Classification of Accounting Theory

At present, a single universally accepted accounting theory does not exist in accounting. Instead, different theories have been proposed and continue to be proposed in the accounting literature.

(a) “Accounting Structure” Theory:

‘Accounting structure’ theory, known by different names such as classical theory, descriptive theory, traditional theory, attempt to explain current accounting practices and predict how accountants would react to certain situations or how they would report specific events.

This theory relates to the structure of the data collection process (accounting) and financial reporting. Thus, this theory is directly connected with accounting practices, i.e., what does exist or what accountants do.

The principal contributors to the accounting structure theory are identified chronologically as follows:

• William A. Paton, Accounting Theory with Special Reference to Corporate Enterprise (1922).
• Henry Rand Hatfield, Accounting; Its Principles and Problems (1927).
• Henry W. Sweeney, Stabilized Accounting (1936).
• Stephen Gilman, Accounting Concepts of Profit (1939).
• A. Paton and A. C. Littleton, An Introduction to Corporate Accounting Standards (1940).
• C. Littleton, Structure of Accounting Theory (1953).
• Maurice Moonitz, the Basic Postulates of Accounting (1961).
• Robert R. Sterling and Richard E. Flaherty, “The Role of Liquidity in Exchange Valuation,”
• Accounting Review (July 1971).
• Robert R. Sterling, John O. Tollefson, and Richard E. Flaherty,
• “Exchange Valuation: An Empirical Test,” Accounting Review (Oct. 1972).
• Yuji Ijiri, Theory of Accounting Measurement (1973).

This theory, basically concerned with observing the mechanical tasks which accountants traditionally perform, is based on the assumption that the objective of financial statement is associated with the stewardship concept of the management role, and the necessity of providing the owners of businesses with information relating to the manner in which their assets (resources) have been managed.

In this view, company directors occupy a position of responsibility and trust in regard to shareholders, and the discharge of these obligations requires the publication of annual financial reports to shareholders. Ijiri explains traditional accounting practice; however, he does place emphasis on the historical cost system.

Sterling advises “to observe accountants’ actions and rationalise these actions by subsuming them under generalized principles.” Theories explaining traditional accounting practice are desirable to obtain greater insight into current accounting practices, permit a more precise evaluation of traditional theory and an evaluation of existing practices that do not correspond to traditional theory.

Such theories relating to the structure of accounting can be tested for internal logical consistency, or they can be tested to see whether or not they actually can predict what accountants do.

Limitations:

(1) The ‘accounting structure’ theory concentrates on accounting practices and the behaviour of practising accountants. The accounting practice begins with observable occurrences (transactions), translates them into symbolic form (money values) and makes them inputs (e.g., sales, costs) into the formal accounting system where they are manipulated into outputs (financial statements).

Accounting practices followed in this way may not reflect the real business situation and real world phenomena. The traditional theory is not concerned with judging the usefulness of the output of accounting practice, but concentrates upon judging the means of manipulation of input into output.

(2) Inconsistencies in traditional theory have given rise to alternative accepted principles and procedures which give significantly divergent reported results. Accrual accounting results in allocations which provide a variety of alternative accounting methods for each major event e.g., LIFO and FIFO valuations of stock and different accountants may prefer different methods depending upon how they are affected. Moreover, the traditional approach is inconsistent with theories developed in related disciplines. For example, the historical cost concept of valuation is externally inconsistent with current value concepts.

Finally, good theory should provide for research to assist advances in knowledge. The conventional approach tends to inhibit change, and by concentrating upon generally accepted accounting principles makes the relationship between theory and practice a circular one.

(b) “Interpretational” Theory:

Truly speaking, ‘accounting structure’ and ‘interpretational’ theories are part of the classical accounting theory (model). The principal writers under ‘accounting structure’ such as Hatfield, Littleton, Paton and Littleton, Sterling and Ijiri are mainly positivist, inductive writers, concerned with traditional accounting practice in terms of historical cost system, with some deviations such as the lower of cost or market.

Accounting practices under accounting structure theory are the result of recording business events as they take place. Such practices lack application of judgement and consequences. Interpretational theory attempts to give some meaning to accounting practice.

The theory based on “accounting structure” only, although logically formulated, does not require meaningful interpretation of accounting practices and analysis of accounting activities.

Interpretational theory emphasises on giving interpretations and meaning as accounting practices are followed. This theory provides a suitable basis for evaluating accounting practices, resolving accounting issues and making accounting propositions.

