Accounting Theory, 7th Edition Solution Manual
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Solutions Manual
to accompany
Accounting Theory 7e
By
Victoria Wise
Chapter 1
Introduction
to accompany
Accounting Theory 7e
By
Victoria Wise
Chapter 1
Introduction
Chapter 1: Introduction
1.2
Chapter 1 - Accounting Theory
THEORY IN ACTION
Theory in Action 1.1 Theory implementation and politics
1. The article describes how a particular theoretical approach has been
replaced by another. Explain why one theory replaces another, and who, or
what, 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 be
independently observed and consistent after repeated observations. Some theories are
speculative or ideas or guesses floated to encourage researchers to undertake the
observations required to prove or disprove the theory. The question often debated is
what comes first — the theory or the observation? For example, did Darwin start
thinking about different species and the idea of natural selection or did evolution enter
his thoughts? Did he detail these thoughts as a testable proposition and then set out to
observe? Or did he observe aspects of nature which led him to formulate a theory of
evolution? 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 supported
by observations, then the theory is accepted. But not necessarily by everyone. Why not?
Some may not be satisfied with the methods adopted to test the propositions; others
simply may not believe the theory explains or defines reality and propose alternative
theories.
In the specific case of Bernanke’s theoretical choices based upon his detailed
knowledge of the Great Depression, a similar process would be required and if the
weight of evidence supported Bernanke’s propositions in explaining economic
outcomes, then his theoretical perspective would supplant other theoretical perspectives.
In the social sciences it is even more complicated than the physical sciences. The
interpretations of outcomes and behaviours are subject to individual research
interpretations and the full range of factors impacting on the economy, for example, are
much more difficult to control or isolate.
2. Does the reintroduction of a theory mean that it should not have been
replaced in the first place?
Theories about how the economy works and what will happen in the economy where
there is monetary policy or fiscal policy intervention are appropriate in assisting policy-
makers understand the possible implications of decisions they make or are under
consideration. However, they are rarely complete models and often outcomes cannot be
predicted. Reintroduction of a theory suggests that new evidence in support of the
theory has been reported.
1.2
Chapter 1 - Accounting Theory
THEORY IN ACTION
Theory in Action 1.1 Theory implementation and politics
1. The article describes how a particular theoretical approach has been
replaced by another. Explain why one theory replaces another, and who, or
what, 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 be
independently observed and consistent after repeated observations. Some theories are
speculative or ideas or guesses floated to encourage researchers to undertake the
observations required to prove or disprove the theory. The question often debated is
what comes first — the theory or the observation? For example, did Darwin start
thinking about different species and the idea of natural selection or did evolution enter
his thoughts? Did he detail these thoughts as a testable proposition and then set out to
observe? Or did he observe aspects of nature which led him to formulate a theory of
evolution? 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 supported
by observations, then the theory is accepted. But not necessarily by everyone. Why not?
Some may not be satisfied with the methods adopted to test the propositions; others
simply may not believe the theory explains or defines reality and propose alternative
theories.
In the specific case of Bernanke’s theoretical choices based upon his detailed
knowledge of the Great Depression, a similar process would be required and if the
weight of evidence supported Bernanke’s propositions in explaining economic
outcomes, then his theoretical perspective would supplant other theoretical perspectives.
In the social sciences it is even more complicated than the physical sciences. The
interpretations of outcomes and behaviours are subject to individual research
interpretations and the full range of factors impacting on the economy, for example, are
much more difficult to control or isolate.
2. Does the reintroduction of a theory mean that it should not have been
replaced in the first place?
Theories about how the economy works and what will happen in the economy where
there is monetary policy or fiscal policy intervention are appropriate in assisting policy-
makers understand the possible implications of decisions they make or are under
consideration. However, they are rarely complete models and often outcomes cannot be
predicted. Reintroduction of a theory suggests that new evidence in support of the
theory has been reported.
Solution Manual to accompany Accounting Theory 7e
1.3
3. Should a theory be discarded if it does not specify the means of achieving a
stated objective? Explain your answer.
The theory itself doesn’t have to specify the means of achieving a stated objective;
however, it has to provide a sound basis for explaining, defining and predicting
behaviour. The application of the theory can have many elements and it is in the
interpretation of what will induce the predicted effects in the economy predicted by the
theory which will result in predicted or other stated outcomes.
Instructors should ask the students to discuss how we would know whether a reduction
of corporate interest rates resulted in an increase in the inflation rate?
1.3
3. Should a theory be discarded if it does not specify the means of achieving a
stated objective? Explain your answer.
The theory itself doesn’t have to specify the means of achieving a stated objective;
however, it has to provide a sound basis for explaining, defining and predicting
behaviour. The application of the theory can have many elements and it is in the
interpretation of what will induce the predicted effects in the economy predicted by the
theory which will result in predicted or other stated outcomes.
Instructors should ask the students to discuss how we would know whether a reduction
of corporate interest rates resulted in an increase in the inflation rate?
Loading page 4...
Chapter 1: Introduction
1.4
Theory in Action 1.2 Out of Control
1. ‘Rogue’ is defined in the Oxford dictionary as ‘that which lacks appropriate
control; something which is irresponsible or undisciplined’. Given this
definition, who is ultimately responsible for the rogue trading outlined in the
Societe Generale scandal: the trader directly involved; management, who are
responsible for the high-risk, high-reward framework in which the trader
operated; or a combination of both?
Obviously all parties are responsible for their actions. The weak risk-management
controls in place at Societe Generale allowed behaviour which ultimately could not be
controlled by the employer. Why? Because Societe Generale created an environment
where traders could become ‘rogues’. It is important to appreciate that the emergence of
‘rogue’ behaviour can be a function of environment and in particular the embedded
controls designed to detect and inhibit such behaviour. In addition, if management was
pushing for outcomes, in a way the ‘rogue’ was seeking to meet management’s
performance expectations. Actions, demands, and also incentives, create and/or
reinforce behaviour. The impact of financial performance benchmarks should not be
underestimated. Students should discuss how controls, monitoring, and incentives can
discourage/create behaviours and what types of factors are more likely to stimulate
‘rogue’ behaviour.
2. Discuss the role played in the SocGen case by each of the three elements:
personality, institutional framework, opportunity.
(1) Personality — in a competitive environment people will either compete or leave.
In the competition itself behaviours will have to change and adapt, risk
preferences will shift and consideration of the downside possibilities discounted.
Research shows that a group environment often results in different behaviour to
individual or isolated thinking.
(2) Institutional framework — SocGen was not controlling its risk associated with
trading and this allowed the individual involved to operate outside the accepted
parameters. Also, the individual’s knowledge of back-room trading operations and
processes meant that significant ‘positions’ and losses could be hidden and offset
against the upside, this gave the institution the result required and basically shifted
the trader into rogue trades (possibly to ‘make budget’).
(3) Opportunity — this relates to the first two points. The opportunity was created by
the position and background experience and knowledge the trader held and the
environment encouraging an unregulated approach.
The three elements are inter-related. Students should discuss which factor was the most
critical in creating the behaviours documented, and the alternative view that the
elements are equally important.
1.4
Theory in Action 1.2 Out of Control
1. ‘Rogue’ is defined in the Oxford dictionary as ‘that which lacks appropriate
control; something which is irresponsible or undisciplined’. Given this
definition, who is ultimately responsible for the rogue trading outlined in the
Societe Generale scandal: the trader directly involved; management, who are
responsible for the high-risk, high-reward framework in which the trader
operated; or a combination of both?
Obviously all parties are responsible for their actions. The weak risk-management
controls in place at Societe Generale allowed behaviour which ultimately could not be
controlled by the employer. Why? Because Societe Generale created an environment
where traders could become ‘rogues’. It is important to appreciate that the emergence of
‘rogue’ behaviour can be a function of environment and in particular the embedded
controls designed to detect and inhibit such behaviour. In addition, if management was
pushing for outcomes, in a way the ‘rogue’ was seeking to meet management’s
performance expectations. Actions, demands, and also incentives, create and/or
reinforce behaviour. The impact of financial performance benchmarks should not be
underestimated. Students should discuss how controls, monitoring, and incentives can
discourage/create behaviours and what types of factors are more likely to stimulate
‘rogue’ behaviour.
2. Discuss the role played in the SocGen case by each of the three elements:
personality, institutional framework, opportunity.
(1) Personality — in a competitive environment people will either compete or leave.
In the competition itself behaviours will have to change and adapt, risk
preferences will shift and consideration of the downside possibilities discounted.
Research shows that a group environment often results in different behaviour to
individual or isolated thinking.
(2) Institutional framework — SocGen was not controlling its risk associated with
trading and this allowed the individual involved to operate outside the accepted
parameters. Also, the individual’s knowledge of back-room trading operations and
processes meant that significant ‘positions’ and losses could be hidden and offset
against the upside, this gave the institution the result required and basically shifted
the trader into rogue trades (possibly to ‘make budget’).
(3) Opportunity — this relates to the first two points. The opportunity was created by
the position and background experience and knowledge the trader held and the
environment encouraging an unregulated approach.
The three elements are inter-related. Students should discuss which factor was the most
critical in creating the behaviours documented, and the alternative view that the
elements are equally important.
Loading page 5...
Solution Manual to accompany Accounting Theory 7e
1.5
3. How could Societe Generale have been unaware of the activity of its trader
and of the environment that it had created for the trader to 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 explain
behaviour? Then a good theory of rogue behaviour should do just that. However, most
theories in accounting are usually better at explaining the elements of behaviour after
they have occurred, rather than predict them. The problem is access to observable data.
Positive theories are based on predicting behaviour based on past observations. Would
this approach work in the case of behaviour which the traders did not want observed?
4. Do you think that the actions of ‘rogue’ traders are predictable under
particular theories (such as agency theory)? Explain your answer.
Knowledge of appropriate behavioural theories will not stop behaviour of the type
outlined. However, knowledge does empower management: the embedding of
appropriate bonding and monitoring mechanisms and other relevant incentives and
disincentives are predicted (under agency theory) to have a particular influence on an
individual’s behaviour. Such a theoretical approach to risk-management could be used
to identify the environmental factors that could lead to rogue behaviour. But we will not
know whether applying the elements of the theories to register the existence of such
environments and then action is taken to change the environment, actually changes/ed
behaviour. Why? Because the rogue behaviour may exist undetected; or may never
occur. This is a concern with positive research, particularly in the behavioural area, we
just never have a complete set of observations.
1.5
3. How could Societe Generale have been unaware of the activity of its trader
and of the environment that it had created for the trader to 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 explain
behaviour? Then a good theory of rogue behaviour should do just that. However, most
theories in accounting are usually better at explaining the elements of behaviour after
they have occurred, rather than predict them. The problem is access to observable data.
Positive theories are based on predicting behaviour based on past observations. Would
this approach work in the case of behaviour which the traders did not want observed?
4. Do you think that the actions of ‘rogue’ traders are predictable under
particular theories (such as agency theory)? Explain your answer.
