WIXLIB

ICli. IA 'C llN l llll ll llOIN'1'1111 l'1w lH" 1 1111 11 1 11x pl 11,i11 11cl li,v 11,1 1 111 111 L111 µ; 1.1111(11',Y 1L1' 1 1wl. i11cl 111 11Hl (l ll Ll,v 11 11 111,H111·11,l l111111d v 11·ill11 l1lo 1111cl 1 i, l1 111 d11 1·0 1 n1·0 110L 1'( 11ll y f11cLH. H.nt ber,Lli 11y 111'(1 Ll1 11:011 01 11 i : 1'( l11Lio1 1HhipH i11 Lil e IHtHin cHH wo l'l d and concept sH1rn li HH "v11 lu e" nnd " irn:o me" Lli nt ni ny appear differently to variousoliHcrvc rH. T ltu::i, scvcnd Lll eories may be developed from the same set of"facts" and co ncepts, each of whi ch may appear logical within the framework of t he observations of specific individuals. The choice of a mostappropriat e t heory depends on how well it supports the development ofprocedures and t echniques that best fulfill the objectives of accounting.One of the first steps in J.hJ:Lq.evel22ment of ac.c ting th. ory,, h r e fore, is a clear statement . o!.!!:! obj!i;:,!:i of §.cc21.!nti!.i & In descriptivestatistics, a summarized description of a population cannot be madeunless the statistician first understands the type of information that iswa nted. A description of the height and weight of the individuals in agiven country may be of little value to a person who is interested in theireconomic well-being. Similarly, the type of information useful to management in the making of decisions is not necessarily the same as the type ·ofinformation needed by stockholders and prospective investors of thefirm. Managers need information that will tell them the effect of currentdecisions on future income. Stockholders who have an effective control ofmanagement need information to be able to judge the relative efficiencyof management. Stockholders, prospective investors, and creditors needinformation that will help them predict the future course of the firm andthe probability of future financial success. While these o.Qjectives ma,ylead to the same accounting principles, different principles may be required to meet the- everal objectives of accounting. 'the major emphasisin t development ·of financial accounting theory ?basedon the ob}eCBVes of report ing to stocKilola ers, "illve stors, crediforS, aii:dother outside interest s-;- althoughthe ob}ect 1ves-· ofm anagement arequently t!lik, en.iniQJ on.sideratio;- - ·- These objectives have changed over time as one or more of the severalinterested groups have dominated in their pressure for information fromaccountants. At various stages in the development of accounting, theowner-manager, the creditor, and the stockholder-investor have eachdominated in determining the type of information reported in financialstatements. Therefore, a good understanding of current objectives andaccounting practices requires a study of the historical development ofaccounting theory. A summary of this development is, therefore, presented in the following two chapters.1111-rr ,).lfi'r.f1.: ,.,. . l. Jol J"1rre-THE SEVERAL A PPROACHES TO ACCOUNTING THEO RYOnce th ob, ctivJ)s ccol1ntin,g re established, o 9 r . ofseveral arm roac he.s to. a.Q.Q.ounting theory must be selected in order toderive logicall;y: son eived a. ccou ting Princir"ies. These objectiv-es ho -L11 . 111111 ' Ml :1llOl OI OtiY 0 11A CC: UlJt 1INb'11 ll ORY311v111· 1 11 111 y ho 11 1otl ill11cl wil. li 1,11 0 tl ovo lo p111 111(, ol' Lli oory, b11 L n oli 11ngc inLii u l nHio objo :Liv oH mi µ; ll L roqu iro 11 rofo n11ul t1tio 11 of tho cnLirc theoreticalHLn1 cL111·c. J'o r exnmp lc, one o( t he ob jec tives of financ ial reporting mightl o to provide information to stockholders and other outsiders to permitlili cm to make useful predictions regarding the future operations of thefirm . This objective leads to the development of an operating concept ofincome t o t he enterprise and to the stockholders. But if the objectiveshould be the measurement of the social benefits of the firm, the measurement of these benefits should include the value added to the economy andall social benefits and costs not measured directly by the mechanism ofthe m rket.Some of the approaches to the development of accounting theory thathave been suggested and used include the following: (1) the deductivereasoning and the axiomatic approaches, (2) the inductive approaches,(3) the pragmatic or "common-law" approach, (4) the ethical approach,(5) the use of communications theory, (6) the application of behavioralrelationships, and (7) emphasis on sociological factors. None of theseapproaches or methods, however, is independent of the others. Generallymore than one approach is used either explicitly or implicitly in the development of accounting principles. The theorJ: de y:elQpJ)Q aJld discussedin the foJ lO\y ing chap! er s is eclectic in nature, drawing upon .all of thesevarious approach 3t variOl,!S :Q.OiQt§., although the grfilJ:,t est relia11.9 e is1p QILdedlLc.tiYe rea.aoning.Deductive ReasoningThe deductive method of reasoning in- c; co nting is ih r r o c s