Chapter 1: An Introduction to Accounting Theory Instructor’s Manual
CHAPTER HIGHLIGHTS
The chapter is concerned with what accounting theory is and where it fits within the “structure”
of financial accounting. The definition of accounting theory used in this chapter is broad and
complements the objectives of the text. Theory itself helps to explain and predict phenomena
that exist in a given field, and this likewise holds true in accounting. In accounting, theory can
be developed in response to needs arising from practice, including concepts such as realization
and matching. However, as an “infrastructure” has developed in financial accounting, theory is
formulated in a more institutionalized way by means of the research process.
Along with political factors and economic conditions, accounting theory contributes to the
standard-setting process. The process of developing standards or making rules is itself largely a
deductive process and is certainly concerned with accounting theory.
The relationship of theory to measurement is very important. While some see measurement as
closely related to but separate from theory (as we did in earlier editions), its importance relative
to theory is so great that we now consider it to be part of theory. Measurement is the assignment
of numbers to the attributes or properties of objects being measured. The different types of
measurements and the quality or “goodness” of measurements are examined. The latter
embodies (1) the usefulness of the measurement, illustrated here in a predictive context but
showing up later in an assessment mode and (2) verifiability or objectivity, which is the degree
of consensus among measurers in the statistical sense.
The various valuation models are presented in Appendix 1-A. The models come under the scope
of accounting theory. In addition, the different models are mentioned in several theory chapters
before being discussed in depth in Chapter 14. Even if there is no desire to go further into
inflation accounting in Chapter 14, it is important for students to gain a rudimentary grasp of the
concepts involved, as illustrated in Appendix 1-A.
QUESTIONS
Q-1 What does the term “social reality” mean and why are accounting and accounting theory
important examples of it?
The term social reality pertains to the measurement of social phenomena and the use of these
measurements. The measurements may be representationally faithful (low in bias) and have a
high degree of objectivity (verifiability). Or the opposite for either or both of these qualities may
be the case. The important thing to grasp, however, is that important consequences stem from
the measurement, whether they are “good” or “bad.” For example, an excellent year in terms of
income could cause management to be highly rated by shareholders and other interested parties,
resulting in high management bonuses, or provide increased dividends to shareholders. All of
this could occur even though income is a “construct”: not a “real” factor but a conceptual
artifact.
This example shows why accounting is an important area relative to social reality measurements
and constructs. Hopefully, accounting theory can improve the fairness and usefulness of these
measurements.
Accounting Theory (8th edition) Page 1 of 14
,Chapter 1: An Introduction to Accounting Theory Instructor’s Manual
Q-2 Why do the value choices (entry value, exit value, and historical cost) fall within the
domain of accounting theory?
These are examples of different concepts involved with measuring income which have different
underlying purposes. These different purposes—which affect social reality—are discussed in the
appendix.
Q-3 Of the three inputs to the accounting policy-making function, which do you think is the
most important?
Of the three inputs (economic conditions, political factors, and accounting theory) to the policy-
making function, economic conditions is clearly the most important input. Economic conditions
can easily influence the accounting theory track as well as the policy-making function. Inflation,
for example, in the USA during the 1970s and 80s triggered a significant amount of theoretical
work. Theory responded to the actual economic environment. Another prominent example of
the influence economic conditions has is the merger and acquisition wave of the 1960s, which
lead to APB Opinion Nos. 16 and 17. Many other standards have also been triggered by
economic conditions.
Q-4 How can political factors be an input into accounting policy-making if the latter is
concerned with governing and making the rules for financial accounting?
Those who are affected by the rules will usually try to influence what those rules will be. The
investment tax credit provides an excellent example. When APB Opinion No. 2 did not allow
flow through, lobbying led to APB Opinion No. 4, which did allow immediate recognition in
income of investment tax credits. The stock option battles of the 1990’s (and continuing today)
is another example of the political process and its effect on rule-making. From a predictive
standpoint, we are concerned with how and why political factors play a role in the standard-
setting process.
Q-5 Is accounting theory, as the term is defined in this text, exclusively developed and refined
through the research process?
Absolutely not. Many concepts such as conservatism and revenue recognition arose on a
“common law” type of basis. They were responses to particular problems. Research has, of
course, dealt with these issues. Any attempt to leave these concepts outside of the definition of
accounting theory would make the subject matter of accounting theory artificial and incomplete.
Accounting Theory (8th edition) Page 2 of 14
,Chapter 1: An Introduction to Accounting Theory Instructor’s Manual
Q-6 What type of measurement is the measurement of objectivity in Equation (1.1): nominal,
ordinal, interval, or ratio scale?
It is ordinal, due to the squaring effect on each individual deviation from the mean. The zero
point, however, is unique. Hence, there would be perfect consensus among measurers. It would
mean that each individual measurement would be the same for all measurers.
Q-7 The measurement process itself is quite ordinary and routine in virtually all situations.
Comment on this statement.
This is not necessarily the case. Measurements can be extremely complex. For example,
measuring the temperature of the earth’s atmosphere is extremely difficult. The increasing
temperature has led both to the hypothesis of the greenhouse effect and to the theory that the
warming global temperatures are simply a fluctuation, a naturally occurring variation.
Measuring the success of a man’s life can be perplexing. How does accumulation of Bill Gates’
monetary wealth compare with the accomplishments of Ghandi, Nelson Mandela, or Wolfgang
Amadeus Mozart? What does one actually measure to determine success?
Measurements in accounting are significantly less complex, but should not be taken lightly. For
example, determining the replacement cost or exit value of a firm’s machinery and equipment is
not an easy task. Determining net income or earnings during a specified period of time may be
more complicated that it appears to be on the surface.