Knowledge of appropriate behavioural theories will not stop behaviour of the type
outlined. However, knowledge does empower management: the embedding of
appropriate bonding and monitoring mechanisms and other relevant incentives and
disincentives are predicted (under agency theory) to have a particular influence on an
individual’s behaviour. Such a theoretical approach to risk-management could be used
to identify the environmental factors that could lead to rogue behaviour. But we will not
know whether applying the elements of the theories to register the existence of such
environments and then action is taken to change the environment, actually changes/ed
behaviour. Why? Because the rogue behaviour may exist undetected; or may never
occur. This is a concern with positive research, particularly in the behavioural area, we
just never have a complete set of observations.
Loading page 6...
Chapter 2: Theory and method
2.2
Chapter 2 - Accounting theory construction
Questions
1. ‘A theory that is purely syntactic is sterile.’. Is this true? How can this
statement relate to accounting?
Syntactical: This represents the logical relations in the theory. This concerns the rules of
the language employed, e.g., the rules of grammar for English or the rules of
mathematics for a mathematically expressed theory. Syntactical relations are logical
connections 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 or
predict anything about the real world. A less sterile theory can be concerned with
predicting or explaining some phenomena or with prescribing a course of behaviour. It
can be a collection of propositions and conclusions which are designed to illustrate the
principles of a subject. Other terms such as ‘hypothesis’ or ‘supposition’ are often used
instead of theory. In essence the syntactical part of the theory is the simplest form of the
theory and is based on an explicit (or implied) statement of a belief expressed in a
language 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 each
part.
At this point instructors may use a number of theories which have evolved in accounting
and which probably reflect the different ‘views of the world’ or the way accountants see
problems as individuals. For example theories of accounting can be described and
classified as:
(i) an historical record-keeping activity (pragmatic or syntactic theory)
(ii) political theories (pragmatic theories)
(iii) communication — decision making (pragmatic, syntactic and semantic
theories)
(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 social
club for accountants (pragmatic)
That is strictly speaking, not all relations are required in theory formulation. We may
have separate syntactical, semantic and pragmatic theories and a number of branches of
scientific enquiry can be classified under each heading; e.g. mathematics (syntactical),
physics (semantic), political science (pragmatics) and so on. However, the instructor
should now pose the question whether all these relations exist in accounting. The
answer 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 some
understanding of the complexity of defining and studying ‘accounting theory’.
(see the chapter for further brief descriptions)
2.2
Chapter 2 - Accounting theory construction
Questions
1. ‘A theory that is purely syntactic is sterile.’. Is this true? How can this
statement relate to accounting?
Syntactical: This represents the logical relations in the theory. This concerns the rules of
the language employed, e.g., the rules of grammar for English or the rules of
mathematics for a mathematically expressed theory. Syntactical relations are logical
connections 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 or
predict anything about the real world. A less sterile theory can be concerned with
predicting or explaining some phenomena or with prescribing a course of behaviour. It
can be a collection of propositions and conclusions which are designed to illustrate the
principles of a subject. Other terms such as ‘hypothesis’ or ‘supposition’ are often used
instead of theory. In essence the syntactical part of the theory is the simplest form of the
theory and is based on an explicit (or implied) statement of a belief expressed in a
language 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 each
part.
At this point instructors may use a number of theories which have evolved in accounting
and which probably reflect the different ‘views of the world’ or the way accountants see
problems as individuals. For example theories of accounting can be described and
classified as:
(i) an historical record-keeping activity (pragmatic or syntactic theory)
(ii) political theories (pragmatic theories)
(iii) communication — decision making (pragmatic, syntactic and semantic
theories)
(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 social
club for accountants (pragmatic)
That is strictly speaking, not all relations are required in theory formulation. We may
have separate syntactical, semantic and pragmatic theories and a number of branches of
scientific enquiry can be classified under each heading; e.g. mathematics (syntactical),
physics (semantic), political science (pragmatics) and so on. However, the instructor
should now pose the question whether all these relations exist in accounting. The
answer 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 some
understanding of the complexity of defining and studying ‘accounting theory’.
(see the chapter for further brief descriptions)
Loading page 7...
Solution Manual to accompany Accounting Theory 7e
2.3
2. One type of theory construction involves observing the practices and
techniques of working accountants and then teaching those practices and
techniques 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 or
symbols 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 at
the coalface. If there is no special interests then they will produce the best accounting
for their clients. They will react to the demand generated by the market. A pragmatic
theory is where we observe the behaviour of practising accountants and then copy their
accounting procedures and principles.
Advantages:
(i) the solutions of practising accountants are related to the requirements of the
business 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)
that allows the accountant to make decisions on value and possible
investment.
(c) What are the disadvantages of this approach?
Not all theories have a pragmatic orientation, but the nature of accounting makes this
relationship an important one. The problem here is a circular role in this theory.
Accountants teach other accountants how they do things and they perpetuate this role by
then teaching other accounting apprentices. The criticism of this approach is that it does
not have syntactic or semantic input. See above (b).
(d) Do you believe that this is a good approach to developing a theory of
accounting? Why or why not?
This is a question that asks the student to recognise that there are alternative
interpretations in accounting theory. An overall theory of accounting can be an
‘instrument’ for recognising and measuring income and capital. Essentially, it is a set of
rules, a ‘blueprint’, for constructing specific accounting systems for the recognition and
measurement of the income and capital of the particular entity. The results of an
accountant driven specific accounting system of a particular firm provide an
2.3
2. One type of theory construction involves observing the practices and
techniques of working accountants and then teaching those practices and
techniques 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 or
symbols 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 at
the coalface. If there is no special interests then they will produce the best accounting
for their clients. They will react to the demand generated by the market. A pragmatic
theory is where we observe the behaviour of practising accountants and then copy their
accounting procedures and principles.
Advantages:
(i) the solutions of practising accountants are related to the requirements of the
business 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)
that allows the accountant to make decisions on value and possible
investment.
(c) What are the disadvantages of this approach?
Not all theories have a pragmatic orientation, but the nature of accounting makes this
relationship an important one. The problem here is a circular role in this theory.
Accountants teach other accountants how they do things and they perpetuate this role by
then teaching other accounting apprentices. The criticism of this approach is that it does
not have syntactic or semantic input. See above (b).
(d) Do you believe that this is a good approach to developing a theory of
accounting? Why or why not?
This is a question that asks the student to recognise that there are alternative
interpretations in accounting theory. An overall theory of accounting can be an
‘instrument’ for recognising and measuring income and capital. Essentially, it is a set of
rules, a ‘blueprint’, for constructing specific accounting systems for the recognition and
measurement of the income and capital of the particular entity. The results of an
accountant driven specific accounting system of a particular firm provide an
Loading page 8...
Chapter 2: Theory and method
2.4
‘explanation’ of what happened to the firm or serve as a basis for ‘prediction’ of what
may happen. In other words the accountant may be the best judge.
Instructors should be aware that this debate is a common one argued between practising
accountants and some normative decision oriented accounting theorists and will invoke
a number of responses from students. A number will argue that an approach which lacks
a decision making investor focus will have the danger of becoming dogmatic or self
fulfilling. A pragmatic approach may mean that too much emphasis is placed upon the
practices and techniques of accountants and little emphasis is placed upon the meaning
of 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 too
obtuse if a completely decision making approach is taken, without regard to the other
roles accounting plays in the real world. Theoretical argument without pragmatic
application 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 in
accounting and which reflect the different ‘views of the world’ or the way accountants
see problems as individuals. For example, theories of accounting can be described and
classified as:
• historical record-keeping activity
Example: firms use accounting principles to keep a record of their transactions so
that they can advise how resources have been used.
• a language
Example: financial statements are used by management to communicate to
shareholders how well they have performed in running the business.
• political theories
Example: management use accounting reports to allocate resources among
different divisions within the firm, or different levels of employees.
• magic or mythology
Example: Enron management used accounting techniques to hide the losses it
suffered from transactions with its special purpose entities.
• communication — decision making
Example: a local bank decided to give loans to a small business after analysing the
business’ financial position.
• an economic good
Example: there are costs involved in producing financial reports (not free).
Accounting information is demanded to make economic decisions, but there is a
cost to its supply since accounting information is a scarce commodity itself.
• a social commodity
Example: government uses accounting numbers (such as profits or research
expenditure) to decide whether to give grants to particular firms.
• ideology and exploitation
Example: firms cut down jobs in their unprofitable divisions.
3. Describe the semantic approach to theory construction.
2.4
‘explanation’ of what happened to the firm or serve as a basis for ‘prediction’ of what
may happen. In other words the accountant may be the best judge.
Instructors should be aware that this debate is a common one argued between practising
accountants and some normative decision oriented accounting theorists and will invoke
a number of responses from students. A number will argue that an approach which lacks
a decision making investor focus will have the danger of becoming dogmatic or self
fulfilling. A pragmatic approach may mean that too much emphasis is placed upon the
practices and techniques of accountants and little emphasis is placed upon the meaning
of 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 too
obtuse if a completely decision making approach is taken, without regard to the other
roles accounting plays in the real world. Theoretical argument without pragmatic
application 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 in
accounting and which reflect the different ‘views of the world’ or the way accountants
see problems as individuals. For example, theories of accounting can be described and
classified as:
• historical record-keeping activity
Example: firms use accounting principles to keep a record of their transactions so
that they can advise how resources have been used.
• a language
Example: financial statements are used by management to communicate to
shareholders how well they have performed in running the business.
• political theories
Example: management use accounting reports to allocate resources among
different divisions within the firm, or different levels of employees.
• magic or mythology
Example: Enron management used accounting techniques to hide the losses it
suffered from transactions with its special purpose entities.
• communication — decision making
Example: a local bank decided to give loans to a small business after analysing the
business’ financial position.
• an economic good
Example: there are costs involved in producing financial reports (not free).
Accounting information is demanded to make economic decisions, but there is a
cost to its supply since accounting information is a scarce commodity itself.
• a social commodity
Example: government uses accounting numbers (such as profits or research
expenditure) to decide whether to give grants to particular firms.
• ideology and exploitation
Example: firms cut down jobs in their unprofitable divisions.
3. Describe the semantic approach to theory construction.
Loading page 9...
Solution Manual to accompany Accounting Theory 7e
2.5
Semantics: Semantics is sometimes referred to as rules of correspondence or operational
definitions. 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 propositions
to objects or events and manifests itself in terms of measurement theories: for
example measuring the effects of inflation on assets and liabilities and adjusting
the accounts to reflect these adjustments. Theorists in this area argue that by
applying these adjustments, the accounts then have semantic content and can be
related 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 a
mathematical system divorced from logical analysis or output semantics.
(ii) Output semantics – testing the outputs of the accounting system against some
external reference, e.g. increases in profits against share price changes (see also
Theory in Action 3.1).
(iii) It seems logical to conclude that if the purpose of undertaking accounting is to
impart semantic content to the numbers then they should be verified. This can be
undertaken by checking market prices, stock prices or even the historical cost
depending on the stated purpose of the accounting. However, this is a difficult
question as there are very few external referents other than the stock market and
market prices. Further, market prices exist for a minority of businesses. In most
cases the financials determined by accountants are the sole determinant of a firm’s
financial 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 researchers
argued that we should change the accounting methods and output reports produced
according to the prescriptive judgement of the writer. That is we should use some form
of market based accounting to adjust for inflation instead of historical cost accounting.