ofstarting with objectives and postulates and, from these, deriving logicalprinciples that p ovide the bas (); co ete or practic ( appl!cations.Thus , the 2r acti.Qa ( applicatiq,i l s j.nd r les are der.ived f rom the logicalreasoping; the postulates and logically d principles should notmerely support or attempt to explain accounting conventions or currentlyaccepted practice.The structure of }.he deductive process should include the following:(1) the formulation of g eral or specific objectives of financial reporting;(2) a statement of the postulates of accounting concerning the economic,political, and sociological environment in which accounting must operate;(3) a et of constraints to guide the reasoning process; (4) a structure,set of symbols, or framework in which ideas can be expressed and summarized; (5) the development of a set of definitions; (6) the formulationof principles or generalized statements of policy derived by the process oflogic; and finally (7) the application of the principles to specific situations and the establishment of procedural methods and rules.In the deductive process, the formulatioQ QL@i .ctive§ is most iJPpOrtant because different objecti might requi.@ entirely diffur nt struct es .'.: nd res lt in d fferent EEinciples. This is one of the main reasons

1111 l Yw l1 ICh. 111il1 M 1'11r d11i.m11 il 11 l11g l.11,xn hl 11 \1111011111 1u·11 dil'l't1J'u1J(, i11 mnny rospoqts1'1 11111 1.lin K011111·n ll y noeo p!.t d pm(IL\oo 1'01· L110 d QLcmnination of financiali11110111t1. Wliil o Ll1 t1 ro n-rny bo rnnny advantages in ap2lying the same in:.1 01n o oo ncopts to both tax and fi nancifil CQognting1 the basic 9bjectivesu. ro different and it is not likely that 1he s me principles and proceduresvyill meet the different objectives equally well. The frequent proposal fora single all-pervasiveconcept of incomehas many advantages, butit does assume that such a concept could serve all accounting objectivesequally well. While this is not true, it would not be desirable to set up anentirely different set of principles for every purpose served by accounting.Some compromises must be made, but there should also be some freedomto serve different objectives as well as possible. Thus, accounting theoryshould be flexible enough to provide the needs of different obj ectives Qutrjgid enough .to- provide for - uniformity . afi? conSistencyi n financialrep o strn kholders and the general public.·The objectives, postulates, constraints, and structural framework willbe discussed at greater length in Chapter 4. However, they are all essential to the deductive process. The postulates are not necessarily numerousor complicated; they may even seem trivial or obvious. But it is desiral; leto make them exj)licit to provide a framework for subsequent logicalr e asoning. - c9nstrai t §! a striations to the development of pr inciples djrectly from the 2.Qkctiyes d postulates. J hese restrictions arei;iece sary because of certain limitations of th-e environment particularlyCQ.used by uncertainty regarding the future and changes in the environment such as fluctuations in the value of the measuring unit--money.Symbols and a general working framework are necessary to provide ameans of communication of ideas. In accounting, the framework is theaccounting equation and the several derived financial statements. Thestatements should articulate with each other in order to provide an internally consistent framework.A more precise method of formulating the symbols, structure, and constraints is found in the axiomatic or mathematical approach to accountingtheory. In this method , mathematical symbols are given to certain ideasand concepts. The framework is provided in the form of mathematicalmodels utilizing matrix algebra or linear equations. Constraints can beapplied in the form of mathematical expressions. Therefore , starting withbasic postulates, axioms can be set up and, with a form of calculus,theorems can be set up and proved. Thus, the axiomatic method can provide a very useful framework for the deductive approach to accountingilirory.One of the main disadvantages of the deductive method is that if anyof the postulates and premises are false, the conclusions may also befalse. Also, it is thought to be too far removed from reality to be able toderive realistic and workable principles or to provide the basis forpractical rules. But these criticisms generally stem from a misunderstand-arsoCh. 11T'lll! Ml. f!IOl OLOGY Ol1 A :coUNTING 'rt rno Yi11!-( nl' Cli o 1H11·p0Ho 11 11d 111t1a 11i11 µ; ol' (,li (lo ry. IL iH 11 01, 1wt10HHHl',Y Lhn(, (,hnoryho 011Liroly prncLi e11l i11 order to bo uHo l'ul in OH Labli Hll i1 1µ; worlrnbl o p1·0O(l( hu·oH. 