Accounting Theory, 7th Edition Solution Manual

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Solutions Manualto accompanyAccounting Theory 7eByVictoria WiseChapter1Introduction

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Chapter 1: Introduction1.2Chapter 1-Accounting TheoryTHEORY IN ACTIONTheory in Action 1.1Theory implementation and politics1.Thearticledescribeshowaparticulartheoreticalapproachhasbeenreplaced by another. Explain why one theory replaces another, and who, orwhat, determines whether an existing theory survives.A theory is primarily meant to explain or predict an event, behaviour or outcome.Proponents of a theory look for evidence to support the theory. This evidence should beindependently observed and consistent after repeated observations. Some theories arespeculative or ideas or guesses floated to encourage researchers to undertake theobservations required to prove or disprove the theory. The question often debated iswhat comes first—the theory or the observation? For example, did Darwin startthinking about different species and the idea of natural selection ordidevolution enterhis thoughts?Did he detail these thoughts as a testable proposition and then set out toobserve? Or did he observe aspects of nature which led him to formulate a theory ofevolution? The latter is much more likely and for most theoretical development,observations result in development of propositions which are tested over time.Where the body of evidence in support of the underlying theory appears to be supportedby observations, then the theory is accepted. But not necessarily by everyone.Why not?Somemay not be satisfied with the methods adopted to test the propositions; otherssimplymaynot believe the theory explains or defines reality and propose alternativetheories.InthespecificcaseofBernanke’stheoreticalchoicesbaseduponhisdetailedknowledge of the Great Depression,a similar process would be required and if theweightofevidencesupportedBernanke’spropositionsinexplainingeconomicoutcomes, thenhistheoretical perspectivewouldsupplant other theoretical perspectives.In the social sciences it is even more complicated than the physical sciences. Theinterpretationsofoutcomesandbehavioursaresubjecttoindividualresearchinterpretations and the full range of factors impacting on the economy, for example, aremuch more difficult to control or isolate.2.Does thereintroductionofatheory mean that it shouldnot have beenreplaced in the first place?Theories about how the economy works and what will happen in the economy wherethere is monetary policy or fiscal policy intervention areappropriate in assisting policy-makers understand the possible implications of decisions they make or are underconsideration. However, they are rarely complete models and often outcomes cannot bepredicted.Reintroductionof a theory suggests that new evidence in support of thetheory has been reported.

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Solution Manualto accompany Accounting Theory 7e1.33.Should a theory be discarded if it does not specify the means of achieving astated objective? Explain your answer.The theory itself doesn’t have tospecify the means of achieving a stated objective;however, it has to provide a sound basis for explaining, defining and predictingbehaviour. The application of the theory can have many elements and it is in theinterpretation of what will induce the predicted effects in the economy predicted by thetheory which will result in predicted or otherstatedoutcomes.Instructors should ask the students to discuss how we would know whether a reductionofcorporateinterest ratesresulted in an increase in the inflation rate?

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Chapter 1: Introduction1.4Theory in Action 1.2Out of Control1.‘Rogue’is defined in the Oxforddictionary as‘that which lacks appropriatecontrol;somethingwhichisirresponsibleorundisciplined’.Giventhisdefinition, who is ultimately responsible for the rogue trading outlined in theSociete Generalescandal: the trader directly involved; management, who areresponsible for the high-risk, high-reward framework in which the traderoperated; or a combination of both?Obviously all parties are responsible for their actions. Theweak risk-managementcontrolsin place atSociete Generaleallowedbehaviour which ultimately could not becontrolled by the employer. Why? BecauseSociete Generalecreated an environmentwhere traders could become‘rogues’. It is important to appreciate that theemergenceof‘rogue’behaviourcan bea function of environment and in particular theembeddedcontrols designedtodetect and inhibitsuch behaviour. In addition,ifmanagement waspushing for outcomes, in a way the‘rogue’wasseeking to meet management’sperformanceexpectations.Actions,demands,andalsoincentives,createand/orreinforce behaviour. The impact of financial performance benchmarks should not beunderestimated. Students should discuss howcontrols, monitoring, andincentives candiscourage/create behaviours and what types offactorsare more likely to stimulate‘rogue’behaviour.2.Discuss the role played in theSocGencase by each of the three elements:personality, institutional framework,opportunity.(1)Personality—in a competitive environment people will either compete or leave.Inthecompetitionitselfbehaviourswillhavetochangeandadapt,riskpreferences will shift and consideration of the downside possibilities discounted.Research shows that a group environment often results in different behaviour toindividual or isolated thinking.(2)Institutionalframework—SocGenwasnot controlling its riskassociated withtrading and this allowed the individual involved to operate outside the acceptedparameters.Also, theindividual’s knowledge of back-room trading operations andprocessesmeant that significant‘positions’ and lossescouldbehiddenand offsetagainst the upside, this gave the institution the result required and basically shiftedthe trader into rogue trades(possiblyto‘make budget’).(3)Opportunity—this relates to the first two points. The opportunity was created bythe positionand background experience and knowledgethe trader held and theenvironment encouraging anunregulatedapproach.The three elements are inter-related. Students should discuss which factor was the mostcritical in creating the behaviours documented,and the alternativeviewthattheelementsare equally important.

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Solution Manualto accompany Accounting Theory 7e1.53.How couldSociete Generalehave been unaware of the activity of its traderand of the environment that it had created forthe traderto operate within?The types of environments that might create such rogue behaviour may be predictable.Students should consider what the role of theory is;is it to predict and explainbehaviour? Then a good theory of rogue behaviour should do just that. However, mosttheories in accounting are usually better at explaining the elements of behaviour afterthey have occurred, rather than predict them. The problem is access to observable data.Positive theories are based on predicting behaviour based on past observations. Wouldthis approach work in the case of behaviour which the traders did not want observed?4.Do you think that theactions of ‘rogue’ traders are predictable underparticular theories (such as agency theory)? Explain your answer.Knowledge of appropriate behavioural theories will not stop behaviour of the typeoutlined.However,knowledgedoesempowermanagement:theembeddingofappropriate bonding and monitoring mechanisms and other relevant incentives anddisincentives are predicted (under agency theory) to have a particular influence on anindividual’s behaviour. Such a theoretical approach to risk-managementcouldbe usedtoidentify the environmental factors that could lead to rogue behaviour. But we will notknow whether applying the elements of the theories to register the existence of suchenvironments and then action is taken to change the environment, actually changes/edbehaviour. Why? Because the rogue behaviour may exist undetected; or may neveroccur. This isa concernwith positive research, particularly in the behavioural area, wejust never have a complete set of observations.

