Understanding Accounting Theories - Essay Example

? ACCOUNTING THEORY Introduction To better understand accounting theories there is need to develop an understanding of what accounting is in the first place. This picture is best painted by looking at the history of accounting that will also provide insight into the various accounting theories. Among these are the ground concepts that may be used in the formulation of accounting theories among other aspects of accounting theories. Some contend that in the beginning many primitive societies, those that were in existent in the earliest days, developed the art of counting before developing the art of naming (Brown, 2006, 3). These primitive forms of accounting for the number of items provide the basis by which early societies may be said to have been practicing accounting. Such groups are likes of the Egyptian with the need to account for grain harvested and stored. Examples of other such systems may be found in other early civilizations such as the Greeks and the Tibetans. Over time these systems of accounting for various items moved into the business world. This was in earlier European and Asian countries that mostly participated in trade with one another and within their countries. One will find evidence of the differences in practices among the various countries to indicate differentiation in as far as the earlier practice of accounting is concerned. There is also need to mention the contribution of the likes of Luca Pacioli who made contributions to the earlier forms of accounting (Riahi-Belkaoui, 2005, 3). He is credited with developing the double entry system of bookkeeping that is still widely taught and practiced in accounting spheres to date. It is though that over time this Italian system of accounting was adopted in most parts of the world. In the United States various forms of accounting methodologies were also being applied. These methods may not have been allowed for uniformity, due to the differences in the underlying guidelines. These theories were to be streamlined with the development of bodies such as the SEC which became the ultimate authority as far as providing guidance on accounting related matters (Previtis, Walton & Wolnizer, 2011, 121). Accounting theory development The development of accounting theory on the other hand may be said to have progressed with the developments that were being experienced in the accounting field. Their development was also being fueled by the changes that were occurring in corporate world. A good example may be the case with the development of the railway that led to the growth of the stock market for the purposes of raising needed financing. This growth in a whole industry catapulted the need to develop theories to be used in corporate financing deals (Schroeder, Clark & Cathey, 2011, 4). The current environment The recent financial crisis affected the world in a way that most did not see coming. This crisis also exposed a lot of the misdeeds that have been happening in the financial world. The effect is that there has been an increase in the oversight that is being paid to these sectors of the economy. Accountants and the accounting theories that they choose to use are being placed under greater scrutiny by various bodies. This is in a bid to try and prevent the recurrence of another crisis. The major concern being caused by the derivatives that have come to play a major part in corporate entities and that may have carried some blame when it comes to the causal effect of the crisis. Accounting for these derivatives requires additional accounting regulations as compared to other marketable securities (Stickney, 2010, 579). Accounting theory definition Before an in depth analysis and look at the various theories and how they affect the accounting world, one needs to be aware of the definition or the basic characteristics of an accounting theory. Dictionaries place the definition as, well organized knowledge that can be applied in a wide variety of situations. These are principles and assumptions that can be used to predict how a given thing will behave. One of the characteristics of these theories is in their organization of knowledge in a systemic manner. The other characteristic is that they are able to provide reference in future in explaining a given occurrence (Schroeder, Clark & Cathey, 2011, 1). Accounting theories may be classed into two categories. One of these is the normative theories and the other the positive theories. In simple terms the normative theories may be thought of as those that explain what should occur. The positive theories on the other hand explain what has occurred (Schroeder, Clark & Cathey, 2011, 1). We will seek to look at each of these classifications of theories and what various theories may be found in each one of them. Despite the fact that this distinction in most other areas of study does not exist as a theory should be able to explain what is going to happen and that definition should apply when what is predicted happens. Normative accounting Normative accounting theories are also known as prescriptive accounting theories (Macdonald, Rutherford & Bird, 1989, 15). As mentioned they are mainly used in the prediction of what is meant to be. These theories are largely based on historical data and experience. These accounting theories were majorly adopted for use during the early seventies. They basically involve looking at historical data and previously utilized conventions to make deductions or conclusions as to how accounting data should be (Nobes, 2000, 4). Normative