The Routledge Companion to Financial Accounting Theory

Stewart Jones

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781135107253
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

Financial accounting theory has numerous practical applications and policy implications, for instance, international accounting standard setters are increasingly relying on theoretical accounting concepts in the creation of new standards; and corporate regulators are increasingly turning to various conceptual frameworks of accounting to guide regulation and the interpretation of accounting practices.

The global financial crisis has also led to a new found appreciation of the social, economic and political importance of accounting concepts generally and corporate financial reporting in particular. For instance, the fundamentals of capital market theory (i.e. market efficiency) and measurement theory (i.e. fair value) have received widespread public and regulatory attention.

This comprehensive, authoritative volume provides a prestige reference work which offers students, academics, regulators and practitioners a valuable resource containing the current scholarship and practice in the established field of financial accounting theory.

1
Development of financial accounting theory

Stewart Jones

This volume traces aspects of the development of financial accounting theory from its historical antecedents in the UK and USA to the many thriving debates we see today, particularly in the areas of accounting measurement, the role of the conceptual framework and accounting concepts, the trend toward a globalised set of accounting standards, and the politicisation of the standard setting process, particularly at the international level. This volume explores a wide range of financial accounting theory topics, including early ‘practice descriptive’ theories, which were influential from the 1930s to the late 1950s; the normative research traditions of the 1960s and 1970s, which focused primarily on alternative asset valuation models for income determination; positive accounting theory, which came to dominate accounting research from the 1980s and embraces capital markets research; agency theory; earnings management; the impacts of disclosure on the cost of capital and other empirical topics; and the emergence of critical accounting theory, which also emerged in the 1980s and has taken a radically different standpoint from positive theory on many important methodological, ontological and epistemological issues. The classification of accounting research into competing schools of thought covering a discrete chronology is convenient but somewhat arbitrary. One limitation is that it ignores significant points of commonality and interrelationship in accounting research over time. The accounting literature is replete with recycled ideas resurfacing under different methodological and theoretical guises at different chronological junctures. For instance, the concept of fair value accounting (in one form or another) was explored in early accounting writings, but it was developed with much greater conceptual rigour in the ‘normative’ literature of Chambers, Sterling and others. After a long period in the wilderness, the importance of fair value accounting has now enjoyed something of a renaissance, being incorporated into various international financial reporting standards (IFRS) and resurrected in new (testable) empirical contexts, particularly following the fallout of the Global Financial Crisis (GFC). In another example, the staunch theoretical defence of historical cost accounting (HCA) and accounting conservatism by earlier theorists such as Littleton (1953) parallels the rationalisation of these concepts in agency theory many decades later. This volume also explores emerging areas of accounting measurement and reporting, such as carbon accounting and corporate sustainability reporting, where recent research has exhibited normative, empirical and critical accounting theory elements.

While the development of financial accounting theory and testable propositions is clearly important to establishing the scientific status of accounting research, this volume also recognises that there is no coherent or generally accepted body of accounting theory. A theory can be defined as ‘a set of interrelated constructs (concepts), definitions, and propositions that present a systematic view of phenomena by specifying relations among variables with the purpose of explaining and predicting the phenomena’.¹ If this is the litmus test of theory, the accounting discipline has some distance to travel yet. Rather than having a comprehensive accounting theory, different theories continue to be proposed in the literature, each using different approaches to theory construction and verification. Even within the narrow confines of some well-established theoretical fields, there appears to be little consensus on the essential elements making up a theory. For instance, the conceptual framework and accounting measurement issues have continued to be debated and re-debated over many decades, often with a failure to achieve general consensus on fundamental theoretical concepts or antecedent conditions for theory development. Across many fields of accounting, there appears to be wide diversity on the core assumptions and methodological foundations of the accounting discipline, which has impeded the development of a comprehensive accounting theory.

This volume also picks up on important contemporary themes and events which are proving influential in shaping the development of accounting theory and practice. For example, following the turmoil of the GFC which so severely shattered global financial markets, there has been a new-found appreciation of the socio-economic and political importance of accounting. For instance, the fundamental assumptions of capital market efficiency and measurement theory (i.e. fair values) has received widespread public and regulatory attention, much of it critical, in the aftermath of the GFC. Another important theme in recent years is the rise of IFRS and the growing trend towards globalised accounting standards. These developments have also ushered in an age of intensifying politicisation of the standard setting process at the international level. Several chapters of this volume will address accounting topics within the context of these important themes.