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Chapter 2: Theory and method2.2Chapter 2-Accounting theory constructionQuestions1.‘A theory that is purely syntactic is sterile.’. Is this true? How can thisstatement relate to accounting?Syntactical: This represents the logical relations in the theory. This concerns the rules ofthelanguageemployed,e.g.,therulesofgrammarforEnglishortherulesofmathematics for a mathematically expressed theory. Syntactical relations are logicalconnections that cement together and explain the important concepts of the theory.A purely syntactic theory, whilst important, may be sterile if it doesn’t explain orpredict anything about the real world.A less sterile theory can be concerned withpredicting or explaining some phenomena or with prescribing a course of behaviour. Itcan be a collection of propositions and conclusions which are designed to illustrate theprinciples of a subject. Other terms such as ‘hypothesis’ or ‘supposition’ are often usedinstead of theory. In essence the syntactical part of the theory is the simplest form of thetheory and is based on an explicit (or implied) statement of a belief expressed in alanguage such as written language or mathematical language.Students should recognise that there are three recognised parts to a theory: the syntactic,semantic and pragmatic relations. Instructors should briefly review and explain eachpart.At this point instructors may use a number of theories which have evolved in accountingand which probably reflect the different ‘views of the world’ or the way accountants seeproblems as individuals. For example theories of accounting can be described andclassified as:(i)an historical record-keeping activity (pragmatic or syntactic theory)(ii)political theories (pragmatic theories)(iii)communication—decision making (pragmatic, syntactic and semantictheories)(iv)accounting as an economic good (pragmatic)(v)accounting as magic or mythology (pragmatic)(vi)accounting as a social commodity to exploit or aid policies or as a socialclub for accountants (pragmatic)That is strictly speaking, not all relations are required in theory formulation.We mayhave separate syntactical, semantic and pragmatic theories and a number of branches ofscientific enquiry can be classified under each heading; e.g.mathematics (syntactical),physics (semantic), political science (pragmatics) and so on.However, the instructorshould now pose the question whether all these relations exist in accounting.Theanswer is yes to varying degrees and also according to the perceptions of the student(and the instructor) of the importance of each relation. Students should then have someunderstanding of the complexity of defining and studying ‘accounting theory’.(see the chapter for further brief descriptions)

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Solution Manualto accompany Accounting Theory 7e2.32.Onetypeoftheoryconstructioninvolvesobservingthepracticesandtechniques of working accountants and then teaching those practices andtechniques to successive accountants.(a) What type of theory construction is this?This is a pragmatic theory construction.This relation pertains to the effect of words orsymbols on the behaviour of people, in this case, the practicing accountant.(b) What are the advantages of this approach compared with a decision-usefulness approach to theory construction?The advantage is that the theory (and practices) are formed by accountants who are atthe coalface.If there is no special interests then they will produce the best accountingfor their clients.They will react to the demand generated by the market.A pragmatictheory is where we observe the behaviour of practising accountants and then copy theiraccounting procedures and principles.Advantages:(i)the solutions of practising accountants are related to the requirements of thebusiness world.(ii)they have developed (and been handed down) over a number of centuries.(iii)it is a pragmatic approach to solving the problems of accounting.Disadvantages and comparison to a decision making approach:(i)no logical assessment (not deductive)(ii)does not allow change (or change occurs slowly)(iii)we perpetuate current practice(iv)concentrates on pragmatics and ignores the measurement issues (semantics)thatallowstheaccountanttomakedecisionsonvalueandpossibleinvestment.(c) What are the disadvantages of this approach?Not all theories have a pragmaticorientation, but the nature of accounting makes thisrelationshipan important one.The problemhere is a circular role in this theory.Accountants teach other accountants how they do things and they perpetuate this role bythen teaching other accounting apprentices. The criticism of this approach is that it doesnot have syntactic or semantic input. Seeabove (b).(d) Do you believe that this is a good approach to developing a theory ofaccounting? Why or why not?Thisisaquestionthatasksthestudenttorecognisethattherearealternativeinterpretationsinaccounting theory. An overalltheory ofaccounting canbean‘instrument’ for recognising and measuring income and capital. Essentially, it is a set ofrules, a ‘blueprint’, for constructing specific accounting systems for the recognition andmeasurement of the income and capital of the particular entity. The results of anaccountantdrivenspecificaccountingsystemofaparticularfirmprovidean

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Chapter 2: Theory and method2.4‘explanation’ of what happened to the firm or serve as a basis for ‘prediction’ of whatmay happen. In other words the accountant may be the best judge.Instructors should be aware that this debate is a common one argued between practisingaccountants and some normative decision oriented accounting theorists and will invokea number of responses from students. A number will argue that an approach which lacksa decision making investor focus will have the danger of becoming dogmatic or selffulfilling. A pragmatic approach may mean that too much emphasis is placed upon thepractices and techniques of accountants and little emphasis is placed upon the meaningof the actual ‘financial statements’. Accounting then may revert to a procedural art.On the other hand, others may rightly argue that accounting theory may become tooobtuse if a completely decision making approach is taken, without regard to the otherroles accounting plays in the real world. Theoretical argument without pragmaticapplication is likely to be of little benefit to business and society.At this point the instructor can point out there are several theories that have evolved inaccounting and which reflect the different ‘views of the world’ or the way accountantssee problems as individuals. For example, theories of accounting can be described andclassified as:•historical record-keeping activityExample: firms use accounting principles to keeparecord of their transactions sothat they can advise how resources have been used.•alanguageExample: financial statements are used by management to communicate toshareholders how well they have performed in running the business.•political theoriesExample: management use accounting reports to allocate resources amongdifferent divisions within the firm, or different levels of employees.•magic or mythologyExample: Enron management usedaccounting techniques to hide the losses itsuffered from transactions with its special purpose entities.•communication—decision makingExample: a local bank decided to give loans to a small business after analysing thebusiness’ financial position.•an economic goodExample: there are costs involved in producing financial reports (not free).Accounting information is demanded to make economic decisions, but there is acost to its supply since accounting information is a scarce commodity itself.•a social commodityExample: government uses accounting numbers (such as profits or researchexpenditure) to decide whether to give grants to particular firms.•ideology and exploitationExample: firms cut down jobs in their unprofitable divisions.3.Describe the semantic approach to theory construction.

