Ch 2 - Theory and Method

Ch 2 ACCOUNTING THEORY & METHOD Imposing order Accountants often need to impose some sort of order on imprecise events and transactions so that they can summarize their financial implications •

The accountant will need to exercise appropriate judgment appropriate to a range of professional role –

Analyze the financial implications of transactions

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Assess the impact of transactions

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Establish the legal entitlement

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Calculate the current value

A range of accounting theories Range of theories – provide sometimes conflicting interpretations about the nature and significance of accounting •

a historical record: accounting is concerned with providing a faithful record of the past transactions of an entity – does not see the role of accounting as being to provide info about the value of the firm at a particular point in time

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A language: Accounting Perceived as a language of business.- Business

activities are reported in accounting statements using accounting language Translate economic event and transactions into smthg that can be understood by users.

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intracorporate politics” accounting systems reflect and support the values and needs of specific interest groups - accounting info is constructed and used as a resource to shape company policies esp in decision making and furthering the aims of management

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standards setting as politics: according to this theory, management lobby on accounting standards to increase the likelihood the resultant accounting requirements will serve their own interests , and they select accounting techniques to maximize their own utility

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mythology; asserts accounting systems provide a societal resource to be used in sustaining concepts of rationality and are means of justifying, rationalizing, and legitimizing decisosn that ultimately serve other individual or social ends

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magic: accounting has a veneer of rationality and respectability - behind which an accountant can perform a sleight of tricks which can be compared to a magicians tricks

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communication-decision information: accounting is action orientated - a/c reports prepared in manner suited to the needs of users will have an impact on the decision making needs of managers and investors

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an economic good: theory considers accounting as one part of a wide information set which may include, macroeconomic, political, taxation and other specific

information that effects the performance of a firm. .Theory recognizes that accounting data is not costless to produce and that the a/c standards •

a social commodity : Argues that accounting effects the welfare of different groups in society and can be an agent for social change

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ideology and exploitation: accounting is part of an ideological apparatus of capitalist society: it sustains an reinforces society’s structure and provides techniques for exploiting and extracting wealth in support of elite int groups and the expense of employees and society at large

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a social club; accounting principles and standards only exist to promote the interests and aims of accountants – generate a professional culture and create a monopoly enhance their own image

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Theory formulation

Theory formulation WHAT IS A THEORY A Theory is the logical flow of argument leading from fundamental assumptions and connected statements to final conclusions. Different researchers have different perspectives of the role of accounting theory. a.

Some researchers believe that the principal role of accounting theory should be to “explain and predict” particular accounting-related phenomena.

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Other researchers believe that the role of accounting theory is to “prescribe” particular approaches to accounting based on a perspective of the role of accounting. E.g. a theory that prescribes the assets should be valued on the basis of market values rather than historical costs.

If theories are logical arguments, or systems of statements, how are they developed? -

Through deduction (reasoning from general statements to specific statements) i.e. deductive reasoning from general premises to develop predictions, prescriptions or explanations of specific matters; or

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Through induction (reasoning from the particular to the general) i.e. inductive reasoning from specific observations to develop a general implication of those observations.

Deductive Approach o

Deductive reasoning = entails a valid argument in which it is impossible to assert the premises and to deny the conclusion without contradicting oneself

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Deductive approach to theory constriction: begins with establishing the objective of accounting - once identified then definitions and assumptions are stated - then the researcher must develop a logical structure for accomplishing objectives

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Methodology often goes reasoning from general statements to specific statements

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Validity of any theory developed is highly dependent on the ability of the researcher to correctly identify and relate the various components of the accounting process in a logical manner

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The deductive method is basically are a closed, non empirical system

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By combination the results of observations; theories need to be able to predict or explain features of the environment. The discipline of logicn is required to progress from observation based theories to the prediction or explanation of phenomena. Logical deduction is based on the if....then progressive from “Premises” to logical deduction.

