdevelopment of
a positive theory of accounting which will explain why accounting is what it is, why
accountants do what they do, and what effects these phenomena have on people and
resource utilization.

The approach is based on the proposition that managers, shareholders and regulators
are rational and that they effort to exploit their utility. The theory became known as ‘the
Rochester school of accounting’. The positive approach is totally reverse to the
normative approach and efforts to explain why accounting procedures and policies are
as they are, whereas the normative approach attempts to suggest the accounting
procedures and policies to be implemented.

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