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Solution Manualto accompany Accounting Theory 7e2.5Semantics: Semantics is sometimes referred to as rules of correspondence or operationaldefinitions. It connects symbols, words, terms or concepts with real-world objects,events or functions and is seen to make a theory realistic.(i)In accounting semantic theory concerns itself with the correlation of propositionsto objects or events and manifests itself in terms of measurement theories: forexample measuring the effects of inflation on assets and liabilities and adjustingthe accountstoreflect these adjustments. Theorists in this area argue that byapplying these adjustments, the accountsthenhave semantic content and can berelated to the real world (which they see as being market prices).Input semantics–assigning numbers to the transaction inputs of accounting, e.g. assets, liabilities,revenue, expenses.This transactions based approach is often criticised as amathematical system divorced from logical analysis or output semantics.(ii)Output semantics–testing the outputs of the accounting system against someexternal reference, e.g. increases in profits against share price changes (see alsoTheory in Action 3.1).(iii)It seems logical to conclude that if the purpose of undertaking accounting is toimpart semantic content to the numbers then they should be verified. This can beundertaken by checking market prices, stock prices or even the historical costdepending on the stated purpose of the accounting.However, this is a difficultquestion as there are very few external referents other than the stock marketandmarket prices.Further, market prices exist for a minority of businesses. In mostcases the financials determined by accountants are the sole determinant of a firm’sfinancial health.Many students, recognising this problem, will revert to a‘reasonableness test’.(a) Should the outputs of accounting systems be verified?The debate in the 1970’s about inflation was a normative debate in that researchersargued thatwe shouldchange the accounting methods and output reports producedaccording to the prescriptive judgement of the writer. That is we should use some formof market based accounting to adjust for inflation instead of historical cost accounting.Normative accounting research is more concerned with policy recommendations and isconcerned with what should be done in contrast to explaining why current practice iscarried out in the manner that it is.Normative theorists usually attempt to derive either the ‘true income’ or adopt the‘decision—usefulness’ approach whereby accounting reports are an input into users’decisions (e.g., to buy or sell shares, management decisions on the financial wealth offirms, etc.).The major issues are the impact of the changing price environment (prices) and theimpact on income, assets, liabilities and equity.As a consequence many normativetheorists are measurement theorists who attempt to incorporate the effects of inflationinto accounting reports. In this sense they take a semantic viewpoint—relating thefigures in the accounting reports to actual objects (assets, liabilities) or events (changesin inflation).

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Chapter 2: Theory and method2.6(b) If so, how can this be achieved? If not, why?Certainly if we have a valuation approach to accounting then inflation affects value andshould be taken into account in making decisions. Whether accounting should be purelya semantic science (or a syntactic or pragmatic science) is in itself a normativestatement and whichever way students answer this point should be brought to theirattention.Inflation may matter to some accountants but not to others. For example a managementaccountant who is trying to control costs or projects may have to pay a great deal ofattention to the inflation rates in various sectors, an accountant who is responsible forhedging money market funds will be interested in the real rate of return on funds or lookto inflation induced hedges (e.g., in real assets). On the other hand taxation accountants,auditors or record keepers may have very little interest in the effects of inflation.4.In the 1970s there was much debate about how to account for inflation.(a) Did this debate involve positive theory or normative theory?Compare the above normative approach to a positive approach, which would ask theempirical questions:‘Why do accountants manipulate data under the accrual system?’or, ‘Is accrual data more useful than cash flow data?’Instead of simply normativelyrecommending change.The approach is basically whether we understand the world asit is or suggest change based upon assumed premise.(b) Is it important to account for the effects of inflation? Why or why not?However both approachesmay or may not beindividuallyvalidbut compliment eachother.Both approaches need to be more rigorously examined before any conclusion iswarrantedand normative theories should contain pragmatic and semantic input andsimilarly positive theories should have logical and normative reasoning.5.Researchers who develop positive theories and researchers who developnormative theories often do not share the same views about the roles of theirrespective approaches to theory construction.(a) How do positive and normative theories differ?(b) Can positive theories assist normative theories, or vice versa? If yes, givean example. If not, why not?Normative accounting research makes policy recommendations and is concerned withwhat should be done in contrast to explaining why current practice is carried out in themanner that it is (positive theory).Normative theorists usually attempt to derive either the ‘true income’ or adopt the‘decision—usefulness’ approach whereby accounting reports are an input into users’decisions (e.g., to buy or sell shares, management decisions on the financial wealth offirms, etc.).The major issues are the impact of the changing price environment (prices)and the impact on income, assets, liabilities and equity.As a consequence manynormative theorists are measurement theorists who attempt to incorporate the effects ofinflation into accounting reports. In this sense they take a semantic viewpoint—relating the figures in the accounting reports to actual objects (assets, liabilities) or

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Solution Manualto accompany Accounting Theory 7e2.7events (changes in inflation). To some extent the approach of the IASB is a normativeapproach.Positive accounting theory was a reversion to testing or relating accounting theoriesback to the ‘facts’ or ‘experiences’ of the real world. Examples of such research werequestionnaires and surveys of bank officers or investors regarding their use of financialreports for decision making; or whether inflation adjusted accounting reports actuallyaided decision making. Current positive accounting research is aimed at explaining thereasons for actual accounting practices and in predicting the role of accounting data ineconomic,politicalandsocialdecisionmaking.Positivetheoryhasexpandedaccounting theory from the purely decision making focus of normative theorists intoanalysis of political and economic factors.Using the normative recommendation of IFRS, that fair values should be used infinancial statements, a positive theorists would first undertake a number of empiricaltests to see if they are actually useful/used by decision makers in their valuation models.In this sense they complement each other–normative theory the deductive analysiswith positive theory the empirical verification.6.Can accounting theory be constructed as a purely syntactical exercise? Whyor why not?The major problem with syntactics is that the truth value of any proposition isascertained by logic or reasoning alone. If the underlying accepted premises of the logichave no reference to the real world or are false, then the conclusions have either nopragmatic usefulness or the conclusion is incorrect. The tutor should mention here thereaction of logical positivism against metaphysical or abstract theorising (see text).Logical positivism argued that all theoretical statements should be capable of beingreduced to statements which can be immediately observed and that anything that cannotbe empirically verified is meaningless. The reaction was against romantic theorisingwhich had no practical application. Logical argument should be precise and serviceable.Science usually progresses via logical debate and counter debate. However, syntacticsalone cannot act as a source of true statements about the world. Syntactics alone areonly concerned with the derivation of statements from other given statements. This isthe real weakness of syntactics as a stand alone method.As an example of syntactics in accounting theory the instructor can use the theory ofdouble-entry and historical costs which has been confirmed and verified by auditorsmany times.The criticisms of this approach are:(i)allmanipulationsarecorrectaslongastherulesofmathematicalbookkeeping are applied(ii)there are many acceptable sets of ‘equations’(iii)no semantic verification—not descriptive of real world objects or events.