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Inductive Approach o o o o

reasoning from the particular to the general – b/c the research generalizes about the universe on the basis of limited observations of specific situations Induction is a method of reasoning by which a general law or principle is inferred or observed in particular instances Making observations and drawing conclusions from them - the inductivist draws theoretical and abstract conclusions from limited observation of specific situations In accounting involves making observations about financial information of business enterprises and proceeding to construct generalizations and principles of accounting from those observation on the basis of reoccurring relationships The Route from observation to explanation Facts acquired through Universal laws Observation

and theories

Predictions

and explanation

Observation – it enable the observer to produce singular statements which, o o o

by a process of generalization lead to the production of universal statements which may be elevated to theories and laws after a large number of similar observations.

REMEBER ONCE A THEORY IS FORMULATED IT IS VERY IMOIRTANT THAT IT’S VERIFIED Formulating a theory

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Epistemology – the study of the acquisition of knowledge

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Accounting theorists have drawn on the natural sciences

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Accounting: –

Social science

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Measurement and technical process

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Scientific or naturalistic method?

Parts of a theory A theory must be expressesed in a language – can be verbal or mathematical There are three types of relationships in the theoretical structure that should be noted 1 Syntactics: •

Rules of the language used

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Syllogism: set of premises and conclusion

SYNTCTIC Relationship • •

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Represents the logical relations in the theory. For example, the rules of grammar for a language or the rules of mathematics for a mathematically expressed theory. An example in accounting is the double-entry system. A trial balance will always balance by virtue of the construction of the rules of debits and credits and the logic of mathematics. The syntactic, or logical, relationship has to do with the rules of the language used. For example, if the theory is expressed in English, then the relationship refers to the rules grammar; if the theory is mathematical, then this relationship refers to the rules of mathematics. An analytic (or syntactic) methodology relies upon a syllogism. A syllogism consists of a set of premises and a conclusion, such as the following: Premise 1: If all accounting theory students are brilliant, Premise 2: And you are an accounting theory student, Conclusion: Then you are brilliant. This is a syllogism which forms an analytic proposition. We do not need to know the meaning of „accounting theory student‟ or „brilliant‟ to see that the syllogism is logical. It is logical because, if we accept that the premises are true, the conclusion that „you are brilliant‟ necessarily follows. It is important to understand that syntactic relations refer to a flow of logic, not to the accuracy of the argument‟s representation of the „real world‟. As such, evaluating the syntactic relations of a theory involves evaluating the validity (i.e. the logic) of the argument that constitutes the theory. It does not involve establishing truth, where „truth‟ is regarded as accuracy in relation to observations from the real world. If an argument is valid, then if its premises are true its conclusion must also be true. An argument can still be valid if its premises do not accurately represent realworld phenomena or if its conclusions are not correct. The test of validity is simply to ask whether, if the premises were true, the conclusion would necessarily follow. For example, take the following argument: Premise 1: All accounts relating to assets have debit balances. Premise 2: The accumulated depreciation account relates to assets. Conclusion: The accumulated depreciation account has a debit balance. The conclusion, or hypothesis, that the accumulated depreciation account has a debit balance is incorrect. However, the logic is valid because if the premises were both true, the conclusion would also be true. (Premise 1 is incorrect because there are accounts

that relate to assets, e.g. contra asset accounts such as accumulated depreciation, which have credit balances). 2 Semantics: •

Links the basic concepts of a theory to objects in the real world

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Parts of a theory

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The rules of correspondence on operational definitions in the theory. These rules connect symbols, words, terms or concepts with real-world objects, events or functions and are seen to make a theory realistic. An example in accounting is measuring the effects of inflation on assets and liabilities. Theorists in this area argue that by applying adjustments from historical cost to market prices, the accounts now have semantic content and can be related to the real world (which they see as being market prices).