The following provides a brief introduction to each chapter. Chapters 1–3 explore the early development of accounting theory and practice in the UK and USA. The study of the history of accounting concepts and practices is a useful guide to understanding and interpreting current and potential future practices and forming a better appreciation of the social, economic and political forces which have shaped accounting thought over time. In Chapter 2, Richard Edwards examines the British contribution to the development of financial accounting theory, starting with the Companies Act, which introduced limited liability in 1855. Edwards explores a variety of topics which came to dominate accounting practice over the historical period he covers, including the early development and influence of HCA and depreciation accounting, the use and abuse of secret reserves, cash flow reporting, the evolution of group accounts, price level accounting, the relevance and impact of statutory regulation, early conceptual framework initiatives, and the early development of empirical research initiatives in the UK. Edwards concludes that financial accounting theory and financial regulation in the UK have developed rather haphazardly with no consistent evolutionary pattern. History is rife with contradictions, and accounting ideas tend to be recycled at different times. For example, attitudes towards secret reserves changed from cautionary approval to eventual illegalisation. Further, while HCA was firmly entrenched in early UK accounting practices, there was occasional discussion and debate in the early accounting treatises and publications (from various sources) about the relevance of market values for assets. An insight of Edwards is that many accounting thinkers with innovative ideas – what he terms Baxter’s ‘countless anonymous innovators’ – remain unknown. However, it is possible to identify some influential thinkers who have dramatically impacted accounting practice, such as through the British judiciary. Edwards concludes that ideas about how accounting should best be done might well advance financial transparency, but history has shown us that improvements can be ephemeral. This could in part be a consequence of lack of congruence between the priorities of preparers and users of accounting information.

In Chapter 3, Gary J. Previts and Dale L. Flesher outline historical, regulatory, socio-economic and political factors which have shaped accounting thought and practice in the United States over nearly two hundred years. The chapter covers the transformation of the American economy from a predominantly agricultural to an industrial one and from a developing and mainly debtor economy to a major creditor nation. The chapter explores several themes and events that have influenced the evolution of US accounting thought and practice, from the early accounting emanating from popular books and manuals, to the regulatory phase involving the development of large railroads, to a period of common law influence, and then on to the current period, in which codification has been adopted in the form of the accounting standards and concepts statements issued by the Financial Accounting Standards Board (FASB). Previts and Flesher conclude that over the past two hundred years, the form and format of disclosure have significantly changed, from the locked proprietor’s ledger balance of accounts, to crude railroad balance sheets, to the modern corporate financial statements that we know today. The authors also point out how the focus shifted during this period, from financial statements to a ‘Trueblood Report’ style, decision usefulness orientation for financial reports to the current, broader, business reporting model as envisioned by the Jenkins Committee and influenced by modern web-based technology and the instant global communication culture. Previts and Flesher also identify the philosophy of ‘American pragmatism’ in accounting thought and the regulatory maxim of ‘sunshine’ or disclosure (or publicity) as dominant ideas in the development of accounting thought and practice. They conclude that the central assumption or belief evolving from the sunshine era of the post–Civil War period was the ‘full and fair disclosure’ concept and the modern, growing views about ‘transparency’, which include the trend towards sustainability reporting. This assumption is that disclosure will impact decisions in a way that is consistent with economic and social well-being. However, the authors conclude that disclosure assumes that stakeholders are capable of understanding and acting upon this information, which is a tenuous assumption at best. Previts and Flesher also address the issue of a globalised set of accounting standards as originally promised by the Norwalk Agreement in 2002. More than a decade later, the SEC’s endorsement of IFRS seems increasingly improbable (having repeatedly failed to meet its self-imposed deadlines to support IFRS adoption). While Previts and Flesher conclude that the failure to achieve convergence should not be a particular surprise to anyone, the continued efforts to develop the conceptual framework continue to occupy the attention of standard setters globally.

In Chapter 4, Stewart Jones and Max Aiken explore early accounting developments in the UK and USA. Their focus is on the development and influence of ‘practice descriptive’ theories of accounting. These early theories came into prominence from the 1930s to the early 1950s. This theoretical movement, as put forward in the words of Gilman (1939), May (1936), Paton and Littleton (1940), Littleton (1953) and others, attempted to develop coherent propositions and concepts which could justify, explain and articulate accounting regulations and conventional accounting procedures, principles and doctrines as advanced by professional accountants, regulators and policy makers. Littleton (1953) became the most influential and prolific writer in this field. His theories emphasised the importance of unadjusted HCA as the basis of accounting measurement, the primary importance of income determination as the ‘centre of gravity’ in accounting thought, and the dominance of the income statement over the balance sheet. Littleton’s theoretical position used observations from history and accounting practices to both build and corroborate theoretical propositions, many of which may still hold currency in today’s accounting world. However, Littleton’s ideas sharply contrasted with other emerging scholars of the 1950s, particularly R.J. Chambers. Debate over accounting measurement and valuation approaches, and how the history of accounting has shaped these debates (or provides evidence for different theoretical approaches), continues unabated, as we see in other chapters of this volume.

