Essay on why do we need so many accounting theories
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Merriam-Webster defines theory as " a
plausible or scientifically acceptable general principle or body of principles
offered to explain phenomena.....," and "a hypothesis assumed for the
sake of argument or investigation." [1] In accounting, a theory aims to explain
(i.e., why?) and predict accounting practices (Watts and Zimmerman 1986).
Diversity in accounting theories is likely due
to two reasons. The first reason relates to the diversity of users in terms of
their decision-making process and their information preferences (Wolk et al.
1992). There are many user groups of information and each group has different
ability of absorbing and analyzing information to make investment or economic
decisions (e.g., sophisticated users such as blockholders, financial analysts
vs. unsophisticated investors such as small investors). Heterogeneity in
information preferences may lead to different stock prices which may indicate
that one user group is favored over another user group. For example, annual
reports are free of charge for all user groups. However, users with access to
private information (i.e., inside information) are better off than those with
no access to such information.
The second reason is associated with the
development methodology of an accounting theory. An accounting theory can be
developed using different methodologies (approaches) such as, the inductive
method, deductive method, the pragmatic method, the ethical method, and
behavioral method (Schroeder and Clark 1995). In the inductive method,
conclusions are drawn based on observations. Put differently, data is gathered
or observations are made to test a hypothesis and draw a conclusion (e.g.,
measuring income on the basis of inflation adjustments). The inductive approach
is described as "going from the specific to the general."
Introduction to Current Liabilities
The deductive method begins with identifying
accounting objectives and then stating key definitions and assumptions. Unlike
the inductive method, the deductive method can be described as "going from
general to the specific." This approach requires various components
following a logical pattern. These components are (1) a structure for the
accounting objectives, (2) an environment for the accounting practices, (3)
definitions and assumptions, and (4) procedures. The validity of an accounting
theory using this approach depends on identifying the objectives correctly and
relating the various components in a logical pattern.
As for the pragmatic method, a theory
development depends on the utility or usefulness concept. It argues that a
utilitarian solution can be reached once a problem is determined. However,
solutions to a problem obtained through the pragmatic method should be seen as tentative
solutions. Although the pragmatic approach emphasizes the usefulness of
accounting information to decision-makers, it does not emphasize on the
truthfulness of accounting information.
The behavioral approach focuses on the relevance
of information communicated for the purpose of decision-making and the behavior
of individuals and groups communicated by this information. Therefore, the
employment of accounting techniques must be evaluated based on the behavior of
users of accounting and financial information. Because the accounting
information has an impact on the behavior of decision-makers, a new
multidisciplinary area in the field of accounting has emerged, namely
"behavioral accounting." [2] Research studies that have examined the
impact of accounting information on human behavior can be classified into five
groups (Belkaoui 1992). The first group examines the adequacy of disclosures
and shows that variation in the adequacy of corporate disclosures can be
attributed to firm size, profitability, stock market status (e.g., NYSE, AMEX,
NASDAQ) and audit firm size. The second group investigates the usefulness of
financial statement information. The overall results of this group of studies
show that (a) there is some consensus between financial information preparers
and financial information users with respect to the relevance of information
disclosed in the financial statements, and (b) the financial statements are not
the only source of information that users rely on to form their investment
decisions.
The third group of studies reports on the
attitudes about accounting practices and techniques. In general, these studies
show that attitudinal differences exist among professional groups as a result
of accepting certain accounting techniques suggested by authoritative
accounting bodies (e.g., FASB). The forth group examines materiality judgments
and shows materiality judgments are influenced by many factors and these
judgments vary among individuals. The final group tests the decision effects of
alternative accounting procedures. The results indicate that individual
decisions are influenced by alternative accounting practices, and the extend of
this influence may be attributed to the task nature, experimental context
nature, and users' characteristics.
As for the ethical approach, the main focus is
on the concepts of truth, fairness, and justice. These concepts are very
important to establish an adequate accounting system. Although the concept of
truth may refer to the following meaning "in conformity with facts,"
it may be interpreted differently from one individual group to another. For
example, some may view accounting facts as information that is objective and
verifiable. [3] Accordingly, this group may consider
historical costs as accounting facts. Others may employ the truth concept to
refer to the valuation of assets and expenses in current economic conditions.
