BS422 - Accounting Theory Lecture Notes

Lecturer: Langeni Hornelius

KKMU - School of Business

Contents
1 Accounting and Agency Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.1 Learning Outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 What Theory Is . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 Positive Facts and Normative Opinions . . . . . . . . . . . . . . . . . . . . . . 2
1.4 Accounting Theory, Economics, and Law . . . . . . . . . . . . . . . . . . . . 3
1.5 Agency Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 The Conceptual Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2.1 Key Elements of the Framework . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.2 The Elements of Financial Statements . . . . . . . . . . . . . . . . . . . . . . 4
2.3 Recognition and Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . 5

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1 Accounting and Agency Theory
1.1 Learning Outcomes
After completing this chapter, the reader will be able to:
• Explain what agency theory is.
• Evaluate any statement as being one of fact rather than of opinion and vice versa.
• Understand the differences between a theory, a theorem, a postulate, a hypothesis, and a
law.
• Appreciate the need to surface assumptions when appraising statements of any kind.

1.2 What Theory Is

A theory is an explanation that asserts a similar result will be observed whenever a specific set
of circumstances occurs. For example, a theory of speeding suggests that when a car is driven
over the speed limit, the probability of an accident significantly exceeds that for cars driven
within the limit. This implies speeding drivers are more likely to have accidents. This is a
proper theory as it applies universally to any car in any jurisdiction with a speed limit.
A theory can be tested for accuracy against known facts, such as accident records associated
with speeding versus non-speeding vehicles. If the facts support the theory, it is validated;
otherwise, it remains a theory but may not be correct. A theory makes general statements of
cause and effect or association, testable against facts, and need not be correct every time but
often enough to be reliable. Unlike a law, which must be universally true, a theory is usually
reliable.

1.3 Positive Facts and Normative Opinions

Theories can be normative or positive. Normative theories prescribe what should happen, as-
suming a desired outcome such as prosperity. For instance, normative stakeholder theory as-
serts that firms perform best by addressing all stakeholder concerns, not just maximizing share-
holder wealth [1]. Milton Friedmans monetarist theory suggests controlling inflation through
money supply management [2], and act utilitarianism holds that the best decision promotes the
highest net welfare for the largest number of people. These theories prescribe behavior rather
than describe it.
Positive theories explain or predict facts without assuming a particular outcome. Positive ac-
counting theory suggests that firms manipulate reported profits upwards when directors bonuses
or lender-imposed dividend payout ratios are significant [3]. Modigliani and Millers work
posits that share value is unaffected by debt levels or dividend ratios [4, 5], and Kohlbergs
theory suggests individuals evolve morality in stages [6]. These theories describe and predict
behavior without explicitly prescribing it.
Normative theories involve value judgments, using terms like “should,” “ought,” or subjective
adjectives like “good” or “bad.” These cannot be tested against current facts. Positive theories
are value-free, confined to testable fact statements. Predictions about the future, part of positive
theories, cannot be tested now but can be framed for future testing.

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1.4 Accounting Theory, Economics, and Law
Accounting is historically derived from law and economics [7, 8]. Law defines legal ownership,
classifying assets like houses or shares as ownable, but not spouses or children. Assets are
typically held before sale, except for inventory (stock in British English), which is intended for
quick sale.
Economics explains how people behave toward assets, influencing decisions on buying, selling,
pricing, or investing. It often prevails when economic substance differs from legal form, such as
in finance leases treated as ownership in accounting due to economic substance. Historically,
accounting recorded payments and tallied assets, liabilities, income, expenditure, and equity
annually using double-entry bookkeeping, which spread globally by the sixteenth century due
to international trade and foreign exchange impacts.
Inflation and time affect value, contrasting with the legal constancy of historical cost, which,
if falsified, is fraudulent. Current value, especially for liquid assets like shares or currencies,
changes rapidly, making valuation a craft rather than an exact science, with balance sheets
offering momentary snapshots.

1.5 Agency Theory

Agency theory, central to accounting practice, explains economic behavior in large firms, orig-
inating from Berle and Means [9], applied by Fama [10, 11], and formalized by Jensen and
Meckling [12]. It posits that modern companies are owned by shareholders (principals) but
managed by directors (agents) with differing economic interests. Shareholders seek wealth
growth through profits, dividends, and rising share prices, while managers may prioritize high
pay, benefits, or prestigious projects, creating agency costs.
These costs are mitigated through monitoring costs (e.g., accounting reports, audits, corpo-
rate governance) and bonding costs (e.g., shares, stock options, profit-tied bonuses aligning
managers interests with shareholders). Effective bonding and governance resolve the agency
problem in most large firms, though issues persist in some, including family businesses, where
managers may claim bonuses despite losses. Accounting ensures accountability, tracing back
to ancient practices like clay tokens used 22,000 years ago to track livestock [13], evolving to
promote trust through practices like stock options.