Normative accounting research is more concerned with policy recommendations and is
concerned with what should be done in contrast to explaining why current practice is
carried 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 of
firms, 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 many normative
theorists are measurement theorists who attempt to incorporate the effects of inflation
into accounting reports. In this sense they take a semantic viewpoint — relating the
figures in the accounting reports to actual objects (assets, liabilities) or events (changes
in inflation).
2.5
Semantics: Semantics is sometimes referred to as rules of correspondence or operational
definitions. 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 propositions
to objects or events and manifests itself in terms of measurement theories: for
example measuring the effects of inflation on assets and liabilities and adjusting
the accounts to reflect these adjustments. Theorists in this area argue that by
applying these adjustments, the accounts then have semantic content and can be
related 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 a
mathematical system divorced from logical analysis or output semantics.
(ii) Output semantics – testing the outputs of the accounting system against some
external reference, e.g. increases in profits against share price changes (see also
Theory in Action 3.1).
(iii) It seems logical to conclude that if the purpose of undertaking accounting is to
impart semantic content to the numbers then they should be verified. This can be
undertaken by checking market prices, stock prices or even the historical cost
depending on the stated purpose of the accounting. However, this is a difficult
question as there are very few external referents other than the stock market and
market prices. Further, market prices exist for a minority of businesses. In most
cases the financials determined by accountants are the sole determinant of a firm’s
financial 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 researchers
argued that we should change the accounting methods and output reports produced
according to the prescriptive judgement of the writer. That is we should use some form
of market based accounting to adjust for inflation instead of historical cost accounting.
Normative accounting research is more concerned with policy recommendations and is
concerned with what should be done in contrast to explaining why current practice is
carried 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 of
firms, 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 many normative
theorists are measurement theorists who attempt to incorporate the effects of inflation
into accounting reports. In this sense they take a semantic viewpoint — relating the
figures in the accounting reports to actual objects (assets, liabilities) or events (changes
in inflation).
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Chapter 2: Theory and method
2.6
(b) If so, how can this be achieved? If not, why?
Certainly if we have a valuation approach to accounting then inflation affects value and
should be taken into account in making decisions. Whether accounting should be purely
a semantic science (or a syntactic or pragmatic science) is in itself a normative
statement and whichever way students answer this point should be brought to their
attention.
Inflation may matter to some accountants but not to others. For example a management
accountant who is trying to control costs or projects may have to pay a great deal of
attention to the inflation rates in various sectors, an accountant who is responsible for
hedging money market funds will be interested in the real rate of return on funds or look
to 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 the
empirical questions: ‘Why do accountants manipulate data under the accrual system?’
or, ‘Is accrual data more useful than cash flow data?’ Instead of simply normatively
recommending change. The approach is basically whether we understand the world as
it 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 approaches may or may not be individually valid but compliment each
other. Both approaches need to be more rigorously examined before any conclusion is
warranted and normative theories should contain pragmatic and semantic input and
similarly positive theories should have logical and normative reasoning.
5. Researchers who develop positive theories and researchers who develop
normative theories often do not share the same views about the roles of their
respective approaches to theory construction.
(a) How do positive and normative theories differ?
(b) Can positive theories assist normative theories, or vice versa? If yes, give
an example. If not, why not?
Normative accounting research makes policy recommendations and is concerned with
what should be done in contrast to explaining why current practice is carried out in the
manner 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 of
firms, 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 many
normative theorists are measurement theorists who attempt to incorporate the effects of
inflation into accounting reports. In this sense they take a semantic viewpoint —
relating the figures in the accounting reports to actual objects (assets, liabilities) or
2.6
(b) If so, how can this be achieved? If not, why?
Certainly if we have a valuation approach to accounting then inflation affects value and
should be taken into account in making decisions. Whether accounting should be purely
a semantic science (or a syntactic or pragmatic science) is in itself a normative
statement and whichever way students answer this point should be brought to their
attention.
Inflation may matter to some accountants but not to others. For example a management
accountant who is trying to control costs or projects may have to pay a great deal of
attention to the inflation rates in various sectors, an accountant who is responsible for
hedging money market funds will be interested in the real rate of return on funds or look
to 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 the
empirical questions: ‘Why do accountants manipulate data under the accrual system?’
or, ‘Is accrual data more useful than cash flow data?’ Instead of simply normatively
recommending change. The approach is basically whether we understand the world as
it 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 approaches may or may not be individually valid but compliment each
other. Both approaches need to be more rigorously examined before any conclusion is
warranted and normative theories should contain pragmatic and semantic input and
similarly positive theories should have logical and normative reasoning.
5. Researchers who develop positive theories and researchers who develop
normative theories often do not share the same views about the roles of their
respective approaches to theory construction.
(a) How do positive and normative theories differ?
(b) Can positive theories assist normative theories, or vice versa? If yes, give
an example. If not, why not?
Normative accounting research makes policy recommendations and is concerned with
what should be done in contrast to explaining why current practice is carried out in the
manner 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 of
firms, 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 many
normative theorists are measurement theorists who attempt to incorporate the effects of
inflation 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 Manual to accompany Accounting Theory 7e
2.7
events (changes in inflation). To some extent the approach of the IASB is a normative
approach.
Positive accounting theory was a reversion to testing or relating accounting theories
back to the ‘facts’ or ‘experiences’ of the real world. Examples of such research were
questionnaires and surveys of bank officers or investors regarding their use of financial
reports for decision making; or whether inflation adjusted accounting reports actually
aided decision making. Current positive accounting research is aimed at explaining the
reasons for actual accounting practices and in predicting the role of accounting data in
economic, political and social decision making. Positive theory has expanded
accounting theory from the purely decision making focus of normative theorists into
analysis of political and economic factors.
Using the normative recommendation of IFRS, that fair values should be used in
financial statements, a positive theorists would first undertake a number of empirical
tests 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 analysis
with positive theory the empirical verification.
6. Can accounting theory be constructed as a purely syntactical exercise? Why
or why not?
The major problem with syntactics is that the truth value of any proposition is
ascertained by logic or reasoning alone. If the underlying accepted premises of the logic
have no reference to the real world or are false, then the conclusions have either no
pragmatic usefulness or the conclusion is incorrect. The tutor should mention here the
reaction of logical positivism against metaphysical or abstract theorising (see text).
Logical positivism argued that all theoretical statements should be capable of being
reduced to statements which can be immediately observed and that anything that cannot
be empirically verified is meaningless. The reaction was against romantic theorising
which had no practical application. Logical argument should be precise and serviceable.
Science usually progresses via logical debate and counter debate. However, syntactics
alone cannot act as a source of true statements about the world. Syntactics alone are
only concerned with the derivation of statements from other given statements. This is
the real weakness of syntactics as a stand alone method.
As an example of syntactics in accounting theory the instructor can use the theory of
double-entry and historical costs which has been confirmed and verified by auditors
many times.
The criticisms of this approach are:
(i) all manipulations are correct as long as the rules of mathematical
bookkeeping are applied
(ii) there are many acceptable sets of ‘equations’
(iii) no semantic verification — not descriptive of real world objects or events.
2.7
events (changes in inflation). To some extent the approach of the IASB is a normative
approach.
Positive accounting theory was a reversion to testing or relating accounting theories
back to the ‘facts’ or ‘experiences’ of the real world. Examples of such research were
questionnaires and surveys of bank officers or investors regarding their use of financial
reports for decision making; or whether inflation adjusted accounting reports actually
aided decision making. Current positive accounting research is aimed at explaining the
reasons for actual accounting practices and in predicting the role of accounting data in
economic, political and social decision making. Positive theory has expanded
accounting theory from the purely decision making focus of normative theorists into
analysis of political and economic factors.
Using the normative recommendation of IFRS, that fair values should be used in
financial statements, a positive theorists would first undertake a number of empirical
tests 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 analysis
with positive theory the empirical verification.
6. Can accounting theory be constructed as a purely syntactical exercise? Why
or why not?
The major problem with syntactics is that the truth value of any proposition is
ascertained by logic or reasoning alone. If the underlying accepted premises of the logic
have no reference to the real world or are false, then the conclusions have either no
pragmatic usefulness or the conclusion is incorrect. The tutor should mention here the
reaction of logical positivism against metaphysical or abstract theorising (see text).
Logical positivism argued that all theoretical statements should be capable of being
reduced to statements which can be immediately observed and that anything that cannot
be empirically verified is meaningless. The reaction was against romantic theorising
which had no practical application. Logical argument should be precise and serviceable.
Science usually progresses via logical debate and counter debate. However, syntactics
alone cannot act as a source of true statements about the world. Syntactics alone are
only concerned with the derivation of statements from other given statements. This is
the real weakness of syntactics as a stand alone method.
As an example of syntactics in accounting theory the instructor can use the theory of
double-entry and historical costs which has been confirmed and verified by auditors
many times.
The criticisms of this approach are:
(i) all manipulations are correct as long as the rules of mathematical
bookkeeping 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 method
2.8
Under this approach science progresses by trial and error. The non falsification of bold
hypothesis or the falsification of cautious hypothesis mark significant advances in
science.
See also the answer to question one.
In addition instructors may wish to channel discussion towards a discussion about how
we view the world. For example, using ontological assumptions and the Morgan and
Smircich six-way classification that we may assume reality as being anything from a
concrete structure (realist — objectivist viewpoint) down to reality as a projection of
human imagination (unstable — human specific).
If we have an ontological viewpoint that the accounting world is relatively concrete and
stable then it is more appropriate to choose a syntactic-scientific approach to accounting
theory. That means that we are more likely to have a structured, prior theoretical base
but this must be backed up by empirical validation. On the other hand if we view the
world of accounting as being a product of human imagination we are more likely to
have an unstructured research methodology with no prior syntactic other than the
assumption that we are facing a soft ontology.
7. Classify the following hypotheses according to whether they are conclusions
of 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 in
determining divisional performance.
(a) normative
(b) positive
(c) positive
2.8
Under this approach science progresses by trial and error. The non falsification of bold
hypothesis or the falsification of cautious hypothesis mark significant advances in
science.
See also the answer to question one.
In addition instructors may wish to channel discussion towards a discussion about how
we view the world. For example, using ontological assumptions and the Morgan and
Smircich six-way classification that we may assume reality as being anything from a
concrete structure (realist — objectivist viewpoint) down to reality as a projection of
human imagination (unstable — human specific).
If we have an ontological viewpoint that the accounting world is relatively concrete and
stable then it is more appropriate to choose a syntactic-scientific approach to accounting
theory. That means that we are more likely to have a structured, prior theoretical base
but this must be backed up by empirical validation. On the other hand if we view the
world of accounting as being a product of human imagination we are more likely to
have an unstructured research methodology with no prior syntactic other than the
assumption that we are facing a soft ontology.
7. Classify the following hypotheses according to whether they are conclusions
of 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 in
determining divisional performance.
(a) normative
(b) positive
(c) positive
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Solution Manual to accompany Accounting Theory 7e
2.9
8. Give an example of the types of issues that might be resolved by accounting
theories 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 before
they release their accounting reports
9. Explain the naturalistic and syntactic approach to theory construction. Are
these approaches mutually exclusive?
The difference between scientific and naturalistic research is set out in table 2.2 on page
32. The instructor should aid students’ understanding by briefly categorising accounting
research into scientific and naturalistic. The International View (2.2) is an excellent
backdrop to illustrate the difference and to show how research has delineated.