In Chapter 5, Tom Lee examines the objectives and qualitative characteristics of financial reporting currently prescribed by accounting standard setters in the conceptual framework (CF), particularly the CF of the International Accounting Standards Board (IASB). Chapter 5 is timely, as the FASB in the US and the IASB have agreed to harmonise their CFs. Although the CF harmonisation project is still incomplete (and may be for some time), the FASB (2010) and the IASB (2010) have issued identical statements on the objectives and qualitative characteristics of financial information. Lee is largely critical of FASB/IASB efforts on the CF to date. A key concern is that the concept of decision usefulness articulated in the CF is divorced from reality, as it fails to address the many different types of financial decisions possible in practice. Further, Lee believes the concept of relevance is only vaguely defined in terms of potential rather than actual influence on economic decisions, and, similarly, faithful representation is defined without full appreciation of the ambiguous nature of the economic phenomena being represented. Lee sees the most obvious omission in the IASB CF (2010) to be the lack of focus on the nature of the economic phenomena interpreted by accountants to be useful for decisions. However, economic reality represented in accounting terms consists mainly of socially constructed institutional facts that, to date, have been identified without common agreement as to their meaning and function. Lee concludes that the construction of a CF that will be effective and have authority as a body of professional knowledge must involve an appropriate and detailed analysis of the ontology and epistemology of economic reality for accounting purposes.

In Chapter 6, the late Ray Chambers reviews competing concepts of income and capital maintenance, particularly replacement cost accounting versus the exit price system (more particularly, continuous cotemporary accounting or CoCoA). Chambers observes that by the 1980s, two concepts of capital maintenance yielding two distinct concepts of income had developed a strong following in the literature. These concepts are financial and physical capital maintenance. Chambers’ position is clear and uncompromising: only financial capital maintenance and the exit price system can avoid the variant valuation rules of HCA, the multiplicity of calculations of the Edwards and Bell replacement cost approach, and the ‘arithmetical solecisms of both’. According to Chambers, the CoCoA system captures the effects of ‘all rises and falls in specific prices’ and has the added advantage relative to other current value systems of both simplicity and understandability. Under CoCoA, non-monetary assets are valued at their selling prices and dated cash equivalents are valued at balance date. Cash equivalents can then legitimately be added together and related to the amounts of monetary items. According to Chambers, the differences between book values and the observed selling prices of assets at balance date, whatever their ‘causes’, would be accumulated in a ‘price variation account’. Valuation at cash equivalents would yield a net asset amount (equal to the equity or capital account balance) that is a homogenous aggregate of uniformly dated values, creating an interpretable and understandable concept of financial position. Chambers then suggests that a general price index be applied to the opening balance so that general purchasing power is maintained. As a disciple of the ‘true income’ approach, Chambers is quick to dismiss the pronouncements of standard setting bodies which would permit optional treatments of different valuation models. He rejects the prevailing professional view that a single serviceable concept of income is not feasible or practicable and that it should be permissible (even a pragmatic necessity) to publish financial statements using more than one valuation method.

In Chapter 7, Sir David Tweedie takes a personal perspective of the standard setting process from his unique vantage point as a former chairman of the IASB. Sir David provides unique insight into the political factors and controversies which have shaped standard setting in the international arena, particularly the development of the IASB-US convergence program. As Sir David observes, a major triumph of the IASB to date is that more than one hundred countries globally now use IFRS. However, Sir David argues that countries moving to IFRS are faced with the three issues of cost, change and loss of control or autonomy in standard setting. In the context of the IASB-US convergence program, the loss of sovereignty or autonomy in standard setting has been the main sticking point for US regulators in shifting to IFRS. The issues have been different in Europe. For instance, some governments in Europe have regretted the decision to move from national to international standards – according to Sir David, it was a decision made by the EU ‘with great courage and almost certainly in complete ignorance of some of the consequences of the International Accounting Standards Europe proposed to adopt’. Sir David indicates that the IASB’s first decade was characterised by a constant juggling act to engender greater European confidence in IFRS while also engaging the US FASB in the challenging process of securing US acceptance of IFRS. Despite the tardiness of the US to embrace IFRS, the momentum behind IFRS as the de facto global accounting standards seems irreversible. Looking to the future, the IASB’s vision appears to be different from that of the US, whose standard setting approach is to limit the number of standards to be issued and, ideally, to have very short standards dealing with major points of principle. Sir David concludes that, ultimately, we are back to the issue of fair presentation and the willingness of preparers, auditors and regulators to accept judgement in accounting.