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Chapter 2: Theory and method2.8Under this approach science progresses by trial and error. The non falsification of boldhypothesis or the falsification of cautious hypothesis mark significant advances inscience.See also the answer to question one.In addition instructors may wish to channel discussion towards a discussion about howwe view the world.For example, using ontological assumptions and the Morgan andSmircich six-way classification that we may assume reality as being anything from aconcrete structure (realist—objectivist viewpoint) down to reality as a projection ofhuman imagination (unstable—human specific).If we have an ontological viewpoint that the accounting world is relatively concrete andstable then it is more appropriate to choose a syntactic-scientific approach to accountingtheory. That means that we are more likely to have a structured, prior theoretical basebut this must be backed up by empirical validation. On the other hand if we view theworld of accounting as being a product of human imagination we are more likely tohave an unstructured research methodology with no prior syntactic other than theassumption that we are facing a soft ontology.7.Classify the following hypotheses according to whether they are conclusionsof positive or normative theories. Explain your answers.(a)Historical cost accounting should be replaced by a market value system.(b)Historical cost accounting provides information used by creditors.(c)Historical cost accounting is used by many managers to allocate costs indetermining divisional performance.(a)normative(b)positive(c)positive

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Solution Manualto accompany Accounting Theory 7e2.98.Give an example of the types of issues that might be resolved by accountingtheories developed using the following methods of theory construction.(a)psychological pragmatic approach(b)scientific approach(c)naturalistic approach(d)normative approach(e)positive approach(a) the behaviour of investors to the release of accounting data(b) the reaction of all stock prices to the release of accounting data and why(c) the reaction of employees in one particular firm to the release of accounting data(d) all accounting reports should be adjusted by inflation before they are released(e) what type of accounting do firms in one particular industry use for inventory beforethey release their accounting reports9.Explain the naturalistic and syntactic approach to theory construction. Arethese approaches mutually exclusive?The difference between scientific and naturalistic research is set out in table 2.2on page32. The instructor should aid students’ understanding by briefly categorising accountingresearch into scientific and naturalistic.The International View (2.2) is an excellentbackdrop to illustrate the difference and to show how research hasdelineated.10.The decision-usefulness approach to theory development can be used todeveloptheories of accounting.(a)Explain what is meant by the decision-usefulness approach to theorydevelopment.(b)How can the decision-usefulness approach relate to accounting theoryformulation?(c)Give two examples of decisions that require data obtained fromaccounting reports.The decision-usefulness approach is an instrumentalist approach (see diagram p.25). Ina narrower sense, one direct test of an overall theory of accounting would be todetermine whether the output data of the accounting systems, which are constructed onthe basis of the overall theory, are useful to users. The data of the accounting systemsare utilised by users in their prediction models, and the conclusions (predictions) arethen used in their decision models. The problem is that if the prediction is verified, itverifies the prediction model, not the accounting system and its output. There are othervariables besides accounting data that affect the prediction. We do not know how theaccounting data were utilised. Also, if the decision turns out to be right, it verifies thedecision model, not the accounting system.Interpreting the evidence on decision-making is extremely difficult. We do not knowhow to interpret the evidence to determine that accounting information is useful. Thus, adirecttestisvirtuallyimpossible.Accountingstandardsettersusuallydetermineusefulness with the weaker, more direct tests which are usually advanced by accountingcommittee setting bodies and include: relevance, verifiability, freedom from bias,timeliness, comparability, reliability and understandability.

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Chapter 2: Theory and method2.10Some decisions:(i)To invest in a firm’s stock(ii)To loan funds to a firm(iii)To purchase or buy an asset.11.What type of a theory is historical cost? How has it been derived? Do youhave any criticisms of historical cost accounting?Historical cost is usually described as a pragmatic theory whereby premises aredetermined by observing the practice of accountants. Criticisms: no logical analysis ofaccountants’ actions, does not allow change, does not focus on measurement, circularityof logic in the rules, outputs not verified, doublethink, conventions not subject tofalsification. The argument is pragmatic positive as it is observable and descriptive ofthe behaviour of accountants over a number of centuries.It is also true that historical cost accounting provides a system of allocating costs overdifferentreporting periods (accrualaccounting).In this sense itisa deductiveargument.A point of logical contention, however, is whether the allocation of costs istruly systematic (in a deductive sense), because a number of the ways in which the costsare allocated appear to be done in an ad hoc fashion without inductive reference toevents that occur in the real world of asset valuation.12.Explain the psychological pragmatic approach to accounting theory. Give aexample of how it can be applied.The psychological pragmatic approach to accounting theory is examining the reactionsby investors and the general public to the release of accounting data.One researchquestion is whether investors are fooled by cosmetic accounting numbers or are theyfinancially rational.This research issue is covered in a later chapter but has gainedgreater prominence after the failure of ENRON and their questionable accountingpractices.13.Give an example of an accounting convention usually adopted in historicalcostaccounting. Conventions govern the way accounting is practised, andconventionsare, by definition, known from practice.(a)What theoretical approach is used to derive conventions?(b)What does your answer to (a) imply about the potential for accountingtheories based on conventions to be innovative in providing usefulinformation?Accounting conventions (assumed premises) in historical cost are:•Conservatism–stewardship and accelerating the reporting of bad news overgood news•Matching costs–calculation and focus on the income statement as a valuationmetric (the balance sheet is the cost residual from this outcome)•They are innovative in providing solutions to stewardship problems and agencyproblems such as the payment of CEO bonuses.14.How do you think massive amounts of data now available from informationtechnologies will affect

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Solution Manualto accompany Accounting Theory 7e2.11(a)the development of accounting theories(b)the testing of accounting theoriesThe massive amount of data now available from information technologies will affect:the development of accounting theories by making theories capable of being tested in bythe application of semantic (availability of prices, and accounting data) and pragmatics(the reaction of accountants, investors and society) to the release of accounting reports.This means a probable move away from syntactic and normative theories towards moreempirical based positive theories.However, be aware of the British school that tends to have a closer relationship withsyntactic arguments from sociology, history and psychology.In combination the trend may be towards a combination of these two approaches.15.What are some common criticisms of a scientific approach to professionssuch as accounting and law? Are they valid? Why or why not?The instructor should start by providing or asking for a brief overview of the scientificmethod,definedasasystematicapproachofobservation,hypothesisformation,hypothesis testing and hypothesis evaluation in testing a theory. A discussion of themethods used and the advantages/disadvantages should be analysed in class. (See thetext for a more detailed description.)The answers given by students to this question will be varied, but the tutor should aimto impart knowledge of the different forms of scientific methods and the way in whichscience is seen to advance. The essential components are:i.Syntacticsii.Semanticsiii.Pragmaticsiv.Hypothesis formulationv.Testingvi.EvaluationWhether the scientific method is valid is a question of degree but a comparison betweenalternatives will help. For example:The dogmatic basis is used when we believe in a statement because of confidence in theperson or group issuing the statement. This confidence may be due toareligious orpolitical belief, ordueto the credentials, position or charisma of the speaker or writer.We employ this basis frequently, since we cannot be expected to personally ‘test’everything. We believe in what we read in the newspapers, in textbooks we use inschool, in what our teachers tell us, etc. The weakness of this basis is that personalopinion, rather than evidence, is the critical factor. Introspective evidence is acceptable.The self-evident basis is used when we believe in a statement because it appears to besensible or obviously true, based on our general knowledge and experience. Forexample, the statement ‘children love to eat candy’ would be accepted as self-evidentlytrue by most people. They would not feel an empirical study needs to be conducted. Theweakness of this basis is that what is sensible or obvious to one person is not to another.What appears to be so obvious may turn out to be incorrect.