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The semantic relationship links the basic concepts of a theory to objects in the real world. Sometimes these relationships are referred to as rules of correspondence, or operational definitions. Semantic relationships concern the relationship of a word, sign or symbol to a real-world object or event and it is the semantic relationships that make the theory realistic and reasonable. For example, the accounting equation A = L + E is purely abstract. Only as we correlate each concept to real-world objects do we make the equation realistic. The truth value, or semantic accuracy, of a premise is established by reference to real world descriptive accuracy. It is established in relation to individual premises and the conclusion, but not the line of logic (argument). For example, consider the following argument: Premise 1: All asset accounts have debit balances. Premise 2: The sales returns account is not an asset account. Conclusion: The sales returns account has a debit balance. The conclusion that is reached is true because in the real world sales returns accounts have a debit balance. However, if we look at the logic flowing from premises 1 and 2, then the argument is not valid. In this case truth is inductively derived from the observation. However, the syllogism fails any test of logic. That is, logic is flawed. Pragmatics: The effect of words or symbols on people: is an inductive approach where it

based on continual observation of the behaviour of accountants in order to copy their accounting procedures and principles. o o o o

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Relate to the effects of words or symbols on the behaviour of people. Not all theories have a pragmatic orientation, but the nature of accounting makes this relation an important one. For example, the analysis of reactions of investors and other users of published financial reports is an important area of research in accounting theory. The study of pragmatics in accounting leads us to form political and social theories about the reactions of people to financial information

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The nature of accounting is such that if an overall theory of accounting exists, it must have a pragmatic orientation. We are interested in how accounting concepts and their real world corresponding events or objects affect people‟s behaviour. Another pragmatic approach is to observe that people react to the same message in different ways. As an example, investors or other users of accounting reports who base their actions on those accounting reports might either buy or sell shares on the stock market in response to announcements of unexpected high or low earnings.

o Criticism• does not include an analytical judgement of the quality of an accountant’s actions. • Doesnot provide for accounting techniques to be challenge and does not allow for change. Focus in accountant’s behaviour not on measuring the attributes of the firm. Criteria of truth: TESTING A THEORY An important function of a scientific theory is testing to determine whether it is worthy of acceptance Distinction between truth and the criteria of truth Truth = What it means for a statement to be true – confirmed by scientific testing Criteria of Truth: how we determine if a statement is true Philosophers have had difficulty defining the phrase “truth” – this has not stopped scientists from testing theories What is authoritative to one person, however, may not e so for another. People have confidence in different criteria for truth. Three different kinds of criteria or authoritative bases that people use are: -

The dogmatic basis The self-evident basis The scientific basis

If the statement is analytical, the testing is a logical one. Mathematical statements are of this type. Their truth is determined by proving that mathematical rules have been followed. This testing reveals whether analysis is valid rather than true. If an argument is valid and its premise are true, then the conclusion is also true. If the statement is empirical, then persuasive, objective evidence exists to support it. A decision must be made by the experts of the given field of study from which the statement evolves concerning the persuasiveness of the evidence. If by „absolute‟ we mean „certain‟, then truth in science is not absolute, because it is inferred knowledge based on a finite amount of evidence.

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From a behavioural point of view, certainty is a matter of degree and conviction. We behave as though a statement is absolutely true, because we are personally convinced by the evidence. But this type of behaviour can occur with the dogmatic and self-evident bases as well. 1 Dogmatic basis - ‘believe what we read’ o o o o o o o o o o o

Whenever we believe in statements made by others simply because they have been made by an authority, we are using the dogmatic basis for judging truth. We cannot personally observe or test all things, and therefore must rely on others to inform us. Underlying the dogmatic basis is the confidence people have in those who make the statements. Such confidence may be due to religious or political beliefs, to training, or to the charisma, credentials or position of the speaker or writer. In accounting, dogmatism is the basis by which accountants come to accept the validity of rules and procedures. An authoritative body approves pronouncements or accounting standards that are accepted by those in the profession. The weakness of the dogmatic basis is that introspective evidence, including personal bias, is acceptable in determining whether a statement is true. The crucial factor is the individual‟s personal opinion about the person or group making the statement. The objective evidence in support of the statement is secondary. Describe the following authoritative bases: dogmatic, self-evident, and scientific. Which category do you think accounting standards fall into? Accounting standards falls into the dogmatic basis. Accountants believe, adhere to, and accept the validity of accounting rules and procedures as it was informed to them via the experts (being the standard setters in Australia - AASB)