10. The decision-usefulness approach to theory development can be used to
develop theories of accounting.
(a) Explain what is meant by the decision-usefulness approach to theory
development.
(b) How can the decision-usefulness approach relate to accounting theory
formulation?
(c) Give two examples of decisions that require data obtained from
accounting reports.
The decision-usefulness approach is an instrumentalist approach (see diagram p.25). In
a narrower sense, one direct test of an overall theory of accounting would be to
determine whether the output data of the accounting systems, which are constructed on
the basis of the overall theory, are useful to users. The data of the accounting systems
are utilised by users in their prediction models, and the conclusions (predictions) are
then used in their decision models. The problem is that if the prediction is verified, it
verifies the prediction model, not the accounting system and its output. There are other
variables besides accounting data that affect the prediction. We do not know how the
accounting data were utilised. Also, if the decision turns out to be right, it verifies the
decision model, not the accounting system.
Interpreting the evidence on decision-making is extremely difficult. We do not know
how to interpret the evidence to determine that accounting information is useful. Thus, a
direct test is virtually impossible. Accounting standard setters usually determine
usefulness with the weaker, more direct tests which are usually advanced by accounting
committee setting bodies and include: relevance, verifiability, freedom from bias,
timeliness, comparability, reliability and understandability.
2.9
8. Give an example of the types of issues that might be resolved by accounting
theories 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 before
they release their accounting reports
9. Explain the naturalistic and syntactic approach to theory construction. Are
these approaches mutually exclusive?
The difference between scientific and naturalistic research is set out in table 2.2 on page
32. The instructor should aid students’ understanding by briefly categorising accounting
research into scientific and naturalistic. The International View (2.2) is an excellent
backdrop to illustrate the difference and to show how research has delineated.
10. The decision-usefulness approach to theory development can be used to
develop theories of accounting.
(a) Explain what is meant by the decision-usefulness approach to theory
development.
(b) How can the decision-usefulness approach relate to accounting theory
formulation?
(c) Give two examples of decisions that require data obtained from
accounting reports.
The decision-usefulness approach is an instrumentalist approach (see diagram p.25). In
a narrower sense, one direct test of an overall theory of accounting would be to
determine whether the output data of the accounting systems, which are constructed on
the basis of the overall theory, are useful to users. The data of the accounting systems
are utilised by users in their prediction models, and the conclusions (predictions) are
then used in their decision models. The problem is that if the prediction is verified, it
verifies the prediction model, not the accounting system and its output. There are other
variables besides accounting data that affect the prediction. We do not know how the
accounting data were utilised. Also, if the decision turns out to be right, it verifies the
decision model, not the accounting system.
Interpreting the evidence on decision-making is extremely difficult. We do not know
how to interpret the evidence to determine that accounting information is useful. Thus, a
direct test is virtually impossible. Accounting standard setters usually determine
usefulness with the weaker, more direct tests which are usually advanced by accounting
committee setting bodies and include: relevance, verifiability, freedom from bias,
timeliness, comparability, reliability and understandability.
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Chapter 2: Theory and method
2.10
Some 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 you
have any criticisms of historical cost accounting?
Historical cost is usually described as a pragmatic theory whereby premises are
determined by observing the practice of accountants. Criticisms: no logical analysis of
accountants’ actions, does not allow change, does not focus on measurement, circularity
of logic in the rules, outputs not verified, doublethink, conventions not subject to
falsification. The argument is pragmatic positive as it is observable and descriptive of
the behaviour of accountants over a number of centuries.
It is also true that historical cost accounting provides a system of allocating costs over
different reporting periods (accrual accounting). In this sense it is a deductive
argument. A point of logical contention, however, is whether the allocation of costs is
truly systematic (in a deductive sense), because a number of the ways in which the costs
are allocated appear to be done in an ad hoc fashion without inductive reference to
events that occur in the real world of asset valuation.
12. Explain the psychological pragmatic approach to accounting theory. Give a
example of how it can be applied.
The psychological pragmatic approach to accounting theory is examining the reactions
by investors and the general public to the release of accounting data. One research
question is whether investors are fooled by cosmetic accounting numbers or are they
financially rational. This research issue is covered in a later chapter but has gained
greater prominence after the failure of ENRON and their questionable accounting
practices.
13. Give an example of an accounting convention usually adopted in historical
cost accounting. Conventions govern the way accounting is practised, and
conventions are, 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 accounting
theories based on conventions to be innovative in providing useful
information?
Accounting conventions (assumed premises) in historical cost are:
• Conservatism – stewardship and accelerating the reporting of bad news over
good news
• Matching costs – calculation and focus on the income statement as a valuation
metric (the balance sheet is the cost residual from this outcome)
• They are innovative in providing solutions to stewardship problems and agency
problems such as the payment of CEO bonuses.
14. How do you think massive amounts of data now available from information
technologies will affect
2.10
Some 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 you
have any criticisms of historical cost accounting?
Historical cost is usually described as a pragmatic theory whereby premises are
determined by observing the practice of accountants. Criticisms: no logical analysis of
accountants’ actions, does not allow change, does not focus on measurement, circularity
of logic in the rules, outputs not verified, doublethink, conventions not subject to
falsification. The argument is pragmatic positive as it is observable and descriptive of
the behaviour of accountants over a number of centuries.
It is also true that historical cost accounting provides a system of allocating costs over
different reporting periods (accrual accounting). In this sense it is a deductive
argument. A point of logical contention, however, is whether the allocation of costs is
truly systematic (in a deductive sense), because a number of the ways in which the costs
are allocated appear to be done in an ad hoc fashion without inductive reference to
events that occur in the real world of asset valuation.
12. Explain the psychological pragmatic approach to accounting theory. Give a
example of how it can be applied.
The psychological pragmatic approach to accounting theory is examining the reactions
by investors and the general public to the release of accounting data. One research
question is whether investors are fooled by cosmetic accounting numbers or are they
financially rational. This research issue is covered in a later chapter but has gained
greater prominence after the failure of ENRON and their questionable accounting
practices.
13. Give an example of an accounting convention usually adopted in historical
cost accounting. Conventions govern the way accounting is practised, and
conventions are, 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 accounting
theories based on conventions to be innovative in providing useful
information?
Accounting conventions (assumed premises) in historical cost are:
• Conservatism – stewardship and accelerating the reporting of bad news over
good news
• Matching costs – calculation and focus on the income statement as a valuation
metric (the balance sheet is the cost residual from this outcome)
• They are innovative in providing solutions to stewardship problems and agency
problems such as the payment of CEO bonuses.
14. How do you think massive amounts of data now available from information
technologies will affect
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Solution Manual to accompany Accounting Theory 7e
2.11
(a) the development of accounting theories
(b) the testing of accounting theories
The massive amount of data now available from information technologies will affect:
the development of accounting theories by making theories capable of being tested in by
the 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 more
empirical based positive theories.
However, be aware of the British school that tends to have a closer relationship with
syntactic 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 professions
such 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 scientific
method, defined as a systematic approach of observation, hypothesis formation,
hypothesis testing and hypothesis evaluation in testing a theory. A discussion of the
methods used and the advantages/disadvantages should be analysed in class. (See the
text for a more detailed description.)
The answers given by students to this question will be varied, but the tutor should aim
to impart knowledge of the different forms of scientific methods and the way in which
science is seen to advance. The essential components are:
i. Syntactics
ii. Semantics
iii. Pragmatics
iv. Hypothesis formulation
v. Testing
vi. Evaluation
Whether the scientific method is valid is a question of degree but a comparison between
alternatives will help. For example:
The dogmatic basis is used when we believe in a statement because of confidence in the
person or group issuing the statement. This confidence may be due to a religious or
political belief, or due to 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 in
school, in what our teachers tell us, etc. The weakness of this basis is that personal
opinion, 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 be
sensible or obviously true, based on our general knowledge and experience. For
example, the statement ‘children love to eat candy’ would be accepted as self-evidently
true by most people. They would not feel an empirical study needs to be conducted. The
weakness 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.
2.11
(a) the development of accounting theories
(b) the testing of accounting theories
The massive amount of data now available from information technologies will affect:
the development of accounting theories by making theories capable of being tested in by
the 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 more
empirical based positive theories.
However, be aware of the British school that tends to have a closer relationship with
syntactic 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 professions
such 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 scientific
method, defined as a systematic approach of observation, hypothesis formation,
hypothesis testing and hypothesis evaluation in testing a theory. A discussion of the
methods used and the advantages/disadvantages should be analysed in class. (See the
text for a more detailed description.)
The answers given by students to this question will be varied, but the tutor should aim
to impart knowledge of the different forms of scientific methods and the way in which
science is seen to advance. The essential components are:
i. Syntactics
ii. Semantics
iii. Pragmatics
iv. Hypothesis formulation
v. Testing
vi. Evaluation
Whether the scientific method is valid is a question of degree but a comparison between
alternatives will help. For example:
The dogmatic basis is used when we believe in a statement because of confidence in the
person or group issuing the statement. This confidence may be due to a religious or
political belief, or due to 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 in
school, in what our teachers tell us, etc. The weakness of this basis is that personal
opinion, 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 be
sensible or obviously true, based on our general knowledge and experience. For
example, the statement ‘children love to eat candy’ would be accepted as self-evidently
true by most people. They would not feel an empirical study needs to be conducted. The
weakness 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.
Loading page 16...
Chapter 2: Theory and method
2.12
In contrast, the scientific basis is used when we believe in a statement because of the
logical relationship of the terms and the objective, empirical evidence in support of the
statement. The demand for objective, empirical evidence is the significant factor. The
scientific basis was formulated to overcome the weaknesses of the other two.
16. Early auditing theories were constructed by observing the practices of
auditors. What type of theory construction is this? What are the advantages
and disadvantages of this approach?
The theory construction is pragmatic positive as it is observable and descriptive of the
behaviour of auditor practices over a number of centuries. The major system audited
over this period is historical cost accounting that provides a system of allocating costs
over different reporting periods (accrual accounting). Advantages: In this sense because
it is historical the major advantage was the ease of confirming transactions by reference
to vouchers. Another advantage of this approach is that auditors are close to clients and
they are able to assess the accounting needs of business. Disadvantages: A point of
logical contention, however, is whether the allocation of costs is truly systematic (in a
deductive sense), because a number of the ways in which the costs are allocated appear
to be done in an ad hoc fashion without inductive reference to events that occur in the
real world of asset valuation. It may be that auditors are acting in the interests of
managers rather than equity owners. It may also be that auditors are maintaining a
system 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 auditors
make judgements? What competing issues would arise?
The discussion should address the problem of making the experiment realistic enough
for auditors to make decisions in the same way they would in ‘real life’ by providing the
sort of information they would normally receive and under the conditions they would
normally work. When the experiment is sufficiently realistic, it is said to have external
validity.
The researcher would also have to design the experiment so that there are not too many
variables, or factors being changed between the auditors. For example, if the researcher
is trying to determine the effect of providing information in a different order on the
auditors’ decisions, the experiment has to hold other factors constant. The aim is to be
able to attribute the change in the decision to the change in the order in which
information 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 are
assigned to one group), repeated testing (if the experiment is repeated auditors could
learn, grow tired, start to anticipate the researcher’s aims) and experimenter bias (where
the researcher unconsciously sends signals to the participant auditors about the desired
action).