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Chapter 2: Theory and method2.12In contrast, the scientific basis is used when we believe in a statement because of thelogical relationship of the terms and the objective, empirical evidence in support of thestatement. The demand for objective, empirical evidence is the significant factor. Thescientific basis was formulated to overcomethe weaknesses of the other two.16.Earlyauditingtheorieswereconstructedbyobservingthepracticesofauditors. What type of theory construction is this? What are the advantagesand disadvantages of this approach?The theory construction is pragmatic positive as it is observable and descriptive of thebehaviour of auditor practices over a number of centuries.The major system auditedover this period is historical cost accounting that provides a system of allocating costsover different reporting periods (accrual accounting). Advantages: In this sense becauseit is historical the major advantage was the ease of confirming transactions by referenceto vouchers. Another advantage of this approach is that auditors are close to clients andthey are able to assess the accounting needs of business.Disadvantages: A point oflogical contention, however, is whether the allocation of costs is truly systematic (in adeductive sense), because a number of the ways in which the costs are allocated appearto be done in an ad hoc fashion without inductive reference to events that occur in thereal world of asset valuation. It may be that auditors are acting in the interests ofmanagers rather than equity owners.It may also be that auditors are maintaining asystem of accounting that is easy to verify rather than one that provides a more up-to-date information set.17.How would you design an experiment to provide evidence on how auditorsmake judgements? What competing issues would arise?The discussion should address the problem of making the experiment realistic enoughfor auditors to make decisions in the same way they would in ‘real life’ by providing thesort of information they would normally receive and under the conditions they wouldnormally work. When the experiment is sufficiently realistic, it is said to have externalvalidity.The researcher would also have to design the experiment so that there are not too manyvariables, or factors being changed between the auditors. For example, if the researcheris trying to determine the effect of providing information in a different order on theauditors’ decisions, the experiment has to hold other factors constant. The aim is to beable to attribute the change in the decision to the change in the order in whichinformation is provided. If this is achieved, the experiment has internal validity.How many things could upset the internal validity of an experiment?Examples include bias in selection of the auditors (more experienced auditors areassigned to one group), repeated testing (if the experiment is repeated auditors couldlearn, grow tired, start to anticipate the researcher’s aims) and experimenter bias (wherethe researcher unconsciously sends signals to the participant auditors about the desiredaction).

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Solution Manualto accompany Accounting Theory 7e2.13International View2.1 IFRS is a Big Four gravy trainThis is an article that succinctly points out the dangers of having (i) one vision ofaccounting, and (ii) the contagion effect of standard setting.1.The differences–investor decision making and a balance sheet valuationapproach matching expenses against revenueswitha focus on stewardship andperformanceover time.Local authorities should not be assessed the same aslisted stocks.2.Students are encouraged to address this issue and consider that accounting is notone-dimensional. The “simple” answer is yes!3.Murphy is using both a systematic argument-local councils have differentobjectives and a semantic argument–they require different measures.There isalso a hint of pragmatics in the behaviour of the big 4.4.Lack of scientific consideration but students should be encouraged to debate theissues raised.International View2.2 Financial accounting: an epistemological research noteAfter reading this article students should realise the complexity of accounting and thefar reaching impact of the various theories and differentresearch approaches.All theprimary accounting theories in the chapter are touchedon but there is an emphasis onthe competing North American and British approaches:1.(i)The North American approach−ontology–reality is objective to satisfy theman made concepts of investor and management financial decision making.Epistemology is generally as described under scientific research in Table 2.2.(ii)The British approach–ontology–reality is socially constructed based uponthe sociology, psychology, history and political disciplines.Epistemology isshaped by various social interactions and cannot be reduced to single normativestatements or hypotheses to be tested.2.All accounting theories are normative.The instructor should encourage studentsto explain further with the view that a normative assumption is always madeaboutthe objective i.e. Decision making, stewardship, societyetc.3.Effects on society are numerous. Questions of resource usage efficiency, decisionmaking, there are economic gainers andlosers, there are affects on accountants,investors, managers, and society at large.This list is not exhaustive and studentsare encouraged to explore their observations and ideas.

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Chapter 2: Theory and method2.14Theory in Action 2.1Doshare pricesrisewhen profitimproves?1.The article describes a market reaction to accounting profit news. Thisdescription involves an example of which approach to theory:(a)Pragmatic(b)Syntactic, or(c)Semantic?Explain your answer.Describing this reaction to a profit announcement is an example of a semantic approachto theory, in particular output semantics. An output of the accounting system (that is, theprofit figure) is being tested against an external reference (that is, share price). Shareprices react tounanticipatedincreases or decreases in earnings, because these representnew informationthat will cause investors torevise their expectationsregarding thefirm’s future cash flows. In an efficient capital market, changes in expectations of afirm’s cash flows will lead to changes in the firm’s share price if share prices represent acapitalisation of future cash flows. The article describes how the shares inMetcash roseby 7 cents following the announcement of expected future organic and acquisitiongrowth driving sales and earnings. This is because the market expectedMetcash toperform better in the future.The description is also pragmatic in that it is useful in terms of its potential to assistmanagers in knowing how to deal with earnings announcements in order to maximisefirm value.To the extent that the market reaction is compared against a theory developed usingsyntactic relations, there is a syntactic component to the theory as well.Overall, though,we would argue that the primary approach is semantic, by relating theoretical constructsto real world references.2.Consider the following syllogism:When a company reportsbetter prospectsthan previously, investors forcethat company’s share price to increase.•Metcashis a company that has reportedbetter earnings per sharethanpreviously.•Investors forcedMetcash’sshare price to increase.(a)Is there a flaw in the syntaxor semantics within the syllogismthatmeans its conclusion is not true? If so, what is the flaw?(Hint: Considerwhether the general premise at the start of the syllogism must always betrue.)There is no flaw in the syntax of the syllogism. The syntatics is valid as it follows alogical reasoning, which means if both premises were true, the conclusion would also betrue. The fact that the conclusion is not true is caused by a semantics problem.

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Solution Manualto accompany Accounting Theory 7e2.15In the argument above, although the logic is sound, there is a problem with thesemantics of the syllogism. AfterMetcashannounced that itincreasedearnings by 13.3per cent in 2009its share pricerose. The flaw is in the premise‘When a companyreports higherearningsthan previously, investors force that company’s share price toincrease’. The reality shows that when a company reports higherearnings, its shareprice may not always increase. A company’s share price will generally increase when itsearningsexceed those anticipated by the market. Butfor numerous reasons,forexample, the presence of short term traders on the share register of a company, its shareprice might fall as the traders exit the share as the earnings improvements are notexpected to be affecting the very short term cash flows of the firm.(b)What is the practical significance of this theory being invalid and itsconclusion false?The practical significance is that it is not sufficient for a firm just to makeanyearningsto increase its share price, as the market will only value any increase inearningsthat isaboveor supplemental toits expectation. In other words, the firm has toexceedthemarket’s expectation to increase its share price.