2 The Conceptual Framework

A Conceptual Framework is a set of broad principles guiding actions or decisions, integrating
theories into a coherent structure to address inconsistencies, anomalies, or habitual practices
lacking explicit rationale. Before the 1970s, accounting relied on Generally Accepted Account-
ing Principles (GAAP), which described traditional practices [14, 15]. Different countries had
varying GAAP, but universal principles included:
• Income and expenses on the Income Statement; assets, liabilities, and equity on the Bal-
ance Sheet.
• Double-entry bookkeeping for all transactions.
• Inventory valued at the lower of cost and selling price.

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 • Timing differences recognized as receivables/payables, with full current-year expenses
on the Income Statement.
• Net profit distribution to taxes, dividends, and reserves in the Appropriations section.
The first conceptual framework attempt was the USAs 1936 Statement of Accounting Princi-
ples [16], followed by the AICPAs Accounting Principles Board in 1959, and the FASBs 1976
framework based on the Trueblood Report [17], emphasizing investor usefulness [18]. SFAC
1 (1978) defined it as a coherent system of interrelated objectives and fundamentals leading to
consistent standards. Unlike positive GAAP, which describes practices, a conceptual frame-
work is normative, prescribing what should be done.
Resistance from professionals and academics [19, 20, 21] was overcome, favoring a coherent
principle set over ad hoc practices. The IASB issued its framework in 1989 [22], updated in
2010 [23], with a 2015 exposure draft signaling a 2016 revision [24]. Despite convergence
efforts with the US FASB framework (SFAC1), the USA remained outside, and the 2015 revi-
sion reinstated stewardship and prudence [24]. This book adopts the IASB framework for its
international focus.
Standards specify requirements (e.g., IAS 2 on inventory), while the framework is general,
addressing liability recognition. Standards may extend beyond the framework, and in rare con-
flicts, standards prevail. The principles vs. rules debate differs from the framework necessity
discussion, akin to a written constitution, potentially building trust in regulatory institutions.

2.1 Key Elements of the Framework

The IASB framework aims to meet financial report users information needs, focusing on decision-
making, and covers only general-purpose financial reports, targeting a wide user base, includ-
ing but not limited to investors. It assumes a going concern, valuing assets and liabilities for
continued use, not break-up value, except for inventory. Useful reports require:
• Faithful representation of economic events [23, 24].
• Relevance to users decisions [24].
Desirable characteristics include:
• Comparability.
• Verifiability.
• Understandability.
• Timeliness.
Five elementsassets, liabilities, equity, income, expensesrequire two recognition criteria: high
probability of occurrence and reliable measurement. Unmet criteria exclude items from ac-
counts. The framework omits valuation, measurement, capital, and capital maintenance, mak-
ing it incomplete. Revisions aim for comprehensiveness, though new frameworks like inte-
grated accounting may shift paradigms. The 2015 revision defines a reporting entity [24].

2.2 The Elements of Financial Statements

Assets are resources controlled by the entity, resulting from past events, with future economic
benefits. Liabilities are present obligations from past events, expecting future resource out-

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flows. Equity is the residual interest in assets after liabilities. Income increases equity from
ordinary activities (revenue, gains), while expenses decrease it (losses, costs). Recognition
hinges on probability and measurability, ensuring only verifiable items enter financial state-
ments.

2.3 Recognition and Measurement

Recognition involves depicting elements in financial statements when criteria are met. Mea-
surement, though not detailed in the framework, involves assigning monetary values, often
using historical cost or fair value, depending on context. The frameworks flexibility allows
standards (e.g., IAS 38 for intangibles) to specify methods, reflecting its normative guidance
over rigid rules, balancing consistency with practical application.

References

References
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[2] Friedman, M. (1962). Capitalism and Freedom. University of Chicago Press.
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[4] Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the
theory of investment. American Economic Review, 48(3), 261297.
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shares. Journal of Business, 34(4), 411433.
[6] Kohlberg, L. (1969). Stage and sequence: The cognitive-developmental approach to so-
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[14] American Accounting Association. (1966). A Statement of Basic Accounting Theory.
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[15] Grady, P. (1976). Inventory of Generally Accepted Accounting Principles for Business
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[16] American Accounting Association. (1936). Statement of Accounting Principles. AAA.
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