2 Self-evident basis - Reasonableness o o o o o o o

The justification of self-evidence as a way to determine truth is the reasonableness, sensibility or obviousness of a statement based on our general knowledge, experience and observation. For example, „accounting involves the use of market prices‟, is self-evidently true. It hardly seems necessary to conduct an empirical study to determine this. The criterion of self-evidence has revealed its untrustworthiness in the sciences. Some propositions formerly regarded as self-evidently true have been shown to be false. A reason for not relying on the self evident basis to assess the truth of a statement or theory is that self-evidence is usually determined by observation – we observe something and we believe it to be true. However, our powers of observation are not always good. Sometimes we see what we expect to see; at other times we might incorrectly attribute what we see to a wrong cause.

3 Scientific basis - Syntactics and induction

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Scientific endeavour is the trial-and-error testing of speculative hypotheses which can never be proven absolutely true, but can be rejected when shown to be false. Under the falsification view, all hypotheses proposed must be capable of falsification. If a hypothesis is not proposed or worded so that it is falsifiable, then it is not informative and does not add to scientific progress. As such, a theory that gains acceptance (although it can never be asserted to be true) is one that has not been proven false by tests that are designed to reject the theory if it is not true. A good theory is not one that is false, nor is it necessarily one that is true; it is one for which there is a conceivable means of testing its falsity, and the theory withstands the test. The non-falsifications of bold hypotheses or the falsification of cautious hypotheses mark significant advances in science. Theories are never said to be absolutely true but they are the best available at the time.

3.1 Syntactic rules and induction To be meaningful in science, theory must be formulated in a way that makes it testable either by Syntactic rules or induction. o In syntactic rules, examination of the logic of the argument making up the theory is the basis of the test. The validity of argument can be established without reference to sensory experience. Known by reasoning without verify from observation of real-world events. o In induction, statements whose truth or falseness can be known only by reference to empirical evidence. It is according to the correspondence with observations of real-world phenomena. o Inductivist believes that all sciences start with empirically observable facts and science progresses by continual observations and experimentation. o Logical positivism- all meaningful statements must be capable of verification. Anything cannot be verified empirically is regarded as meaningless and theoretical statements should be capable of being reduced to statements of immediate observation. 3.2 Popper and falsification o In falsification view, all hypotheses proposed must be capable of falsification. o

All inductinve evidence is limited, as we do not observe the universe at all times and in all places. We are not justified therefore in making a general rule from this observation of particulars.

o A theory that gains acceptance is one that has not been proven false by tests that are designed to reject the theory if it is not true. o The clearer and more precise the hypothesis, the better. Vague hypotheses are difficult to falsify and unacceptable. o o

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Popper’s point is this: no matter how many observations are made which confirm a theory there is always the possibility that a future observation could refute it. Induction cannot yield certainty. The deduction logic is -: However many confirming instances there are for a theory, it only takes one counter observation to falsify it: only one black swan is needed to repudiate the theory that all swans are white.

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Science progresses when a theory is shown to be wrong and a new theory is introduced which better explains the phenomena. For Popper the scientist should attempt to disprove his/her theory rather than attempt to continually prove it. Popper does think that science can help us progressively approach the truth but we can never be certain that we have the final explanation

3.3 Research programs Lakatosian research program

Scientific theory consists of structure of a positive and negative heuristic o negative heuristic = hard core of the research – stipulates the basic assumptions - not questioned – not subject to falsification – constitutes the dogmatic or self evident part of the research program o positive = surround the core and forms a protective belt of auxiliary (support) hypotheses – methodology of a research program consists of modifying or expanding this protective belt – scientists who work on hypothesis testing in the positive heuristic belt are said to be participating in the research program o o o o o

Any hypotheses challenges the core is ignored or rejected unless it has significant explanatory power beyond the existing hypotheses

A progressive research program has a group of scientists actively working on research in a positive heuristic, whereas a degenerating program has no active research. Lakatos, however, finds it difficult to say that one program is superior to another. The problem is that progress can be very slow, and what appears to be a degenerating program now may well lead to progress many years later. The underlying theory is never proven false; it simply may lie inactive, awaiting revival at some future date.