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Chapter 2: Theory and method2.16Theory in Action 2.2Normative theories of investment1.What is a bull market?A bear market?A bull market is a market which is experiencing a prolonged period of generally risingshare prices. A bull market often occurs when the market is recovering from recessionor experiencing an economic boom.A bear market is a market that is experiencing aprolonged period of decreasing share prices. A bear market often occurs when a marketis moving towards or is in recession.2.Why would high commodity pricesandlow interest rateshelp to maintainshare prices?As Australia is a producer of commodities, high commodity prices due to increases inglobal demand and/or decreases in global supply will increase commodity exportrevenues. High commodity export revenue could enable Australian firms to increasetheir retained earnings and allow Australia to build its reserves and maintain a strongbalance of payment position. This will encourage more investment in Australianbusinesses, and cause share prices to rise. Similarly, low interest rates will result inmore consumer spending or investment in shares as there will be a larger portion ofdisposable income available to be spent after paying for debt and interest, and lessincentive to invest in interest bearing securities since returns are lower.3.What is the theoryunderlyingthe advice to‘buy the dips’? Is this anormative theory? Explain your answer.The theory underpinning the adviceto ‘buy the dips’ isthat firms withvolatileshareprices may present opportunities for investors to acquire equity at competitive prices asthe market isinefficient.Thoseinvestors who buy at lower prices may be able to reapprofits by trading the shares when the market becomes more efficient (and the trendreverses) either on a short term or a longer term basis.The advice that investors should look for firms withvolatile share prices and ‘buy thedips’, is a normative statement, in that it prescribes what investors should do to achievea desirable outcome (gains).On the other hand,atheory that firms will(say)distribute higher dividends and thuspush their share prices to increase,is a positive theoryas it explains/predicts themovement of share prices in relation to rising revenues, profits, and dividends.

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Solution Manualto accompany Accounting Theory 7e2.17Theory in Action 2.3Alternative approaches to accounting theory construction1.What market backlash do businesspeople fear if they do not meet theirforecast earnings or growth targets? Why?Businesspeople who do not meet their forecast earnings or growth target will facepressure first of all from their shareholders. As shareholders demand higher profits,inability to meet profit target will result in some sort of personal penalty, for examplevia reputation effects, reduced or removed performance bonuses, or threats to theiremployment tenure. In general, the market would penalise firms that do not meet theirforecast target by marking the firms down, that is reducing the firms’ share prices.2.Mr. Fletcher describes how he has learned not to publicly disclose five-yearannual profit growth targets. Explain what is likely to have caused him tolearn that lesson. In coming to the conclusion, what approach to theoryconstruction has Mr. Fletcher applied? Explain your answer.Mr. Fletcher mentioned that he‘has done it once’, that is he has publicly disclosed five-year annual profit growth targets before, against the board of directors advice. It islikely that during that five years he was not able to deliver the targeted performance,putting pressure on himself and risking his position as Coles Myer CEO, and puttingpressure on the board of directors. Since then, he has learnt not to disclose any profitgrowth because the risk of doing that is too high in such a susceptible market. In thiscase, Mr. Fletcher applies the psychological pragmatic approach, which observes users’responses to accountants’ outputs (the five-year profit growth targets). After profittargets are disclosed, users react when firm’s performance is not according to what waspredicted. His is also an inductive approach, leading from an initial premise ofindividual personal experiences.3.Can the scientific approach to theory construction and testing be useful inrelationtopredictingwhenandhowinvestorswillreacttoearningsannouncements? How/Why not?Yes, the scientific approach can be used to predict when and how investors will react toearnings announcements. In this case, investors’ reactions are measured through thechanges in share prices (increase/decrease) following the earnings announcements,allowing abnormal gains/losses to be made. The research problem to test is whethershare prices will respond to new information associated with the announcements, andwhen that will happen relative to the announcement day. This can be examined byconducting an event study investigating the share returns associated with the release ofinformation relating to share trades. It would be expected that investors would react toearnings announcements. The question, however, is when investors will react to therelease of such information. Data associated with earnings announcements and anyabnormal gains/losses can be gathered from a sample of firms. Data are then analysed

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Chapter 2: Theory and method2.18andevaluatedtodeterminehowandwheninvestorswouldreacttoearningsannouncements.4.What is the importance to society of developing a theory to explain therelationship between earnings forecasts, earnings announcements, and shareprice movements?The importance is to provide guidance to the society on how share prices move inrelation to earnings forecasts and earnings announcements. By developing and thentesting the theory, researchers will contribute to explain and predict what happen in theshare market surrounding earnings announcements. Society would benefit in terms ofgaining knowledge to guide them in making decisions. For example, firms will considercarefully whether they would announce earnings forecasts if there is a theory suggestingthat share price will move downward when actual earnings do not reflect earningforecasts. Similarly, the theory will also help investors to make decisions, for examplewhether to buy or sell their shares, following earnings announcements.Overall, thepragmatic significance of the theory is that it affects individuals’ wealth distributionsand the distribution of wealth amongst businesses, and also the generation of wealth byfirms whose ability to raise capital is affected.

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Solution Manualto accompany Accounting Theory 7e2.19Theory in Action 2.4Alternative approaches to accounting theory construction1.What market backlash do businesspeople fear if they do not meet theirforecast earnings or growth targets? Why?Businesspeople who do not meet their forecast earnings or growth target will facepressure first of all from their shareholders. As shareholders demand higher profits,inability to meet profit targetsmayresult in some sort of personal penalty, for examplevia reputation effects, reduced or removed performance bonuses, or threats to theiremployment tenure. In general, the market would penalise firms that do not meet theirforecast target by marking the firms down, that is reducing the firms’ share prices.2.Can the scientific approach to theory construction and testing be useful inrelationtopredictingwhenandhowinvestorswillreacttoearningsannouncements?Why or why not?Yes, the scientific approach can be used to predict when and how investors will react toearnings announcements. In this case, investors’ reactions are measured through thechanges in share prices (increase/decrease) following the earnings announcements,allowing abnormal gains/losses to be made. The research problem to test is whethershare prices will respond to new information associated with the announcements, andwhen that will happen relative to the announcement day. This can be examined byconducting an event study investigating the share returns associated with the release ofinformation relating to share trades. It would be expected that investors would react toearnings announcements. The question, however, is when investors will react to therelease of such information. Data associated with earnings announcements and anyabnormal gains/losses can be gathered from a sample of firms. Data are then analysedandevaluatedtodeterminehowandwheninvestorswouldreacttoearningsannouncements.3.What is the importance to society of developing a theory to explain therelationship between earnings forecasts, earnings announcements, and shareprice movements?The importance is to provide guidance to society on how share prices move in relationto earnings forecasts and earnings announcements. By developing and then testing thetheory, researchers will contribute to explainingand predictingwhat happen in the sharemarketat the timesurrounding earnings announcements. Society would benefit in termsof gaining knowledge to guide them in makingefficientdecisions. For example, firmswill consider carefully whether they would announce earnings forecasts if there is atheory suggesting that share price will move downward when actual earnings do notreflectearningforecasts.Similarly,thetheorywillalsohelpinvestorstomakedecisions,forexamplewhethertobuyorselltheirshares,followingearningsannouncements.Overall, the pragmatic significance of the theory is that it affectsindividuals’ wealth distributions and the distribution of wealth amongst businesses, andalso the generation of wealth by firms whose ability to raise capital is affected.Case Study 2.1