'l'li o main 1n,11·poso of theory il: l to provide a l'ntmewo rk .for Llwd11volopm c11 t ol' new ideas and new procedures and to help in t110 nudeingol' ehoioos among alternative procedures. If these objectives aro mot., iL iHnot necessary that theory be based completely on practical con oo pt.H w·Lh it it be restricted to the development of procedures that arc cornpl ot.ol,vworkable and practical in terms of current known technology. l'n 1'11,(1(,1many of the currently accepted principles and procedures aro µ;11JH11·11,Iguides to action rather than specific rules that can be followed pro ·i 1·H li ,vin every applicable case. 3The Inductive ApproachThe process of induction involves the making of observations of clctnil 1dmeasurements and then drawing generalized conclusions or 'principkHfrom these. Detailed observations are made for a few items, and frornthese, generalizations are made regarding the entire universe or a groupof similar situations. These generalizations, however, are subj ect to laterconfirmation or refutation after further experimentation and observation.All principles inductively derived are, therefore, conceptually falsifi abL.Thus, through the inductive process, Newton was able to observe th ocharacteristics of motion and from these observations and measuremcntr-lderive generalizations or laws of motion.In a:ccounting, the inductive process involves the making of observations of financial data regarding business enterprises. If recurring rela tionships can be found , generalizations and principles can be formulated.Thus new ideas and principles can be derived, particularly if the observerdoes not let himself be influenced by current principles and practices. Undoubtedly, there are many financial relationships that may prove beneficial to the users of financial statements in evaluating the operations ofthe enterprise and in making predictions regarding the future of the firm.Just because the observer looks only at raw data does not mean, however, that he does not need some initial postulates and concepts. By themere making of a choice regarding what to observe he is reflecting preconce\ved notions of what might be relevant. By restricting himself tothe financial data of a firm, for example, he is drawing on certain postulates regarding the environment of accounting. Furthermore, if he restricts3 For example, the capitalization of long-term leases that are, in substance, a purchase of property, as re commended by the AICP A Accouµting Principles Board inOpinion No . 5, is a general guide that cannot necessarily be follow ed with precisionin every case, particularly if the lease contract includes t he purchase of services acquired jointly with the use of property. See Accounting Principles Board, "Reportingof Leases in Financial Statements of Lessee," Opinion No. 5. (New York : AmericanInsfltute of Certified Public Accountants, September, 1964). Reprin ted in Jom'/lr1l ofAccountancy, Vol. CXVIII (November, 1964), pp. 63-66 .

A :U llN 1ltH i 11 WOl{YIC.:h. 1li i 111H1dl' Lo 11 hHn l' vi 11 011l y f1 1ia 11 1 i11 I ii1 '1L 11H1wl.iw1H, Ito 111 ny or il y (IO!lfirm11xii;(,i 11 1r, p1·110 (,ioo.Tho ndvnntago of tho inductive npproach is that it is not necessarilyconstrnincd by a preconceived model or structure. The researcher is freeto make any observations he may deem relevant. But once generalizationsor principles ar 0 formulated, they should be confirmed by the logicalprocess of the deductive approach. However, the main disadvantage ofthe inductive process is that the observer is likely to be influenced bysubconscious ideas of what are the relevant relationships and what datashould be observed. It is difficult to divorce the inductive approachentirely from the deductive method 'because the latter provides a guide tothe selection of the data to be studied.Another difficulty with the inductive approach is that, iri accounting,the raw data are likely to be different for each firm. Relationships mayalso be different, making it difficult to draw generalizations and basicprinciples. For example, the relationship between total revenues andcosts of goods sold may be a constant over time for some firms, but thisdoes not necessarily mean that the historical gross margin concept isnecessarily a good measurement for the prediction of the future operations of a firm in all cases.The Pragmatic or "Comm on-Law " App roachPhilosophical pragmatism is ". . . marked by the doctrines that themeaning of conceptions is to be sought in their practical bearings, thatthe function of thought is as a guide to action, and that the truth is preeminently to be tested by the practical consequences of belief." 