accounting theory at the time of its wide adoption was mainly concerned with looking at public policy. Its main concerns were with looking at how to account for such factors as accounting for the exchange rates, the inventory and such like items. In the case of normative theories and approaches to accounting the answers that are sought involve looking how certain changes will affect the accounting statements. This creates a situation where the normative theories cannot be refuted by any form of evidence. This is because of the theoretical framework that is used in the developing of these theories (Jensen, 1998, 127). True income theory One such theory that is based under the normative category of theories is the true income theory. True income theory has been borrowed largely from the economical point of view. The earlier proponents of the theory thought of it in the way that is to be outlined. To begin with was that given the existence of certain economic behaviors that occur similar to those in certain spheres of accounting, there is need to ensure that the current forms of record keeping are done to reflect the current valuations. This is based on the fact that in economics as in accounting there is the historical aspect that is involved in the creation of accounting numbers (Higson, 2003, 56). Even in the development of these theories there have been differences in the opinions that have been held by the various proponents of the theory. Theorists who have also advocated for other kinds of theories have also been able to dispute some of the ideas and concepts that have been proposed within the theory. Most of these influences though should be factored in with the consideration that as in economics, accounting looks to find approximate values of significant properties. One of the approaches that have been adopted for this case is known as the market value approach. This seeks to find the accounting numbers based on the current value of items that are existent in the market. This approach has the basis that the market values are ones that are more accurate in how they dictate the prices of items. This is as compared to the reliance on historical data that was initially being used for the determination of these numbers. The criticism that this approach has had to contend with is the fact that it lacks objectivity and realization. There are two basic arguments that are used to this end. These arguments are based on the fact that in the realization of the market values of items, there is an increment in the value that is going to be experienced due to inflation. One is that this increment cannot be utilized in the calculation of taxes. This is due to the fact that in most instances there is no way to convert these values into monetary form for use in the payment of the taxes. The other argument is that it cannot be recognized as income. This therefore limits the ability of the company to utilize these gains in values of say assets as a way in which they can pay for their dividends. The approaches that are held under the normative theories of accounting may not strictly be applicable to the current economic climate. One of the reasons is that with the past economic crisis it was evidenced that the market has the tendency to inflate the prices of the securities that they may be holding. This inflation of assets does not in any way paint a clearer picture as to how well or otherwise a given company may be doing. Secondly is that there are various financial instruments that have been brought into the market over the years. Some of these instruments may be difficult to find historical data as regards to their behavior. They include derivatives such as ETFs and other hedging securities. Thus it may prove impossible to actually accommodate for the movement of these asset classes in any normative accounting theory. Positive accounting theory As earlier stated positive accounting theory is an analysis of what is and not what ought to be. There are various characteristics as well that are inherent in these types of accounting theories. One of these is the hypothesis that is made with the positive accounting theory or by the proponents of the theory during the earlier periods of the theory. Before the analysis one needs to understand that the stand taken by these accounting theorists is an analysis of the relationship that is existent between the various firms and those that they are in contractual obligations with (Bruns & Kaplan, 1987, 75). These groups include the likes of the regulators and the bond holders. The basic hypothesis is that managers have a reason to vary the accounting procedures that they will apply when it comes to analyzing the numbers that they use. This is due to the fact that there are no costs that are associated with the preparation and the presentation of these accounting numbers. These concerns do not arise even when the stock market is involved. The basic idea with most of these accounting decisions is that the markets knowledge of the application of these accounting policies has little if any effect on the final accounting policy that is adopted. There are different hypothesis that are found in the positive accounting theories. The most common one is with the choice that management makes in regards to compensation, political costs and the debt covenants of the company in question. In summary positive accounting theory basically seeks to explain the behavior of management as far as the choices of the accounting methods that they have selected to use. Agency theory One of the theories