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Chapter 2: Theory and method2.20New accounting rules‘don’t add up’1.What are International Financial Reporting Standards?International Financial Reporting Standards are accounting standards developed by theInternationalAccountingStandardsBoard(IASB),whichisanindependentinternationalorganisationsupportedbyprofessionalaccountingbodies.Formerlyknown astheInternational Accounting Standards (IAS), the objective of IFRS is toachieve uniformity and transparency of accounting principles used by entities forfinancial reporting around the world.2.Manyargumentsare expressed in this article. Listthreefactors that youthink are causingconcernabout theimpactofadoptionof IFRS.Three of the factors causingconcernabout the prospect of adopting IFRS include:•Companiesarerequiredtorecognise,presentordiscloseinformationinatransparentway.•The use of fair value accounting which requires asset and liability revaluations tobe passed through the income statement both (a) increases earnings and leveragemeasures ofvolatility; and (b) takes more effort to implement.•IFRSdo not provide more insight into firm riskthan existing accounting standards.3.Consider each of the three factors you mentioned in response to question 2.(a)Is there empirical evidence to support the factor?(b)Is the analysis leading from the factor to theconcernsaboutadoption ofIFRSscientific or naturalistic in its approach? Explain your answer.(i)Companies are required to recognise, present or disclose information in a differentway.Yes. For example, adoption of IFRS in Australia also requires companies to recogniseshare-based transactions, which was not the case previously.The accounts of companiesadopting IFRS differ from those of firms using different national accounting standards.The evidence used as the basis for the claims is naturalistic if it is evidence from firms’individual accounts that underpins the claims by individuals in many cases.Theseaccounts have been observed by individuals who have become concerned about thenature of the changes required under IFRS.However, if a research study has been conducted, say by academics,then that researchstudy is likely to follow the scientific approach of analysing many firms’ financialstatements, or reconstructions of their past financial statements, to come to a generalconclusion regarding the view that firms are required to recognise, present or discloseinformation differently from their current approach.(ii)The use of fair value accounting which requires asset and liability revaluations tobe passed through the income statement both (a) increases earnings and leveragemeasure volatility; and (b) takes more effort to implement.

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Solution Manualto accompany Accounting Theory 7e2.21Yes, there is some empirical evidence that fair value accounting creates more volatility.For example, Barth, Landsman, and Wahlen (1995) examined fair value of US banks’investment securities and found that fair value-based earnings are more volatile thanhistorical-based earnings.The use of fair value accounting leads to a complaint that it introduces volatility intoreported profits, as revaluations must be brought into the income statements.Theevidence used as the basis for the claims is naturalistic if it is evidence from firms’individual accounts that underpins the claims by individuals in many cases.Theseaccounts have been observed by individuals who have become concerned about theincrease in earnings and leverage volatility reported under IFRS.However, if a research study has been conducted, say by academics,then that researchstudy is likely to follow the scientific approach of analysing many firms’ financialstatements, or reconstructions of their past financial statements, to come to a generalconclusion, statistically tested, regarding the view that volatility increases after IFRSadoption.(iii)IFRSdonotprovidemoreinsightintofirmriskthanexistingaccountingstandards.The empirical evidence can include thetype of risk disclosed and its impact on profitand financial position; thedifficulty in riskcompared with the auditoffinancialstatementsprepared under national standards, etc.The evidence used as the basis for the claims is naturalistic if it is evidence fromindividuals learning to prepare/auditing firms’ individual accounts that underpins theclaims by individuals in many cases.However, if a research study has been conducted, say by academics, then that researchstudy is likely to follow the scientific approach of analysing the time spent byaccountants and/or auditors in relation to numerous firms’ financial statements, orreconstructions of their past financial statements, or statements pre-and post-IFRSadoption.4.Howcouldresearchersevaluatethedecision-usefulnessofadoptingInternational Financial Reporting Standards?The decision-usefulness approach builds from a basic assumption that the objective ofaccounting is to assist users of accounting reports in their decision-making process byproviding useful and relevant information in the accounting reports. To evaluate thedecision-usefulness of adopting IFRS, researchers need to examine whether financialreports prepared under IFRS are useful for users in making economic decisions. Thereare a number of ways to do that. One way is to undertake a value-relevance studyinvestigating whether certain items disclosed in financial reports, such as financialinstruments or intangible assets, are value-relevant (i.e. provide relevant and reliableinformation for users). Another way is to conduct a survey among firms that haveadopted IFRS, or survey users of their financial reports.Other research methods can beteased out with the class.

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Chapter 2: Theory and method2.225.What role can positive theory play in resolving the issue(s) described in thearticle?Researchers can conduct positive accounting research to examine and find empiricalevidence that can support or reject the issues described in the article. Investigating howadoption of IFRS works in the UK can be used to enhance the theory of how globalaccounting standards should provide more benefits, as it will describe and explain theissues and consequences associated with adopting IFRS.6.What role can normative theory play in resolving the issue(s) described in thearticle?Commencing with premises regarding the desirable attributes of aglobalaccountingsystem and premises regarding how well differentnational and otheraccountingsystems (including IFRS) meet those attributes, (this may be the outcome of eitherpositive or normative theories, depending upon the nature of the attribute in question).Anormativetheorycanleadtohypothesesregardingthebestwaytoachieveaccounting’s goals.