4 Thus,the pragmatic approach involves the development of ideas that are inagreement with the real world and find usefulness in realistic situations.As applied to accounting theory, the pragmatic approach involves theselection of accounting concepts and techniques based on their utility.Principles and procedures are held to be useful if they accomplish theobjectives of management or if they help stockholders or other readersinterpret accounting statements and al.cl in meeting their specific objectives. Theory that does not have an immediate practical use is assumedto be poor theory.The method used by the AICPA prior to 1959 (and to a large extentsince) in the development of accounting principles was largely pragmaticin approach. Specific procedures or techniques were studied and certainprocedures were recommended on the basis of their usefulness without areliance on a general overall framework of accounting theory and without the necessity for an interdependence of the several procedures recommended in different areas. The principles and procedures recommended,however, gained respectability only if they subsequently became gen4Webster's Third New International Dictionary, Unabridged, p. 1781.Ii. 1111 11. Ml :fl!Ul OLO W OP At:CO lJN I ING f'll UUl{Y'/orn ll y 1w ·1 pLod. '1'1 10 li 11 al w uo l' o l' Llt (1 1·cco 111 rn ond11Lio n wmi, Lhorcforo, t heu1:1o l'u lnoss of t ho proceduro1:1 in actual practice. Usefulness is assumed bygeneral acceptance.By a reliance on general acceptance, the pragmatic approach leads to aform of "common law" in accounting. That is, principles, procedures, andt echniques are considered to be good if there is a precedence for theirgeneral acceptance in a given area. Furthermore, acceptance may moveinto another area if the same type of utility can be found in the new area.For example, LIFO started as an accepted practice in only very restrictedareas and only under specific conditions; but the usefulness of the methodwas soon applied to other areas until it has become a generally acceptedprocedure in most areas of inventory valuation. As new problems arise,procedures are recommended on the basis of similarities to generallyaccepted practices. This is similar iii many respects to the development ofcommon law over time.This approach to the discovery of useful accounting methods has occasionally been referred to as an inductive method. Research is directedtoward the discovery of which accounting procedures are most commonlyused and thought to be the most useful by accountants or users offinancial statements. The research method utilizes questionnaires, interviews, and studies of accounting reports and statements. The results ofthe research method may point out those procedures most commonlythought to be useful, trends toward the general acceptance of newer procedures, or new procedures found useful in a few cases but which may beuseful in many others if the advantages are made known.One of the advantages of the pragmatic approach is that accountingserves a function only if it is useful. If it can be assumed that accountantsknow what is most useful for their own firms or clients, the most commonly used practices can be assumed to be the best. The pragmatic approach also has an advantage in making known new methods that mayprove to be useful to many if widely adopted; and it may lead to greateruniformity and consistency by the widespread adoption of the most usefulprocedures.The pragmatic approach, however, has many serious disadvantages.The most serious criticism is probably that there are no basic criteria fordetermining what is meant by "useful." To whom should accounting databe usefb l and for what purpose? Reports that fail to disclose certainlosses or inefficiencies of management may be considered useful to management but they would not necessarily be useful to stockholders orprospective investors. A clear statement of the objectives of financialaccounting must precede an analysis of how specific procedures can helpaccounting fulfill its functions .A significant limitation of the pragmatic approach is that generallyacc pted practice is not necessarily the most useful from the point ofview of providing information relevant to good decision making. M any

IIAC: .:Ol IH 111 i 11 we mYI .: Ii . 1p1'1111111 l111 11M n1·11 wid1d .v nilopL1 1d i11 11·11 11 Ho Lli o.v 111·0 Hi111pl o 11x podi 11 LH orli1 1«111 1Mo Lltn.v 11ii11i111hm Ll1 0 cl t1To11 L pny mont o f LIH' eo 1·pornLo income tax.r11 HL hncn 11 Ht· procodu rcH a rc wid ely used docs not mean that they are11ocioHHn1·ily useful, good, or logical.Whil e it may be helpful to know what methods are in common use, aninvestigation of practice is not likely to lead to new theories or ideas oreven new procedures. In fact, the publishing of generally accepted procedures and the assumption that these are the best methods .known maydeter progress. Accountants may rely on the general acceptance of theseprocedures rather than attempt to experiment or develop better methods.The Ethical ApproachThe ethical approach to accounting theory places emphasis on theconcepts of justice, truth, and fairness. DR Scott suggested that the basisfor the determination of accounting practice reaches back to the principles underlying social organization

Perry Mason at the University of California, Berkeley. And, of course, this book could not have been written without the continual encourage ment and full support of the members 0f my immediate family-Kathleen, Ma