2.12
In contrast, the scientific basis is used when we believe in a statement because of the
logical relationship of the terms and the objective, empirical evidence in support of the
statement. The demand for objective, empirical evidence is the significant factor. The
scientific basis was formulated to overcome the weaknesses of the other two.
16. Early auditing theories were constructed by observing the practices of
auditors. What type of theory construction is this? What are the advantages
and disadvantages of this approach?
The theory construction is pragmatic positive as it is observable and descriptive of the
behaviour of auditor practices over a number of centuries. The major system audited
over this period is historical cost accounting that provides a system of allocating costs
over different reporting periods (accrual accounting). Advantages: In this sense because
it is historical the major advantage was the ease of confirming transactions by reference
to vouchers. Another advantage of this approach is that auditors are close to clients and
they are able to assess the accounting needs of business. Disadvantages: A point of
logical contention, however, is whether the allocation of costs is truly systematic (in a
deductive sense), because a number of the ways in which the costs are allocated appear
to be done in an ad hoc fashion without inductive reference to events that occur in the
real world of asset valuation. It may be that auditors are acting in the interests of
managers rather than equity owners. It may also be that auditors are maintaining a
system 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 auditors
make judgements? What competing issues would arise?
The discussion should address the problem of making the experiment realistic enough
for auditors to make decisions in the same way they would in ‘real life’ by providing the
sort of information they would normally receive and under the conditions they would
normally work. When the experiment is sufficiently realistic, it is said to have external
validity.
The researcher would also have to design the experiment so that there are not too many
variables, or factors being changed between the auditors. For example, if the researcher
is trying to determine the effect of providing information in a different order on the
auditors’ decisions, the experiment has to hold other factors constant. The aim is to be
able to attribute the change in the decision to the change in the order in which
information 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 are
assigned to one group), repeated testing (if the experiment is repeated auditors could
learn, grow tired, start to anticipate the researcher’s aims) and experimenter bias (where
the researcher unconsciously sends signals to the participant auditors about the desired
action).
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Solution Manual to accompany Accounting Theory 7e
2.13
International View
2.1 IFRS is a Big Four gravy train
This is an article that succinctly points out the dangers of having (i) one vision of
accounting, and (ii) the contagion effect of standard setting.
1. The differences – investor decision making and a balance sheet valuation
approach matching expenses against revenues with a focus on stewardship and
performance over time. Local authorities should not be assessed the same as
listed stocks.
2. Students are encouraged to address this issue and consider that accounting is not
one-dimensional. The “simple” answer is yes!
3. Murphy is using both a systematic argument - local councils have different
objectives and a semantic argument – they require different measures. There is
also a hint of pragmatics in the behaviour of the big 4.
4. Lack of scientific consideration but students should be encouraged to debate the
issues raised.
International View
2.2 Financial accounting: an epistemological research note
After reading this article students should realise the complexity of accounting and the
far reaching impact of the various theories and different research approaches. All the
primary accounting theories in the chapter are touched on but there is an emphasis on
the competing North American and British approaches:
1. (i) The North American approach − ontology – reality is objective to satisfy the
man 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 upon
the sociology, psychology, history and political disciplines. Epistemology is
shaped by various social interactions and cannot be reduced to single normative
statements or hypotheses to be tested.
2. All accounting theories are normative. The instructor should encourage students
to explain further with the view that a normative assumption is always made about
the objective i.e. Decision making, stewardship, society etc.
3. Effects on society are numerous. Questions of resource usage efficiency, decision
making, there are economic gainers and losers, there are affects on accountants,
investors, managers, and society at large. This list is not exhaustive and students
are encouraged to explore their observations and ideas.
2.13
International View
2.1 IFRS is a Big Four gravy train
This is an article that succinctly points out the dangers of having (i) one vision of
accounting, and (ii) the contagion effect of standard setting.
1. The differences – investor decision making and a balance sheet valuation
approach matching expenses against revenues with a focus on stewardship and
performance over time. Local authorities should not be assessed the same as
listed stocks.
2. Students are encouraged to address this issue and consider that accounting is not
one-dimensional. The “simple” answer is yes!
3. Murphy is using both a systematic argument - local councils have different
objectives and a semantic argument – they require different measures. There is
also a hint of pragmatics in the behaviour of the big 4.
4. Lack of scientific consideration but students should be encouraged to debate the
issues raised.
International View
2.2 Financial accounting: an epistemological research note
After reading this article students should realise the complexity of accounting and the
far reaching impact of the various theories and different research approaches. All the
primary accounting theories in the chapter are touched on but there is an emphasis on
the competing North American and British approaches:
1. (i) The North American approach − ontology – reality is objective to satisfy the
man 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 upon
the sociology, psychology, history and political disciplines. Epistemology is
shaped by various social interactions and cannot be reduced to single normative
statements or hypotheses to be tested.
2. All accounting theories are normative. The instructor should encourage students
to explain further with the view that a normative assumption is always made about
the objective i.e. Decision making, stewardship, society etc.
3. Effects on society are numerous. Questions of resource usage efficiency, decision
making, there are economic gainers and losers, there are affects on accountants,
investors, managers, and society at large. This list is not exhaustive and students
are encouraged to explore their observations and ideas.
Loading page 18...
Chapter 2: Theory and method
2.14
Theory in Action 2.1
Do share prices rise when profit improves?
1. The article describes a market reaction to accounting profit news. This
description 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 approach
to theory, in particular output semantics. An output of the accounting system (that is, the
profit figure) is being tested against an external reference (that is, share price). Share
prices react to unanticipated increases or decreases in earnings, because these represent
new information that will cause investors to revise their expectations regarding the
firm’s future cash flows. In an efficient capital market, changes in expectations of a
firm’s cash flows will lead to changes in the firm’s share price if share prices represent a
capitalisation of future cash flows. The article describes how the shares in Metcash rose
by 7 cents following the announcement of expected future organic and acquisition
growth driving sales and earnings. This is because the market expected Metcash to
perform better in the future.
The description is also pragmatic in that it is useful in terms of its potential to assist
managers in knowing how to deal with earnings announcements in order to maximise
firm value.
To the extent that the market reaction is compared against a theory developed using
syntactic 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 constructs
to real world references.
2. Consider the following syllogism:
When a company reports better prospects than previously, investors force
that company’s share price to increase.
• Metcash is a company that has reported better earnings per share than
previously.
• Investors forced Metcash’s share price to increase.
(a) Is there a flaw in the syntax or semantics within the syllogism that
means its conclusion is not true? If so, what is the flaw? (Hint: Consider
whether the general premise at the start of the syllogism must always be
true.)
There is no flaw in the syntax of the syllogism. The syntatics is valid as it follows a
logical reasoning, which means if both premises were true, the conclusion would also be
true. The fact that the conclusion is not true is caused by a semantics problem.
2.14
Theory in Action 2.1
Do share prices rise when profit improves?
1. The article describes a market reaction to accounting profit news. This
description 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 approach
to theory, in particular output semantics. An output of the accounting system (that is, the
profit figure) is being tested against an external reference (that is, share price). Share
prices react to unanticipated increases or decreases in earnings, because these represent
new information that will cause investors to revise their expectations regarding the
firm’s future cash flows. In an efficient capital market, changes in expectations of a
firm’s cash flows will lead to changes in the firm’s share price if share prices represent a
capitalisation of future cash flows. The article describes how the shares in Metcash rose
by 7 cents following the announcement of expected future organic and acquisition
growth driving sales and earnings. This is because the market expected Metcash to
perform better in the future.
The description is also pragmatic in that it is useful in terms of its potential to assist
managers in knowing how to deal with earnings announcements in order to maximise
firm value.
To the extent that the market reaction is compared against a theory developed using
syntactic 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 constructs
to real world references.
2. Consider the following syllogism:
When a company reports better prospects than previously, investors force
that company’s share price to increase.
• Metcash is a company that has reported better earnings per share than
previously.
• Investors forced Metcash’s share price to increase.
(a) Is there a flaw in the syntax or semantics within the syllogism that
means its conclusion is not true? If so, what is the flaw? (Hint: Consider
whether the general premise at the start of the syllogism must always be
true.)
There is no flaw in the syntax of the syllogism. The syntatics is valid as it follows a
logical reasoning, which means if both premises were true, the conclusion would also be
true. The fact that the conclusion is not true is caused by a semantics problem.
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Solution Manual to accompany Accounting Theory 7e
2.15
In the argument above, although the logic is sound, there is a problem with the
semantics of the syllogism. After Metcash announced that it increased earnings by 13.3
per cent in 2009 its share price rose. The flaw is in the premise ‘When a company
reports higher earnings than previously, investors force that company’s share price to
increase’. The reality shows that when a company reports higher earnings, its share
price may not always increase. A company’s share price will generally increase when its
earnings exceed those anticipated by the market. But for numerous reasons, for
example, the presence of short term traders on the share register of a company, its share
price might fall as the traders exit the share as the earnings improvements are not
expected to be affecting the very short term cash flows of the firm.
(b) What is the practical significance of this theory being invalid and its
conclusion false?
The practical significance is that it is not sufficient for a firm just to make any earnings
to increase its share price, as the market will only value any increase in earnings that is
above or supplemental to its expectation. In other words, the firm has to exceed the
market’s expectation to increase its share price.
2.15
In the argument above, although the logic is sound, there is a problem with the
semantics of the syllogism. After Metcash announced that it increased earnings by 13.3
per cent in 2009 its share price rose. The flaw is in the premise ‘When a company
reports higher earnings than previously, investors force that company’s share price to
increase’. The reality shows that when a company reports higher earnings, its share
price may not always increase. A company’s share price will generally increase when its
earnings exceed those anticipated by the market. But for numerous reasons, for
example, the presence of short term traders on the share register of a company, its share
price might fall as the traders exit the share as the earnings improvements are not
expected to be affecting the very short term cash flows of the firm.
(b) What is the practical significance of this theory being invalid and its
conclusion false?
The practical significance is that it is not sufficient for a firm just to make any earnings
to increase its share price, as the market will only value any increase in earnings that is
above or supplemental to its expectation. In other words, the firm has to exceed the
market’s expectation to increase its share price.
Loading page 20...
Chapter 2: Theory and method
2.16
Theory in Action 2.2
Normative theories of investment
1. What is a bull market? A bear market?
A bull market is a market which is experiencing a prolonged period of generally rising
share prices. A bull market often occurs when the market is recovering from recession
or experiencing an economic boom. A bear market is a market that is experiencing a
prolonged period of decreasing share prices. A bear market often occurs when a market
is moving towards or is in recession.
2. Why would high commodity prices and low interest rates help to maintain
share prices?
As Australia is a producer of commodities, high commodity prices due to increases in
global demand and/or decreases in global supply will increase commodity export
revenues. High commodity export revenue could enable Australian firms to increase
their retained earnings and allow Australia to build its reserves and maintain a strong
balance of payment position. This will encourage more investment in Australian
businesses, and cause share prices to rise. Similarly, low interest rates will result in
more consumer spending or investment in shares as there will be a larger portion of
disposable income available to be spent after paying for debt and interest, and less
incentive to invest in interest bearing securities since returns are lower.
3. What is the theory underlying the advice to ‘buy the dips’? Is this a
normative theory? Explain your answer.