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Solution Manualto accompany Accounting Theory 7e2.23Case Study 2.2The thrill is gone1.Lend Lease reported a 13.5% increase in profit for 2004–2005. Why was theshare market unimpressed?The Lend Lease 2004–2005 profit did not meet the market’s expectations. During thatperiod, Lend Lease did well to produce a growth business through its retail andresidential development, including some prominent projects in the US such as cleaningup the WTC site after the September11,2001 attack. However, the market expectedLend Lease to do more infrastructure works,such as toll roads and tunnels, which LendLease has no plansto do. Therefore, the market was unimpressed by the Lend Leaseresults.2.In trying to explain shareholders’ subdued reaction to Lend Lease reportedearnings,explainwhetherand/orhowyoucouldusethefollowingapproaches to accounting theory construction:(a)pragmaticThe pragmatic approach (especially the psychological pragmatic approach) observeshow users respond to accounting outputs (in this case profit announcement). In the LendLease case, shareholders were unimpressed with the profit announcement, causing theshare price to fall.To assess reasons for the subdued reaction, a study using protocolanalysis of shareholders’ reactions to other firms’ earnings announcements and the LendLease earnings announcement, after subjects had been provided with different sets ofprior information aboutanalysts’ forecasts of earnings would be useful to buildcumulative evidence.Alternatively, researchers could survey the users of the financialstatements.This approach could also be undertaken under the positive accounting orscientific method approaches.(b)decision-usefulnessThe decision-usefulnessapproach assumes that accounting outputs provide usefulinformation for users inthedecision-making process. This approach would try todetermine whether accounting outputs (Lend Lease profit announcement) provide usefulinformation for the shareholders to make decisions.Shareholders could be given a set ofprior information and the accounts of Lend Lease, and then in a separate experimentgive a set of different prior information and the accounts of Lend Lease.At the end ofeach analysis of the financial statements, they might be asked to bid for shares, to seewhich set of accounts/prior information leads to the lower share price.(c)positive accounting theoryPositive theory deals with explaining or predicting what actually happens in the realworld.Usingpositivetheory,researcherswouldtrytoexplainwhy,inreality,shareholders were not impressed with Lend Lease performance despite its 13.5% profit.They would probably collect data concerning earnings announcements and analysts’

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Chapter 2: Theory and method2.24forecasts,andstatisticallycomparethereturnsfordifferentcircumstances:whenanalysts’ forecasts are above, below, or at the amount of profit reported.(d)normative theoryNormative theory is concerned with prescribing what should be done. One of the issueswhich becomes the focus of some normative theorists is how to derive the ‘true income’(profit).Intryingtoexplaintheshareholders’responsetoLendLeaseprofitannouncement,normativetheorywouldconcentrateonwhetherLendLeasehasmeasured its profit figure correctly, and if it is the case, whether the profit figure wouldprovideusefulinformationforshareholders(decision-usefulnessapproach).Thenormative theory approach does not explain the subdued reaction; rather it might comeup with recommendations for how firms should calculate and report their profits.(e)scientific approachBased upon observations that firms’ share prices generally increase after positiveearnings announcements, but sometimes do not, the scientific approach would causeresearchers to develop theories about why that was the case. See the explanation for thepositive theory approach.(f)naturalistic approachThe naturalistic approach is appropriate to use in explaining an individual shareholder’sreaction to the Lend Lease announcements, as it focuses on firm-specific problems.Using case study as a method, this approach will try to answer the question why themarket is unimpressed with Lend Lease’s performance, although it has delivered 13.5%profits during 2004–2005 and predicted a double-digit growth in 2006.3.Which of the approaches described in answer toquestion(2)do you believe ismost useful? Why?The approaches are generally not necessarily incompatible. We would argue that thebest approach is through triangulation: the use of multiple approaches to see if they alldeliver consistent outcomes. Overall, though, we argue that the scientificapproachprovides a more generalisable result.This approach is likely to be appliedin a positiveaccounting theory context.It could be supplemented by case studies conducted usingthe naturalistic approach.4.Aretheapproachesyoudescribedinanswertoquestion(2)mutuallyexclusive, or can they be used to complement each other? Explain?There are some approaches that are mutually exclusive within the one study and someothers that are not.For example, positive accounting theory approaches are generally asubset of the scientific method approach.However, positive accounting theory simplyrefers to the development of explanatory theory, and it is thus consistent with thedecision-usefulness approach, etc. All approaches can be used to complement eachother. Scientific and naturalistic approaches, for instance, are mutually exclusive, in thatthey cannot be applied at the same time due to different perspectives. The scientific

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Solution Manualto accompany Accounting Theory 7e2.25approach is a highly structured approach to analyse problems based on prior knowledge.It also relies on predetermined procedures and statistical techniques to validate or refutetested hypothesis, which results in answers that can be applied in general understanding.The naturalistic approach, on the other hand, starts from the view that reality is sociallyconstructed and a product of human imagination. In other words, reality is not objective,but a result of people’s interpretations of situations and events they experience. Hence,this approach is best used to analyse problems with unique setting and no preconceivedassumptionsortheories(suchasshareholders’reactionofLendLeaseprofitannouncement). It aims to solve individual problems, and thus the result may bedifficult to generalise.Some approaches can be used to complement each other. For example, the pragmaticapproach provides a usefulness test for the decision-usefulness approach—one way totest whether accounting outputs provide useful information is by examining users’responses to the reports. As mentioned inquestion 5(b), positive and normative theorycan also complement each other. Normative theory prescribes what should be done, andone way to do that is by usingthedecision-usefulness approach. Positive theoryidentifies and tries to explain what is actually being practiced in the real world usingscientific approach. This, in turn, can form the basis of developing normative theory toimprove current practices.

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Chapter 2: Theory and method2.26Case Study2.3Intergovernmentalworkinggroupofexpertsoninternationalstandards of accounting and reporting1.What are International Financial Reporting Standards(IFRS)?International Financial Reporting Standards are accounting standards developed by theInternationalAccountingStandardsBoard(IASB),whichisanindependentinternationalorganisationsupportedbyprofessionalaccountingbodies.Formerlyknown astheInternational Accounting Standards (IAS), the objective of IFRS is toachieve uniformity and transparency of accounting principles used by entities forfinancial reporting around the world.2.Manyconcernsare expressed in this article. Listthreefactors that you thinkare causingconcernabout theimpactofadoptionof IFRS.Three of the factors causingconcernabout the prospect of adopting IFRS include:•Companies are required to recognise, present or disclose information in atransparentway.•The use of fair value accounting which requires asset and liability revaluationsto be passed through the income statement both (a) increases earnings andleverage measures ofvolatility; and (b) takes more effort to implement.•IFRSdo not provide more insight into firm riskthan existing accountingstandards.3.Consider each of the three factors you mentioned in response to question 2.(a)Is there empirical evidence to support the factor?(b)Is the analysis leading from the factor to theconcernsaboutadoption ofIFRSscientific or naturalistic in its approach? Explain your answer.(i)Companies are required to recognise, present or disclose information in adifferent way.Yes. For example, adoption of IFRS in Australia also requires companies torecognise share-based transactions, which was not the case previously.Theaccounts of companies adopting IFRS differ from those of firms using differentnational accounting standards.The evidence used as the basis for the claims is naturalistic if it is evidence fromfirms’ individual accounts that underpins the claims by individuals in many cases.These accounts have been observed by individuals who have become concernedabout the nature of the changes required under IFRS.However, if a research study has been conducted, say by academics,then thatresearch study is likely to follow the scientific approach of analysing many firms’financial statements, or reconstructions of their past financial statements, to cometo a general conclusion regarding the view that firms are required to recognise,present or disclose information differently from their current approach.

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