Accounting theory

Accounting theory encompasses the conceptual frameworks, principles and methodological approaches that provide the foundation for financial reporting practices and guide the development of accounting standards ^[1]. It represents both the body of knowledge that explains existing accounting practices and the normative concepts that prescribe how accounting should be conducted. Accounting theory serves as the intellectual basis for resolving practical accounting questions and establishing consistent standards for financial reporting across different organizations and jurisdictions.

Historical development

The systematic study of accounting theory emerged in the early twentieth century as the increasing complexity of business enterprises and capital markets created demand for more rigorous foundations for financial reporting. Prior to this period accounting practices developed pragmatically based on customs and conventions without explicit theoretical justification ^[2].

The American Institute of Accountants began efforts to codify accounting principles in the 1930s following the stock market crash which revealed inconsistencies in corporate financial reporting. The Committee on Accounting Procedure established in 1939 issued Accounting Research Bulletins that addressed specific accounting issues though critics observed that these pronouncements lacked a coherent theoretical foundation ^[3].

Concerns about the absence of a guiding framework led to the creation of the Accounting Principles Board in 1959 with the specific purpose of developing accounting theory and its practical applications. The American Accounting Association published A Statement of Basic Accounting Theory in 1966 which attempted to establish theoretical foundations for accounting practice. The Trueblood Committee Report of 1973 examined the objectives of financial statements and influenced subsequent theoretical developments.

The Financial Accounting Standards Board established in 1973 assumed responsibility for setting accounting standards in the United States and undertook development of a conceptual framework. Between 1978 and 1985 the FASB issued six Statements of Financial Accounting Concepts that articulated objectives, qualitative characteristics and definitions intended to guide standard setting ^[4]. These concepts provided theoretical underpinnings for subsequent accounting standards.

Internationally the International Accounting Standards Committee published its Framework for the Preparation and Presentation of Financial Statements in 1989. When the International Accounting Standards Board succeeded the IASC in 2001 it adopted this framework and subsequently worked with the FASB on convergence of their conceptual frameworks. A joint project beginning in 2004 produced revised frameworks though complete convergence was not achieved.

Recent developments have expanded accounting theory to address new areas including sustainability reporting. The International Sustainability Standards Board established in 2021 released its first standards in 2023 extending conceptual frameworks to environmental social and governance information.

Approaches to accounting theory

Two fundamentally different approaches characterize the development and application of accounting theory ^[5].

Normative accounting theory

Normative accounting theory prescribes what accounting practices should be followed to achieve particular outcomes. This approach establishes ideal principles and standards for financial reporting based on logical reasoning about objectives and desirable characteristics. Normative theories are concerned with how things ought to be done rather than how they are actually done.

The conceptual frameworks developed by standard setters represent normative theory because they prescribe objectives, characteristics and definitions that should guide accounting practice. Normative approaches emphasize ethical considerations and encourage accounting choices that align with principles of transparency, fairness and social responsibility. Critics of normative theory argue that its prescriptions may not reflect economic reality or the legitimate interests of various stakeholders.

Positive accounting theory

Positive accounting theory seeks to explain and predict actual accounting practices without prescribing what should be done ^[6]. Developed primarily by Ross Watts and Jerold Zimmerman, positive theory uses empirical research to understand why managers and organizations choose particular accounting methods. The approach assumes that managers often act in their self-interest when making accounting choices.

Positive theory identifies several hypotheses that explain accounting choices. The bonus plan hypothesis suggests that managers select accounting methods that increase reported income when their compensation depends on earnings. The debt covenant hypothesis proposes that managers choose methods that avoid violating loan agreements. The political cost hypothesis indicates that large profitable firms may reduce reported earnings to avoid regulatory scrutiny.

While positive and normative approaches differ in their methods they complement each other in practice. Empirical observations from positive research inform normative prescriptions while normative frameworks provide benchmarks for evaluating actual practices.

The conceptual framework

Conceptual frameworks established by standard-setting bodies provide the theoretical foundation for financial reporting ^[7].

Objectives of financial reporting

The conceptual framework establishes that the objective of general purpose financial reporting is to provide financial information useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the reporting entity. Useful financial information helps users assess the prospects for future net cash inflows to the entity and management's stewardship of the entity's economic resources.

Qualitative characteristics

The framework identifies qualitative characteristics that make financial information useful ^[8]. Fundamental characteristics include relevance which means the information is capable of making a difference in decisions, and faithful representation which requires that information represents the economic phenomena it purports to represent. Enhancing characteristics include comparability, verifiability, timeliness and understandability.