Thereby, this group argues that truthful financial statements should display
accounting numbers in their current values (Hendriksen and Van Breda 1991).
Information is value-relevant when it is related
to investors' valuation of the company as reflected in the company's stock
price. Financial reporting under the historical cost (i.e. book value) model
versus the current value model has been a controversy issue as of which is more
relevant to decision-making. The historical cost model assumes that the $
dollar (£ pound or € euro) is a stable monetary unit. Those who are in favor of
using historical cost model argue that forecasts and future commitments are
made based on past transactions. Ijiri (1975) supports this notion. He
indicates that past information serves as a basis for a forecast of future
prices, provides input to the satisfaction notion rather than the optimization
notion (i.e., how much profits have been already made rather than how much more
profits can be made), and is employed by many contexts such as cost-plus
contracts and taxable income.
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In addition, historical cost proponents argue
that historical cost data relies on actual (not merely potential) transactions,
is less likely to be manipulated, and induces a long-term view of earnings (Kam
1990). Schroeder et al. (1991) note that under the concept of historical cost,
transactions are recorded based on the original dollar value which is
considered to be objective, since the amount received or paid can be verified
by documents (e.g., bills, invoices, checks, deposit receipts...etc).
On the other hand, opponents of historical cost
model argue that historical costs is not a relevant measurement of goods and
services to meet the objectives of decision makers. This is due to specific
price-level changes (e.g., changes in technology and shifts in consumer
preferences and needs), general price-level changes (e.g., inflation), and
fluctuation in currency exchange rates (Elliott 1986). In addition, Elliott
(1986) notes that although historical cost data can be used to produce known
and expected future results, it may not capture surprises, such as unexpected
bankruptcy.
Opposition to the historical cost model has led
to the development of other models that could provide more relevant information
to decision makers. One of these models is the current value accounting model.
In an inflation context, Zeff and Dharan (1996) illustrate how the current
value model can provide more relevant information than the historical cost
model. They indicate that firms with large amounts of financial assets need to
adjust gains and losses on financial instruments as a result of the inflation
impact. Furthermore, firms with large amounts of long-lived fixed assets, such
as airlines, chemical industries, and hotels have to adjust for the annual
depreciation when prices rise. These adjustments are important for fair and truthful
presentation of the results of financial operations. Sutton and Johnson (1993)
argue that the current value model fits better in more stable and less global
commercial markets. They also note that when cash flow is investors and
creditors' ultimate focus, then recording assets at their current values is
more relevant as current values most closely reflect assets’ ability to realize
cash. On the other hand, reporting financial numbers at current costs may
mislead investors, regulators, and politicians. For example, large companies
reporting higher earnings may attract politicians and regulators, who may
impose anti-trust actions and new taxes regulations (Watts and Zimmerman 1978),
thereby prompting these companies to report financial statements using current
costs to show lower operating income (Swanson 1990). Evidence supports this
notion. For example, large and profitable companies in the United States (e.g.,
Freeman and Newman 1986), United Kingdom (e.g., Sutton 1988), and Canada (e.g.,
Thornton 1986) show more interests in reporting under the current cost system
using different means such as lobbying, writing supporting letters to
regulators and officials, and disclosing frequent reported current cost data
voluntarily.
Based on the competing views above, it is
arguably to ask the following questions: are current financial statements
reported under the historical cost system less relevant than they were in the
past? Will the current values give a truthful and fair presentation to the
financial statements after the impact of the 2008 financial crisis on the world
capital markets? Core et al. (2003) test whether is a change in the link
between stock prices and financial variables during the "New Economy
Period" (i.e., the late of 1990s). They show that the association remains
stable during this period compared to previous periods. Others like Collins et
al. (1997), and Francis and Schipper (1999) report that the value relevance of
earnings and book values, on average, has not changed (i.e. stable) over time.
However, others (e.g., Chang 1998; Brown et al. 1999; Lev and Zarowin 1999)
show a decline in the overall value relevance of corporate earnings and book
values.
In sum, the debate between the historical cost
advocates and the current value proponents will continue to be a controversy
issue. As a result, there are and will be growing demands for different methods
that can convey higher utility of relevant financial information to decision
makers and measure financial transactions adequately.
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