The theory underpinning the advice to ‘buy the dips’ is that firms with volatile share
prices may present opportunities for investors to acquire equity at competitive prices as
the market is inefficient. Those investors who buy at lower prices may be able to reap
profits by trading the shares when the market becomes more efficient (and the trend
reverses) either on a short term or a longer term basis.
The advice that investors should look for firms with volatile share prices and ‘buy the
dips’, is a normative statement, in that it prescribes what investors should do to achieve
a desirable outcome (gains).
On the other hand, a theory that firms will (say) distribute higher dividends and thus
push their share prices to increase, is a positive theory as it explains/predicts the
movement of share prices in relation to rising revenues, profits, and dividends.
2.16
Theory in Action 2.2
Normative theories of investment
1. What is a bull market? A bear market?
A bull market is a market which is experiencing a prolonged period of generally rising
share prices. A bull market often occurs when the market is recovering from recession
or experiencing an economic boom. A bear market is a market that is experiencing a
prolonged period of decreasing share prices. A bear market often occurs when a market
is moving towards or is in recession.
2. Why would high commodity prices and low interest rates help to maintain
share prices?
As Australia is a producer of commodities, high commodity prices due to increases in
global demand and/or decreases in global supply will increase commodity export
revenues. High commodity export revenue could enable Australian firms to increase
their retained earnings and allow Australia to build its reserves and maintain a strong
balance of payment position. This will encourage more investment in Australian
businesses, and cause share prices to rise. Similarly, low interest rates will result in
more consumer spending or investment in shares as there will be a larger portion of
disposable income available to be spent after paying for debt and interest, and less
incentive to invest in interest bearing securities since returns are lower.
3. What is the theory underlying the advice to ‘buy the dips’? Is this a
normative theory? Explain your answer.
The theory underpinning the advice to ‘buy the dips’ is that firms with volatile share
prices may present opportunities for investors to acquire equity at competitive prices as
the market is inefficient. Those investors who buy at lower prices may be able to reap
profits by trading the shares when the market becomes more efficient (and the trend
reverses) either on a short term or a longer term basis.
The advice that investors should look for firms with volatile share prices and ‘buy the
dips’, is a normative statement, in that it prescribes what investors should do to achieve
a desirable outcome (gains).
On the other hand, a theory that firms will (say) distribute higher dividends and thus
push their share prices to increase, is a positive theory as it explains/predicts the
movement of share prices in relation to rising revenues, profits, and dividends.
Loading page 21...
Solution Manual to accompany Accounting Theory 7e
2.17
Theory in Action 2.3
Alternative approaches to accounting theory construction
1. What market backlash do businesspeople fear if they do not meet their
forecast earnings or growth targets? Why?
Businesspeople who do not meet their forecast earnings or growth target will face
pressure 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 example
via reputation effects, reduced or removed performance bonuses, or threats to their
employment tenure. In general, the market would penalise firms that do not meet their
forecast 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-year
annual profit growth targets. Explain what is likely to have caused him to
learn that lesson. In coming to the conclusion, what approach to theory
construction 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 is
likely 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 putting
pressure on the board of directors. Since then, he has learnt not to disclose any profit
growth because the risk of doing that is too high in such a susceptible market. In this
case, Mr. Fletcher applies the psychological pragmatic approach, which observes users’
responses to accountants’ outputs (the five-year profit growth targets). After profit
targets are disclosed, users react when firm’s performance is not according to what was
predicted. His is also an inductive approach, leading from an initial premise of
individual personal experiences.
3. Can the scientific approach to theory construction and testing be useful in
relation to predicting when and how investors will react to earnings
announcements? How/Why not?
Yes, the scientific approach can be used to predict when and how investors will react to
earnings announcements. In this case, investors’ reactions are measured through the
changes in share prices (increase/decrease) following the earnings announcements,
allowing abnormal gains/losses to be made. The research problem to test is whether
share prices will respond to new information associated with the announcements, and
when that will happen relative to the announcement day. This can be examined by
conducting an event study investigating the share returns associated with the release of
information relating to share trades. It would be expected that investors would react to
earnings announcements. The question, however, is when investors will react to the
release of such information. Data associated with earnings announcements and any
abnormal gains/losses can be gathered from a sample of firms. Data are then analysed
2.17
Theory in Action 2.3
Alternative approaches to accounting theory construction
1. What market backlash do businesspeople fear if they do not meet their
forecast earnings or growth targets? Why?
Businesspeople who do not meet their forecast earnings or growth target will face
pressure 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 example
via reputation effects, reduced or removed performance bonuses, or threats to their
employment tenure. In general, the market would penalise firms that do not meet their
forecast 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-year
annual profit growth targets. Explain what is likely to have caused him to
learn that lesson. In coming to the conclusion, what approach to theory
construction 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 is
likely 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 putting
pressure on the board of directors. Since then, he has learnt not to disclose any profit
growth because the risk of doing that is too high in such a susceptible market. In this
case, Mr. Fletcher applies the psychological pragmatic approach, which observes users’
responses to accountants’ outputs (the five-year profit growth targets). After profit
targets are disclosed, users react when firm’s performance is not according to what was
predicted. His is also an inductive approach, leading from an initial premise of
individual personal experiences.
3. Can the scientific approach to theory construction and testing be useful in
relation to predicting when and how investors will react to earnings
announcements? How/Why not?
Yes, the scientific approach can be used to predict when and how investors will react to
earnings announcements. In this case, investors’ reactions are measured through the
changes in share prices (increase/decrease) following the earnings announcements,
allowing abnormal gains/losses to be made. The research problem to test is whether
share prices will respond to new information associated with the announcements, and
when that will happen relative to the announcement day. This can be examined by
conducting an event study investigating the share returns associated with the release of
information relating to share trades. It would be expected that investors would react to
earnings announcements. The question, however, is when investors will react to the
release of such information. Data associated with earnings announcements and any
abnormal gains/losses can be gathered from a sample of firms. Data are then analysed
Loading page 22...
Chapter 2: Theory and method
2.18
and evaluated to determine how and when investors would react to earnings
announcements.
4. What is the importance to society of developing a theory to explain the
relationship between earnings forecasts, earnings announcements, and share
price movements?
The importance is to provide guidance to the society on how share prices move in
relation to earnings forecasts and earnings announcements. By developing and then
testing the theory, researchers will contribute to explain and predict what happen in the
share market surrounding earnings announcements. Society would benefit in terms of
gaining knowledge to guide them in making decisions. For example, firms will consider
carefully whether they would announce earnings forecasts if there is a theory suggesting
that share price will move downward when actual earnings do not reflect earning
forecasts. Similarly, the theory will also help investors to make decisions, for example
whether to buy or sell their shares, following earnings announcements. Overall, the
pragmatic significance of the theory is that it affects individuals’ wealth distributions
and the distribution of wealth amongst businesses, and also the generation of wealth by
firms whose ability to raise capital is affected.
2.18
and evaluated to determine how and when investors would react to earnings
announcements.
4. What is the importance to society of developing a theory to explain the
relationship between earnings forecasts, earnings announcements, and share
price movements?
The importance is to provide guidance to the society on how share prices move in
relation to earnings forecasts and earnings announcements. By developing and then
testing the theory, researchers will contribute to explain and predict what happen in the
share market surrounding earnings announcements. Society would benefit in terms of
gaining knowledge to guide them in making decisions. For example, firms will consider
carefully whether they would announce earnings forecasts if there is a theory suggesting
that share price will move downward when actual earnings do not reflect earning
forecasts. Similarly, the theory will also help investors to make decisions, for example
whether to buy or sell their shares, following earnings announcements. Overall, the
pragmatic significance of the theory is that it affects individuals’ wealth distributions
and the distribution of wealth amongst businesses, and also the generation of wealth by
firms whose ability to raise capital is affected.
Loading page 23...
Solution Manual to accompany Accounting Theory 7e
2.19
Theory in Action 2.4
Alternative approaches to accounting theory construction
1. What market backlash do businesspeople fear if they do not meet their
forecast earnings or growth targets? Why?
Businesspeople who do not meet their forecast earnings or growth target will face
pressure first of all from their shareholders. As shareholders demand higher profits,
inability to meet profit targets may result in some sort of personal penalty, for example
via reputation effects, reduced or removed performance bonuses, or threats to their
employment tenure. In general, the market would penalise firms that do not meet their
forecast 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 in
relation to predicting when and how investors will react to earnings
announcements? Why or why not?
Yes, the scientific approach can be used to predict when and how investors will react to
earnings announcements. In this case, investors’ reactions are measured through the
changes in share prices (increase/decrease) following the earnings announcements,
allowing abnormal gains/losses to be made. The research problem to test is whether
share prices will respond to new information associated with the announcements, and
when that will happen relative to the announcement day. This can be examined by
conducting an event study investigating the share returns associated with the release of
information relating to share trades. It would be expected that investors would react to
earnings announcements. The question, however, is when investors will react to the
release of such information. Data associated with earnings announcements and any
abnormal gains/losses can be gathered from a sample of firms. Data are then analysed
and evaluated to determine how and when investors would react to earnings
announcements.
3. What is the importance to society of developing a theory to explain the
relationship between earnings forecasts, earnings announcements, and share
price movements?
The importance is to provide guidance to society on how share prices move in relation
to earnings forecasts and earnings announcements. By developing and then testing the
theory, researchers will contribute to explaining and predicting what happen in the share
market at the time surrounding earnings announcements. Society would benefit in terms
of gaining knowledge to guide them in making efficient decisions. For example, firms
will consider carefully whether they would announce earnings forecasts if there is a
theory suggesting that share price will move downward when actual earnings do not
reflect earning forecasts. Similarly, the theory will also help investors to make
decisions, for example whether to buy or sell their shares, following earnings
announcements. Overall, the pragmatic significance of the theory is that it affects
individuals’ wealth distributions and the distribution of wealth amongst businesses, and
also the generation of wealth by firms whose ability to raise capital is affected.
Case Study 2.1
2.19
Theory in Action 2.4
Alternative approaches to accounting theory construction
1. What market backlash do businesspeople fear if they do not meet their
forecast earnings or growth targets? Why?
Businesspeople who do not meet their forecast earnings or growth target will face
pressure first of all from their shareholders. As shareholders demand higher profits,
inability to meet profit targets may result in some sort of personal penalty, for example
via reputation effects, reduced or removed performance bonuses, or threats to their
employment tenure. In general, the market would penalise firms that do not meet their
forecast 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 in
relation to predicting when and how investors will react to earnings
announcements? Why or why not?
Yes, the scientific approach can be used to predict when and how investors will react to
earnings announcements. In this case, investors’ reactions are measured through the
changes in share prices (increase/decrease) following the earnings announcements,
allowing abnormal gains/losses to be made. The research problem to test is whether
share prices will respond to new information associated with the announcements, and
when that will happen relative to the announcement day. This can be examined by
conducting an event study investigating the share returns associated with the release of
information relating to share trades. It would be expected that investors would react to
earnings announcements. The question, however, is when investors will react to the
release of such information. Data associated with earnings announcements and any
abnormal gains/losses can be gathered from a sample of firms. Data are then analysed
and evaluated to determine how and when investors would react to earnings
announcements.