In Chapter 8, Chris Nobes explores empirical research evidence about the adoption of IFRS across different countries. He notes that the literature appears to give the misleading impression that IFRS is now widely used for most corporate financial reporting and by most companies in the world. But Nobes finds significant variations in how IFRS is actually applied across many reporting jurisdictions. Related to this issue, Nobes discusses two regulatory issues which vary significantly across these reporting jurisdictions: translations of IFRS and enforcement of IFRS. Nobes observes several important caveats on IFRS adoption, including that the requirement or permission to use IFRS is restricted in most jurisdictions to certain types of reporters (e.g. listed companies) or types of reporting (e.g. consolidated statements) or both; that most of the so-named IFRS adoptions do not require the direct application of IFRS as issued by the IASB; and that, in several countries, companies and auditors do not refer to compliance with IASB-IFRS even when such compliance is being achieved. After examining the regulatory environments of the sixteen countries with the largest stock markets in the world, Nobes concludes that none of them requires IASB-IFRS for all types of regulated reporting, and most of them do not even allow (let alone require) even some local version of IFRS for unconsolidated reporting. Nobes also finds empirical evidence that the most powerful single explanatory variable for a company’s IFRS policy choices is its pre-IFRS policies. Since a company’s pre-IFRS policies were mostly determined by the accounting requirements or other institutional features of its country, then country can be used as a proxy variable for pre-IFRS practices. Country is also a major explanatory variable for the amount of IFRS policy change over time.

In Chapter 9, Amir Amel-Zadeh and Geoff Meeks explore the role of fair value accounting during the GFC. Did fair value contribute to the banking crisis that led to the near collapse of the global financial system? In the search for culprits for the GFC, bankers, journalists and politicians have been quick to point the finger at the accounting profession for insisting on inappropriate (fair value) measures of financial assets which ostensibly distorted the financial position of major investment banks. At the height of the GFC, political pressures on standard setters (particularly on the FASB from the US Congress and the SEC) led to a major re-thinking of fair value requirements under accounting standards, culminating in a series of guidelines and amendments to existing fair value accounting rules. In reviewing the relevant literature, Amel-Zadeh and Meeks focus on three particular issues relating to the solvency of banks and the stability of the financial system: procyclicality, feedback and contagion, and bank failure. Amel-Zadeh and Meeks conclude that if there had been a pure fair value system in place in the crisis, then it is quite likely that fair value accounting could have exacerbated the GFC, as many critics have contended. However, because so much of the corporate balance sheet was exempt from fair valuation, and because accounting regulators softened fair value requirements as the banking crisis developed, the authors conclude that it is unlikely that fair value measurement was the real culprit behind the GFC. However, the authors conclude that the GFC has increased our understanding of some important limitations of fair value accounting applied in practice.

In Chapter 10, Geoff Whittington analyses the IASB’s approach to fair value accounting. He d...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of figures
• List of tables
• Contributors
• 1 Development of financial accounting theory
• 2 History of financial accounting theory in Britain
• 3 Financial accounting and reporting in the United States of America – 1820 to 2010: Toward sunshine from shadows
• 4 Evolution of early practice descriptive theory in accounting
• 5 Accounting and the decision usefulness framework
• 6 Price variation and inflation accounting research
• 7 Standard setting, politics and change management: a personal perspective
• 8 International differences in IFRS adoptions and IFRS practices
• 9 Fair value and the great financial crisis
• 10 Fair value and IFRS
• 11 Valuation models: An issue of accounting theory
• 12 Earnings management: Implications and controversies
• 13 Agency theory: Usefulness and implications for financial accounting
• 14 Disclosure and the cost of capital: A survey of the theoretical literature
• 15 A Bayesian understanding of information uncertainty and the cost of capital
• 16 Controlling for risk in accounting research
• 17 Financial measurement and financial markets
• 18 Social theorisation of accounting: Challenges to positive research
• 19 True and fair: A business ethos ‘par excellence’
• 20 Accounting for the carbon challenge
• 21 Corporate sustainability reporting: Theory and practice
• Index