that falls under the category of positive accounting theory is the agency theory. This is a theory that has many applications in the academic world. Some of these applications include in finance, economics, political, science among many other areas. Agency theory may be defined in two major ways. There are distinctions that exist within these two different interpretations of the theory. In spite of this fact one has to realize that both definitions of agency theory have one similarity. This is the fact that both definitions have the same assumptions as concerns people, information and organizations. They both also rely on the contract that is entered between the principal and the agent. One of this is the positivist agency theory that is meant to look at any conflicts that are likely to come up between the agent and the principal. The theory then finds ways in which these conflicts may be minimized. A paper by Jensen is a good example of this view. This is where he analyzed the alignment of a manager’s goal with that of owners in a company in which the manager also has a stack. The other interpretation lies with the principal-agent research which looks at all the principal agent relationships under one umbrella. These are the owner and manager, employee and employer and other such like relationships. Its main aims are to formulate a single theory that will be used to accommodate all these relationships (Clarke, 2004, 80). The basic formulation of positive accounting theory as exhibited by the agency theory is that most of the corporations accounting principles are governed by self interest. These self interested parties are in the cases of either the management of the company, the employees of the company or the owners. Either of these groups is at a position to affect the current way in which accounting for the organizations transactions will be done. Positive accounting theory may be relevant in the current economic environment for one reason. The environment of the financial crisis that has been mentioned in the text also provides evidence to the self serving interest of the various stakeholders of the company. On one end were the employees of large corporations, especially financial institutions, who manipulated the accounting principles that the companies were employing. These manipulations created an environment where they were able to gain more in terms of salaries through bonuses. This was done mainly through various accounting changes such as the realization of assets on the books before certain transactions were complete. There was also the use of mark to market accounting in an environment with increasing asset values. This increased the revenues that a given trade, hence company would gain thereby increasing their pay. There are also the partners who own companies such as Goldman Sachs. These partners are also self interested in that increases in the value of the holdings of the company increases the incomes that they are able to take away. Conclusion Accounting as a field in finance has come a long way. Along that long road there have been various developments that have been directed towards the refinement and the alignment of the various concepts. The most notable development may be the development and wide spread use of double entry bookkeeping. There have also been various theories that have been developed that have been aimed at explaining the various occurrences within the accounting field. These theories can be divided into two major categories. These are the positive accounting theories and the normative accounting theories. The normative accounting theory basically seeks to analyze the data that is presented in accounting on a historical perspective. The positive accounting theories try to explain what is happening at the moment. It should be realized that the earlier theories were mainly normative and these were to later develop into the positive theories. In the explanation of the various accounting concepts it may also be noted that the use of one class of accounting theory may not have the intended outcome. In most cases both the normative and the positive approaches may be used in the explanation of the various ideals that are currently being adopted in the world of accounting. Reference list Brown, R. (2006). History of accounting and accountants. [S.l.], Cosimo, Inc. Bruns, W. J., & Kaplan, R. S. (1987). Accounting & management: field study perspectives. Boston, Mass, Harvard Business School Press. 75 Clarke, T. (2004). Theories Of Corporate Governance: The Philosophical Foundations Of Corporate governance. New York, Routledge. Higson, A. (2003). Corporate financial reporting: theory and practice. London [u.a.], Sage Publications. Jensen, M. C. (1998). Foundations of organizational strategy. Cambridge, Mass, Harvard University Press. Macdonald, G., Rutherford, B. A., & Bird, P. A. (1989). Accounts, accounting and accountability. Van Nostrand Rheinhold. Nobes, C. W. (2000). Introduction to financial accounting [...] XA-DE. London [u.a.], International Thomson Business Press. Schroeder, R. G., Clark, M. W. and Cathey, J. M. (2011). Financial Accounting theory and analysis: Text and cases. New Jersey, John Wiley and Sons. Stickney, C. P. (2010). Financial accounting: an introduction to concepts, methods, and uses. Mason, OH, South-Western/Cengage Learning. Previts, G. J., Walton, P. J., & Wolnizer, P. W. (2011). A global history of accounting, financial reporting and public policy: Americas. Bingley, Emerald. Riahi-Belkaoui, A. (2005). Accounting theory. London, Thomson. Read More