3. What is the importance to society of developing a theory to explain the
relationship between earnings forecasts, earnings announcements, and share
price movements?
The importance is to provide guidance to society on how share prices move in relation
to earnings forecasts and earnings announcements. By developing and then testing the
theory, researchers will contribute to explaining and predicting what happen in the share
market at the time surrounding earnings announcements. Society would benefit in terms
of gaining knowledge to guide them in making efficient decisions. For example, firms
will consider carefully whether they would announce earnings forecasts if there is a
theory suggesting that share price will move downward when actual earnings do not
reflect earning forecasts. Similarly, the theory will also help investors to make
decisions, for example whether to buy or sell their shares, following earnings
announcements. Overall, the pragmatic significance of the theory is that it affects
individuals’ wealth distributions and the distribution of wealth amongst businesses, and
also 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 method
2.20
New accounting rules ‘don’t add up’
1. What are International Financial Reporting Standards?
International Financial Reporting Standards are accounting standards developed by the
International Accounting Standards Board (IASB), which is an independent
international organisation supported by professional accounting bodies. Formerly
known as the International Accounting Standards (IAS), the objective of IFRS is to
achieve uniformity and transparency of accounting principles used by entities for
financial reporting around the world.
2. Many arguments are expressed in this article. List three factors that you
think are causing concern about the impact of adoption of IFRS.
Three of the factors causing concern about the prospect of adopting IFRS include:
• Companies are required to recognise, present or disclose information in a
transparent way.
• The use of fair value accounting which requires asset and liability revaluations to
be passed through the income statement both (a) increases earnings and leverage
measures of volatility; and (b) takes more effort to implement.
• IFRS do not provide more insight into firm risk than 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 the concerns about adoption of
IFRS scientific or naturalistic in its approach? Explain your answer.
(i) Companies are required to recognise, present or disclose information in a different
way.
Yes. For example, adoption of IFRS in Australia also requires companies to recognise
share-based transactions, which was not the case previously. The accounts of companies
adopting 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. These
accounts have been observed by individuals who have become concerned about the
nature of the changes required under IFRS.
However, if a research study has been conducted, say by academics, then that research
study is likely to follow the scientific approach of analysing many firms’ financial
statements, or reconstructions of their past financial statements, to come to a general
conclusion regarding the view that firms are required to recognise, present or disclose
information differently from their current approach.
(ii) The use of fair value accounting which requires asset and liability revaluations to
be passed through the income statement both (a) increases earnings and leverage
measure volatility; and (b) takes more effort to implement.
2.20
New accounting rules ‘don’t add up’
1. What are International Financial Reporting Standards?
International Financial Reporting Standards are accounting standards developed by the
International Accounting Standards Board (IASB), which is an independent
international organisation supported by professional accounting bodies. Formerly
known as the International Accounting Standards (IAS), the objective of IFRS is to
achieve uniformity and transparency of accounting principles used by entities for
financial reporting around the world.
2. Many arguments are expressed in this article. List three factors that you
think are causing concern about the impact of adoption of IFRS.
Three of the factors causing concern about the prospect of adopting IFRS include:
• Companies are required to recognise, present or disclose information in a
transparent way.
• The use of fair value accounting which requires asset and liability revaluations to
be passed through the income statement both (a) increases earnings and leverage
measures of volatility; and (b) takes more effort to implement.
• IFRS do not provide more insight into firm risk than 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 the concerns about adoption of
IFRS scientific or naturalistic in its approach? Explain your answer.
(i) Companies are required to recognise, present or disclose information in a different
way.
Yes. For example, adoption of IFRS in Australia also requires companies to recognise
share-based transactions, which was not the case previously. The accounts of companies
adopting 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. These
accounts have been observed by individuals who have become concerned about the
nature of the changes required under IFRS.
However, if a research study has been conducted, say by academics, then that research
study is likely to follow the scientific approach of analysing many firms’ financial
statements, or reconstructions of their past financial statements, to come to a general
conclusion regarding the view that firms are required to recognise, present or disclose
information differently from their current approach.
(ii) The use of fair value accounting which requires asset and liability revaluations to
be passed through the income statement both (a) increases earnings and leverage
measure volatility; and (b) takes more effort to implement.
Loading page 25...
Solution Manual to accompany Accounting Theory 7e
2.21
Yes, 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 than
historical-based earnings.
The use of fair value accounting leads to a complaint that it introduces volatility into
reported profits, as revaluations must be brought into the income statements. 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. These
accounts have been observed by individuals who have become concerned about the
increase in earnings and leverage volatility reported under IFRS.
However, if a research study has been conducted, say by academics, then that research
study is likely to follow the scientific approach of analysing many firms’ financial
statements, or reconstructions of their past financial statements, to come to a general
conclusion, statistically tested, regarding the view that volatility increases after IFRS
adoption.
(iii) IFRS do not provide more insight into firm risk than existing accounting
standards.
The empirical evidence can include the type of risk disclosed and its impact on profit
and financial position; the difficulty in risk compared with the audit of financial
statements prepared under national standards, etc.
The evidence used as the basis for the claims is naturalistic if it is evidence from
individuals learning to prepare/auditing firms’ individual accounts that underpins the
claims by individuals in many cases.
However, if a research study has been conducted, say by academics, then that research
study is likely to follow the scientific approach of analysing the time spent by
accountants and/or auditors in relation to numerous firms’ financial statements, or
reconstructions of their past financial statements, or statements pre- and post- IFRS
adoption.
4. How could researchers evaluate the decision-usefulness of adopting
International Financial Reporting Standards?
The decision-usefulness approach builds from a basic assumption that the objective of
accounting is to assist users of accounting reports in their decision-making process by
providing useful and relevant information in the accounting reports. To evaluate the
decision-usefulness of adopting IFRS, researchers need to examine whether financial
reports prepared under IFRS are useful for users in making economic decisions. There
are a number of ways to do that. One way is to undertake a value-relevance study
investigating whether certain items disclosed in financial reports, such as financial
instruments or intangible assets, are value-relevant (i.e. provide relevant and reliable
information for users). Another way is to conduct a survey among firms that have
adopted IFRS, or survey users of their financial reports. Other research methods can be
teased out with the class.
2.21
Yes, 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 than
historical-based earnings.
The use of fair value accounting leads to a complaint that it introduces volatility into
reported profits, as revaluations must be brought into the income statements. 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. These
accounts have been observed by individuals who have become concerned about the
increase in earnings and leverage volatility reported under IFRS.
However, if a research study has been conducted, say by academics, then that research
study is likely to follow the scientific approach of analysing many firms’ financial
statements, or reconstructions of their past financial statements, to come to a general
conclusion, statistically tested, regarding the view that volatility increases after IFRS
adoption.
(iii) IFRS do not provide more insight into firm risk than existing accounting
standards.
The empirical evidence can include the type of risk disclosed and its impact on profit
and financial position; the difficulty in risk compared with the audit of financial
statements prepared under national standards, etc.
The evidence used as the basis for the claims is naturalistic if it is evidence from
individuals learning to prepare/auditing firms’ individual accounts that underpins the
claims by individuals in many cases.
However, if a research study has been conducted, say by academics, then that research
study is likely to follow the scientific approach of analysing the time spent by
accountants and/or auditors in relation to numerous firms’ financial statements, or
reconstructions of their past financial statements, or statements pre- and post- IFRS
adoption.
4. How could researchers evaluate the decision-usefulness of adopting
International Financial Reporting Standards?
The decision-usefulness approach builds from a basic assumption that the objective of
accounting is to assist users of accounting reports in their decision-making process by
providing useful and relevant information in the accounting reports. To evaluate the
decision-usefulness of adopting IFRS, researchers need to examine whether financial
reports prepared under IFRS are useful for users in making economic decisions. There
are a number of ways to do that. One way is to undertake a value-relevance study
investigating whether certain items disclosed in financial reports, such as financial
instruments or intangible assets, are value-relevant (i.e. provide relevant and reliable
information for users). Another way is to conduct a survey among firms that have
adopted IFRS, or survey users of their financial reports. Other research methods can be
teased out with the class.
Loading page 26...
Chapter 2: Theory and method
2.22
5. What role can positive theory play in resolving the issue(s) described in the
article?
Researchers can conduct positive accounting research to examine and find empirical
evidence that can support or reject the issues described in the article. Investigating how
adoption of IFRS works in the UK can be used to enhance the theory of how global
accounting standards should provide more benefits, as it will describe and explain the
issues and consequences associated with adopting IFRS.
6. What role can normative theory play in resolving the issue(s) described in the
article?
Commencing with premises regarding the desirable attributes of a global accounting
system and premises regarding how well different national and other accounting
systems (including IFRS) meet those attributes, (this may be the outcome of either
positive or normative theories, depending upon the nature of the attribute in question).
A normative theory can lead to hypotheses regarding the best way to achieve
accounting’s goals.
2.22
5. What role can positive theory play in resolving the issue(s) described in the
article?
Researchers can conduct positive accounting research to examine and find empirical
evidence that can support or reject the issues described in the article. Investigating how
adoption of IFRS works in the UK can be used to enhance the theory of how global
accounting standards should provide more benefits, as it will describe and explain the
issues and consequences associated with adopting IFRS.
6. What role can normative theory play in resolving the issue(s) described in the
article?
Commencing with premises regarding the desirable attributes of a global accounting
system and premises regarding how well different national and other accounting
systems (including IFRS) meet those attributes, (this may be the outcome of either
positive or normative theories, depending upon the nature of the attribute in question).
A normative theory can lead to hypotheses regarding the best way to achieve
accounting’s goals.
Loading page 27...
Solution Manual to accompany Accounting Theory 7e
2.23
Case Study 2.2
The thrill is gone
1. Lend Lease reported a 13.5% increase in profit for 2004–2005. Why was the
share market unimpressed?
The Lend Lease 2004–2005 profit did not meet the market’s expectations. During that
period, Lend Lease did well to produce a growth business through its retail and
residential development, including some prominent projects in the US such as cleaning
up the WTC site after the September 11, 2001 attack. However, the market expected
Lend Lease to do more infrastructure works, such as toll roads and tunnels, which Lend
Lease has no plans to do. Therefore, the market was unimpressed by the Lend Lease
results.
2. In trying to explain shareholders’ subdued reaction to Lend Lease reported
earnings, explain whether and/or how you could use the following
approaches to accounting theory construction:
(a) pragmatic
The pragmatic approach (especially the psychological pragmatic approach) observes
how users respond to accounting outputs (in this case profit announcement). In the Lend
Lease case, shareholders were unimpressed with the profit announcement, causing the
share price to fall. To assess reasons for the subdued reaction, a study using protocol
analysis of shareholders’ reactions to other firms’ earnings announcements and the Lend
Lease earnings announcement, after subjects had been provided with different sets of
prior information about analysts’ forecasts of earnings would be useful to build
cumulative evidence. Alternatively, researchers could survey the users of the financial
statements. This approach could also be undertaken under the positive accounting or
scientific method approaches.
(b) decision-usefulness
The decision-usefulness approach assumes that accounting outputs provide useful
information for users in the decision-making process. This approach would try to
determine whether accounting outputs (Lend Lease profit announcement) provide useful
information for the shareholders to make decisions. Shareholders could be given a set of
prior information and the accounts of Lend Lease, and then in a separate experiment
give a set of different prior information and the accounts of Lend Lease. At the end of
each analysis of the financial statements, they might be asked to bid for shares, to see
which set of accounts/prior information leads to the lower share price.