Elements of financial statements

The conceptual framework defines the elements that comprise financial statements. Assets are present economic resources controlled by the entity as a result of past events. Liabilities are present obligations to transfer economic resources as a result of past events. Equity represents the residual interest in assets after deducting liabilities. Income includes revenues and gains while expenses include losses. These definitions provide boundaries for what appears in financial statements.

Recognition and measurement

The framework establishes criteria for when elements should be recognized in financial statements and how they should be measured. Recognition occurs when an item meets the definition of an element and can be measured reliably. Measurement bases include historical cost, current cost, realizable value and present value. The selection of measurement approaches involves trade-offs between different qualitative characteristics.

Major theoretical perspectives

Various theoretical perspectives have influenced accounting thought and practice ^[9].

Decision usefulness

Decision usefulness theory holds that the primary purpose of accounting information is to facilitate decision making by investors and other users. This perspective focuses on what information users need and how they process it. Research examines whether particular accounting disclosures are associated with changes in stock prices or other evidence that users find the information valuable.

Stewardship

The stewardship perspective emphasizes the accountability of management to owners and other stakeholders. Financial reporting should enable assessment of how well management has discharged its responsibilities for the resources entrusted to it. This view may favor different accounting choices than the decision usefulness perspective particularly regarding measurement and disclosure.

Economic consequences

Economic consequences theory recognizes that accounting standards can affect economic behavior beyond simply reporting existing conditions. If accounting rules influence managerial decisions, contract terms, regulatory actions or resource allocations then standard setters must consider these effects. This perspective complicates standard setting by requiring consideration of how proposed rules might change behavior.

Agency theory

Agency theory examines the relationships between principals such as shareholders and agents such as managers who act on their behalf. Accounting information helps principals monitor agent performance and provides the basis for incentive compensation. The theory explains demand for audited financial statements and for accounting choices that reduce information asymmetry between parties.

Applications of accounting theory

Accounting theory serves several practical purposes ^[10].

Standard setting

Standard setters use the conceptual framework as a basis for developing specific accounting standards. When new transactions or circumstances arise the framework provides guidance for determining appropriate treatment. Consistency with the framework helps ensure that individual standards work together coherently.

Resolving practice issues

Practitioners use accounting theory to address situations not specifically covered by existing standards. Understanding the underlying concepts helps accountants determine appropriate treatment by analogy to similar situations or by applying fundamental principles. Professional judgment guided by theory produces more consistent and defensible decisions.

Education and research

Accounting theory provides the intellectual foundation for accounting education. Students learn not only specific rules but the concepts and reasoning that underlie them. Academic research tests theoretical propositions and extends understanding of how accounting functions in economic systems.

Advantages of accounting theory

• Provides coherent foundation for consistent standard setting
• Enables resolution of new issues by reference to established concepts
• Improves comparability of financial information across entities
• Guides professional judgment in ambiguous situations
• Supports education by explaining the rationale for practices
• Facilitates international convergence of accounting standards

Limitations of accounting theory

• Theoretical ideals may conflict with practical constraints
• Different theories may prescribe contradictory treatments
• Conceptual frameworks remain incomplete in important areas
• Political pressures may override theoretical considerations in standard setting
• Changing economic conditions may render existing theory obsolete
• Measurement and recognition concepts involve significant judgment

Accounting theory — recommended articles

Standard — Financial management — Documentation — Decision making — Management — Corporate governance — Organization — Stakeholder — Quality management

References

• Watts R.L., Zimmerman J.L. (1986), Positive Accounting Theory, Prentice-Hall.
• Godfrey J., Hodgson A., Tarca A., Hamilton J., Holmes S. (2010), Accounting Theory, John Wiley & Sons, 7th edition.
• FASB (2024), Conceptual Framework for Financial Reporting.
• Hendriksen E.S., Van Breda M.F. (1992), Accounting Theory, Richard D. Irwin, 5th edition.
• Scott W.R. (2019), Financial Accounting Theory, Pearson, 8th edition.

Footnotes

1. Godfrey J. et al. (2010), p. 5
2. Hendriksen E.S., Van Breda M.F. (1992), pp. 1-15
3. Godfrey J. et al. (2010), pp. 25-35
4. FASB Concepts Statements 1-6
5. Scott W.R. (2019), pp. 265-290
6. Watts R.L., Zimmerman J.L. (1986), pp. 1-25
7. FASB (2024), Chapter 1
8. FASB (2024), Chapter 3
9. Scott W.R. (2019), pp. 45-80
10. Godfrey J. et al. (2010), pp. 85-95

Author: Sławomir Wawak