Why do we need so many accounting theories


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.

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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."

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.

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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.

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.

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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.