(c) positive accounting theory
Positive theory deals with explaining or predicting what actually happens in the real
world. Using positive theory, researchers would try to explain why, in reality,
shareholders were not impressed with Lend Lease performance despite its 13.5% profit.
They would probably collect data concerning earnings announcements and analysts’
2.23
Case Study 2.2
The thrill is gone
1. Lend Lease reported a 13.5% increase in profit for 2004–2005. Why was the
share market unimpressed?
The Lend Lease 2004–2005 profit did not meet the market’s expectations. During that
period, Lend Lease did well to produce a growth business through its retail and
residential development, including some prominent projects in the US such as cleaning
up the WTC site after the September 11, 2001 attack. However, the market expected
Lend Lease to do more infrastructure works, such as toll roads and tunnels, which Lend
Lease has no plans to do. Therefore, the market was unimpressed by the Lend Lease
results.
2. In trying to explain shareholders’ subdued reaction to Lend Lease reported
earnings, explain whether and/or how you could use the following
approaches to accounting theory construction:
(a) pragmatic
The pragmatic approach (especially the psychological pragmatic approach) observes
how users respond to accounting outputs (in this case profit announcement). In the Lend
Lease case, shareholders were unimpressed with the profit announcement, causing the
share price to fall. To assess reasons for the subdued reaction, a study using protocol
analysis of shareholders’ reactions to other firms’ earnings announcements and the Lend
Lease earnings announcement, after subjects had been provided with different sets of
prior information about analysts’ forecasts of earnings would be useful to build
cumulative evidence. Alternatively, researchers could survey the users of the financial
statements. This approach could also be undertaken under the positive accounting or
scientific method approaches.
(b) decision-usefulness
The decision-usefulness approach assumes that accounting outputs provide useful
information for users in the decision-making process. This approach would try to
determine whether accounting outputs (Lend Lease profit announcement) provide useful
information for the shareholders to make decisions. Shareholders could be given a set of
prior information and the accounts of Lend Lease, and then in a separate experiment
give a set of different prior information and the accounts of Lend Lease. At the end of
each analysis of the financial statements, they might be asked to bid for shares, to see
which set of accounts/prior information leads to the lower share price.
(c) positive accounting theory
Positive theory deals with explaining or predicting what actually happens in the real
world. Using positive theory, researchers would try to explain why, in reality,
shareholders were not impressed with Lend Lease performance despite its 13.5% profit.
They would probably collect data concerning earnings announcements and analysts’
Loading page 28...
Chapter 2: Theory and method
2.24
forecasts, and statistically compare the returns for different circumstances: when
analysts’ forecasts are above, below, or at the amount of profit reported.
(d) normative theory
Normative theory is concerned with prescribing what should be done. One of the issues
which becomes the focus of some normative theorists is how to derive the ‘true income’
(profit). In trying to explain the shareholders’ response to Lend Lease profit
announcement, normative theory would concentrate on whether Lend Lease has
measured its profit figure correctly, and if it is the case, whether the profit figure would
provide useful information for shareholders (decision-usefulness approach). The
normative theory approach does not explain the subdued reaction; rather it might come
up with recommendations for how firms should calculate and report their profits.
(e) scientific approach
Based upon observations that firms’ share prices generally increase after positive
earnings announcements, but sometimes do not, the scientific approach would cause
researchers to develop theories about why that was the case. See the explanation for the
positive theory approach.
(f) naturalistic approach
The naturalistic approach is appropriate to use in explaining an individual shareholder’s
reaction 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 the
market 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 to question (2) do you believe is
most useful? Why?
The approaches are generally not necessarily incompatible. We would argue that the
best approach is through triangulation: the use of multiple approaches to see if they all
deliver consistent outcomes. Overall, though, we argue that the scientific approach
provides a more generalisable result. This approach is likely to be applied in a positive
accounting theory context. It could be supplemented by case studies conducted using
the naturalistic approach.
4. Are the approaches you described in answer to question (2) mutually
exclusive, or can they be used to complement each other? Explain?
There are some approaches that are mutually exclusive within the one study and some
others that are not. For example, positive accounting theory approaches are generally a
subset of the scientific method approach. However, positive accounting theory simply
refers to the development of explanatory theory, and it is thus consistent with the
decision-usefulness approach, etc. All approaches can be used to complement each
other. Scientific and naturalistic approaches, for instance, are mutually exclusive, in that
they cannot be applied at the same time due to different perspectives. The scientific
2.24
forecasts, and statistically compare the returns for different circumstances: when
analysts’ forecasts are above, below, or at the amount of profit reported.
(d) normative theory
Normative theory is concerned with prescribing what should be done. One of the issues
which becomes the focus of some normative theorists is how to derive the ‘true income’
(profit). In trying to explain the shareholders’ response to Lend Lease profit
announcement, normative theory would concentrate on whether Lend Lease has
measured its profit figure correctly, and if it is the case, whether the profit figure would
provide useful information for shareholders (decision-usefulness approach). The
normative theory approach does not explain the subdued reaction; rather it might come
up with recommendations for how firms should calculate and report their profits.
(e) scientific approach
Based upon observations that firms’ share prices generally increase after positive
earnings announcements, but sometimes do not, the scientific approach would cause
researchers to develop theories about why that was the case. See the explanation for the
positive theory approach.
(f) naturalistic approach
The naturalistic approach is appropriate to use in explaining an individual shareholder’s
reaction 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 the
market 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 to question (2) do you believe is
most useful? Why?
The approaches are generally not necessarily incompatible. We would argue that the
best approach is through triangulation: the use of multiple approaches to see if they all
deliver consistent outcomes. Overall, though, we argue that the scientific approach
provides a more generalisable result. This approach is likely to be applied in a positive
accounting theory context. It could be supplemented by case studies conducted using
the naturalistic approach.
4. Are the approaches you described in answer to question (2) mutually
exclusive, or can they be used to complement each other? Explain?
There are some approaches that are mutually exclusive within the one study and some
others that are not. For example, positive accounting theory approaches are generally a
subset of the scientific method approach. However, positive accounting theory simply
refers to the development of explanatory theory, and it is thus consistent with the
decision-usefulness approach, etc. All approaches can be used to complement each
other. Scientific and naturalistic approaches, for instance, are mutually exclusive, in that
they cannot be applied at the same time due to different perspectives. The scientific
Loading page 29...
Solution Manual to accompany Accounting Theory 7e
2.25
approach is a highly structured approach to analyse problems based on prior knowledge.
It also relies on predetermined procedures and statistical techniques to validate or refute
tested 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 socially
constructed 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 preconceived
assumptions or theories (such as shareholders’ reaction of Lend Lease profit
announcement). It aims to solve individual problems, and thus the result may be
difficult to generalise.
Some approaches can be used to complement each other. For example, the pragmatic
approach provides a usefulness test for the decision-usefulness approach — one way to
test whether accounting outputs provide useful information is by examining users’
responses to the reports. As mentioned in question 5(b), positive and normative theory
can also complement each other. Normative theory prescribes what should be done, and
one way to do that is by using the decision-usefulness approach. Positive theory
identifies and tries to explain what is actually being practiced in the real world using
scientific approach. This, in turn, can form the basis of developing normative theory to
improve current practices.
2.25
approach is a highly structured approach to analyse problems based on prior knowledge.
It also relies on predetermined procedures and statistical techniques to validate or refute
tested 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 socially
constructed 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 preconceived
assumptions or theories (such as shareholders’ reaction of Lend Lease profit
announcement). It aims to solve individual problems, and thus the result may be
difficult to generalise.
Some approaches can be used to complement each other. For example, the pragmatic
approach provides a usefulness test for the decision-usefulness approach — one way to
test whether accounting outputs provide useful information is by examining users’
responses to the reports. As mentioned in question 5(b), positive and normative theory
can also complement each other. Normative theory prescribes what should be done, and
one way to do that is by using the decision-usefulness approach. Positive theory
identifies and tries to explain what is actually being practiced in the real world using
scientific approach. This, in turn, can form the basis of developing normative theory to
improve current practices.
Loading page 30...
Chapter 2: Theory and method
2.26
Case Study 2.3
Intergovernmental working group of experts on international
standards of accounting and reporting
1. What are International Financial Reporting Standards (IFRS)?
International Financial Reporting Standards are accounting standards developed by the
International Accounting Standards Board (IASB), which is an independent
international organisation supported by professional accounting bodies. Formerly
known as the International Accounting Standards (IAS), the objective of IFRS is to
achieve uniformity and transparency of accounting principles used by entities for
financial reporting around the world.
2. Many concerns are expressed in this article. List three factors that you think
are causing concern about the impact of adoption of IFRS.
Three of the factors causing concern about the prospect of adopting IFRS include:
• Companies are required to recognise, present or disclose information in a
transparent way.
• The use of fair value accounting which requires asset and liability revaluations
to be passed through the income statement both (a) increases earnings and
leverage measures of volatility; and (b) takes more effort to implement.
• IFRS do not provide more insight into firm risk than 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 the concerns about adoption of
IFRS scientific or naturalistic in its approach? Explain your answer.
(i) Companies are required to recognise, present or disclose information in a
different way.
Yes. For example, adoption of IFRS in Australia also requires companies to
recognise share-based transactions, which was not the case previously. The
accounts of companies adopting 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.
These accounts have been observed by individuals who have become concerned
about the nature of the changes required under IFRS.
However, if a research study has been conducted, say by academics, then that
research study is likely to follow the scientific approach of analysing many firms’
financial statements, or reconstructions of their past financial statements, to come
to a general conclusion regarding the view that firms are required to recognise,
present or disclose information differently from their current approach.
2.26
Case Study 2.3
Intergovernmental working group of experts on international
standards of accounting and reporting
1. What are International Financial Reporting Standards (IFRS)?
International Financial Reporting Standards are accounting standards developed by the
International Accounting Standards Board (IASB), which is an independent
international organisation supported by professional accounting bodies. Formerly
known as the International Accounting Standards (IAS), the objective of IFRS is to
achieve uniformity and transparency of accounting principles used by entities for
financial reporting around the world.
2. Many concerns are expressed in this article. List three factors that you think
are causing concern about the impact of adoption of IFRS.
Three of the factors causing concern about the prospect of adopting IFRS include:
• Companies are required to recognise, present or disclose information in a
transparent way.
• The use of fair value accounting which requires asset and liability revaluations
to be passed through the income statement both (a) increases earnings and
leverage measures of volatility; and (b) takes more effort to implement.
• IFRS do not provide more insight into firm risk than 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 the concerns about adoption of
IFRS scientific or naturalistic in its approach? Explain your answer.
(i) Companies are required to recognise, present or disclose information in a
different way.
Yes. For example, adoption of IFRS in Australia also requires companies to
recognise share-based transactions, which was not the case previously. The
accounts of companies adopting 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.
These accounts have been observed by individuals who have become concerned
about the nature of the changes required under IFRS.
However, if a research study has been conducted, say by academics, then that
research study is likely to follow the scientific approach of analysing many firms’
financial statements, or reconstructions of their past financial statements, to come
to 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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