. Kuhnian paradigms or disciplinary matrices Scientific theories and progress in science have a revolutionary character. Revolution = Very radical changes. If the theory does not fulfil the practices, it will be thrown away and new theory develops. Kuhn’s description of the way science progresses fall into 5 stages:i. Pre-science- period where there are no generally accepted ideas. Focus on single paradigm which is widely accepted by general scientific community. This disorganised period of diverse and unstructured activity eventually organises and focuses on a single paradigm (model), or school of thought, which is widely adopted by the general scientific community.

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Normal science- attempts to articulate a paradigm with the aim of improving the match between it and nature.

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The paradigm, which incorporates background knowledge, research procedures and so on, is then taught as the basis of scientific knowledge (fact) and dominates the work of scientists. Scientists work within the accepted paradigm, involving themselves in „...attempts to articulate a paradigm with the aim of improving the match between it and nature‟. This process is called normal science and is comparable to the process of operating under Lakatosian research programs. Normal‟ scientists must presuppose that a paradigm provides the basis for solving all puzzles posed within it. Thus, under this interpretation, much of the work of scientists is involved in puzzle-solving activity, both theoretical and experimental, within the accepted paradigm. Any problems which cannot be solved are the contradictory to the accepted paradigm are called anomalies.

Crisis-revolution- repeated failures to resolve anomalies lead to insecurity and loss of confidence in the paradigm. New paradigm emerges. However, if the number of anomalies grows, confidence in the paradigm is undermined. The mere existence of anomalies does not constitute a crisis. Kuhn recognises that all paradigms will have unexplained problems. An anomaly is regarded as serious only when it is seen to strike at the core of the paradigm and persistently resists attempts by the members of the „normal „ scientific community to remove it. Repeated failures to resolve these serious anomalies eventually lead to pronounced insecurity and a loss of confidence in the paradigm. Scientists then begin to argue and develop new hypotheses, with different schools of thought arising. This eventually results in debate between alternative schools of thought and research.

New normal science- scientists align themselves with new paradigm and it gain support of the majority of the scientific community. Finally, out of this crisis-revolution a new paradigm emerges. Scientists then align themselves with the new paradigm and it eventually gains the support of the majority of the scientific community. With this new paradigm, a new normal science begins, the replacement of the old paradigm by the new paradigm being described as a revolution.

New crisis.

How Have Kuhn and Lakatos research programs affected accoutnign development o o 10

The Kuhn and Lakatosian research programs are applicable to accounting theory development. The Lakatos approach permits research programs to be inactive rather than dismissing alternative theories when reshaping the positive heuristic. An example

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of this as it relates to accounting theory is the normative theories regarding measurement that aborted in the 1960‟s and 1970‟s. In recent times, attention on measurement has been revived with fair value accounting being advocated. The use of various paradigms (models) (for example capital market based, contracting and behavioural) is also an example of refining the heuristic using different research methods that contribute in different ways to theory development. The Kuhn research paradigm involves replacing one theory with another when the anomalies associated with the dominant theory at the time become too systematic and hard to dismiss. This can be applied to accounting theory development once again, in the context of historical cost accounting being the accepted paradigm. The failure of historical cost to reflect economic reality and enhance decision making, as documented via recent corporate collapses, will reignite the debate as to whether this paradigm is appropriate.

3.3a Feyerabend’s approach o Core of Feyer bend’s approach is that reality and society are far too complex for there to only be one method or paradigram to dominate science o Any approach is valid as long as follow the procedures. o Good scientists are those who prepared to develop and accept inconsistent ideas. o There is no single scientific way of getting ideas where they can arise from many intellectual pursuits (search). Any approach is valid

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