The principle writers in interpretational theory are the following:

• John B. Canning, The Economics of Accountancy (1929).
• Sidney S. Alexander, Income Measurement in a Dynamic Economy (1950).
• Edgar O. Edwards and Philip W. Bell, The Theory and Measurement of Business Income (1961).
• Robert T. Sprouse and Maurice Moonitz, A Tentative Set of Board Accounting Principles for Business Enterprises (1962).

The above writers in interpretational theory are more analysts and explicators than advocates and preachers. They analyse and assess what accountants do and seek to do, they undertake to explain a phenomenon to accountants, and help in understanding the implications of using accounting concepts in the real business situation. For example, Sprouse and Moonitz suggest that the assets valuations should be made in terms of their future services.

In “accounting structure” theory, accounting concepts are un-interpreted and do not reflect any meaning except actual data resulting from following specific accounting procedures. Asset valuations, for example, are the result of following a specific method of inventory valuation and depreciation.

Similarly, specific rules are followed for the measurement of these revenues and expenses. Interpretational theory gives meaningful interpretations to these concepts and rules and evaluate alternative accounting procedures in terms of these interpretations and meanings. For example, it can be said that FIFO is the most appropriate if objective is to measure current value of inventories.

In this case, selection of FIFO in interpretational theory is made with a view to suggest specific result and interpretation. It is argued that empirical enquiry should be made to determine whether information users attach the same interpretations and meanings which are intended by producers of information.

Items of information vary as to degree of interpretation; some items by nature reflect higher degree of interpretation and some items are subject to many interpretations. For example, the item cash in balance sheet is fairly well understood by users to mean what prepares intend it to mean.

On the contrary, the items like deferred expenses and goodwill may not reflect any specific interpretation. The role of interpretational theories is to build a correspondence between the interpretations of producers and users as to accounting information.

This theory attempts to find ways to improve the meaning and interpretations of accounting information in terms of experiences about human behaviour and information processing capacity.

‘Accounting structure’ and interpretational theories both are known as classical accounting models. The writers (mentioned above) under both the theories are, in every sense, reformers. Interpretational theorists differ from ‘accounting structure’ theorists more in degree than in kind; the former are motivated less by missionary zeal than by a desire to analyse, criticize, and suggest, and are primarily deductivists.

Many of the prominent interpretational theorists advocate current cost or values. It is said that interpretational theorists may have observed the behaviour of investors and other economic decision makers and concluded with a validated hypothesis that such decisions-makers seek current value, not historical cost, information.

In spite of the difference in emphasis of ‘traditional’ and ‘interpretational’ theorists, broadly, both are concerned with designing financial reports that communicate relevant information to users of accounting information.

(c) “Decision-Usefulness” Theory:

The decision-usefulness theory emphasises the relevance of the information communicated to decision making and on the individual and group behaviour caused by the communication of information.

Accounting is assumed to be action-oriented its purpose is to influence action, that is, behaviour; directly through the informational content of the message conveyed and indirectly through the behaviour of preparers of accounting reports.

The focus is on the relevance of information being communicated to decision-makers and the behaviour of different individuals or groups as a result of the presentation of accounting information. The most important users of accounting reports presented to those outside the firm are generally considered to include investors, creditors, customers, and government authorities.

However, decision usefulness can also take into consideration the effect of external reports on the decisions of management and the feedback effect on the actions of accountants and auditors. Since accounting is considered to be a behavioural process, this theory applies behavioural science to accounting.

Due to this, decision-usefulness theory is sometimes referred to as behavioural theory also. In the broader perspective, decision-usefulness studies analyses behaviour of users of information. A behavioural theory attempts to measure, and evaluate the economic, psychological and sociological effects of alternative accounting procedures and modes of financial reporting.

In adopting the decision usefulness theory or approach, two major aspects or questions must be addressed.

First, who are the users of financial statements? Obviously, there are many users. It is helpful to categorize them into broad groups, such as investors, lenders, managers, employees, customers, governments, regulatory authorities, suppliers etc. These groups are called constituencies of accounting.

Second, what are the decision models or problems of financial statement users? By understanding these decision models preparers will be in a better position to meet the information needs of the various constituencies. Financial statements can then be prepared with these information needs in mind and in this way financial statements will lead to improved decision making and are made more useful.