Q-8 Can assessment measures be used for predictive purposes?
Though an assessment measure concerns an attribute or characteristic of an object at the present
time, it could be used as a surrogate for a prediction measure if none exists. For example, the
best indicator of the current ratio of a firm in a year may be the current ratio today, if budgets
have not been prepared.
Q-9 A great deal of interest is generated each week during the college football and college
basketball seasons by the ratings of the teams by the Associated Press and United Press
International. Sports writers or coaches are polled on what they believe are the top 25
teams in the country. Weightings are assigned (25 points for each first place vote, 24 for
each second place vote, . . . one for each 25th place vote) and the results are tabulated.
The results appear as a weekly listing of the top 25 teams in the nation. Do you think that
these polls illustrate the process of measurement? Discuss.
An argument can be made that a number is assigned to a team on the basis of a property that
might be called the “goodness” or “strength” of a team. However, these measurements do not
Accounting Theory (8th edition) Page 3 of 14
, Chapter 1: An Introduction to Accounting Theory Instructor’s Manual
have a great deal of precision. How good a team is relative to other teams is a property or
quality that is extremely intangible compared to other measurements such as median weight of
interior linemen, average speed of running backs per 100 meters, etc. Unquestionably, the
measurements are indirect.
The qualifications of the measurers are also open to question. Do sportswriters really “know”
football? Constraints are also present because the voters may have seen very few teams and they
may also have regional biases. The numbering scale used is basically ordinal because 1 is
considered to be better than 2, which is better than 3. However, the “goodness” of the interval
between rankings is not uniform. For example, a voter may feel it is a virtual “toss-up” between
1 and 2, both of which he considers to be vastly superior to 3. As a result, the aggregating
process is open to serious question.
It is also not clear whether the pollsters are making assessment or prediction measures. The
measures would be prediction measures if the voter presumes that 1 would beat 2 if they played
the following week. We suspect, however, that an assessment measure is being made. The
property being assessed is the team’s record to date. Hence, a team with a 6-0-0 record is usually
ranked higher than a team with a 5-0-1 record.
Q-10 Accounting practitioners have criticized some proposed accounting standards on the
grounds that they would be difficult to implement because of measurement problems.
They therefore conclude that the underlying theory is inappropriate. Assuming that the
critics are correct about the implementational difficulties, would you agree with their
thinking? Discuss.
This question brings together the relationship among theory, policy, and practice. It also brings
up Larson’s warning of the necessity to differentiate between theory and measurement even
though we believe that Larson’s statement is too strong. Hence, even though the practitioners
may be correct about the measurement process recommended by the proposed standard, it does
not necessarily mean that the underlying theory is inappropriate. Some theories may indeed lead
to dead ends in terms of implementation. More time may also need to be taken to make the
measurements operational.
Q-11 Some individuals believe that valuation methods proposed by a standard-setting body
such as FASB should be based on those measurement procedures having the highest
degree of objectivity as defined by Equation (1.1). Thus, some assets might be valued on
the basis of replacement cost and others on net realizable value. Do you see any problems
with this proposal? Discuss.
The problem here is basically the opposite of that presented in question 10. In this case, part of
the measurement problem might be solved, but at the cost of sacrificing the theoretical base.
Hence, the cart is put before the horse, conceptually speaking. However, there are other
measurement problems presented by this proposal. It is questionable whether replacement cost
dollars and net realizable value dollars can be meaningfully added together, even if computed for
Accounting Theory (8th edition) Page 4 of 14
CHAPTER HIGHLIGHTS
The chapter is concerned with what accounting theory is and where it fits within the “structure”
of financial accounting. The definition of accounting theory used in this chapter is broad and
complements the objectives of the text. Theory itself helps to explain and predict phenomena
that exist in a given field, and this likewise holds true in accounting. In accounting, theory can
be developed in response to needs arising from practice, including concepts such as realization
and matching. However, as an “infrastructure” has developed in financial accounting, theory is
formulated in a more institutionalized way by means of the research process.
Along with political factors and economic conditions, accounting theory contributes to the
standard-setting process. The process of developing standards or making rules is itself largely a
deductive process and is certainly concerned with accounting theory.
The relationship of theory to measurement is very important. While some see measurement as
closely related to but separate from theory (as we did in earlier editions), its importance relative
to theory is so great that we now consider it to be part of theory. Measurement is the assignment
of numbers to the attributes or properties of objects being measured. The different types of
measurements and the quality or “goodness” of measurements are examined. The latter
embodies (1) the usefulness of the measurement, illustrated here in a predictive context but
showing up later in an assessment mode and (2) verifiability or objectivity, which is the degree
of consensus among measurers in the statistical sense.
The various valuation models are presented in Appendix 1-A. The models come under the scope
of accounting theory. In addition, the different models are mentioned in several theory chapters
before being discussed in depth in Chapter 14. Even if there is no desire to go further into
inflation accounting in Chapter 14, it is important for students to gain a rudimentary grasp of the
concepts involved, as illustrated in Appendix 1-A.
QUESTIONS
Q-1 What does the term “social reality” mean and why are accounting and accounting theory
important examples of it?
The term social reality pertains to the measurement of social phenomena and the use of these
measurements. The measurements may be representationally faithful (low in bias) and have a
high degree of objectivity (verifiability). Or the opposite for either or both of these qualities may
be the case. The important thing to grasp, however, is that important consequences stem from
the measurement, whether they are “good” or “bad.” For example, an excellent year in terms of
income could cause management to be highly rated by shareholders and other interested parties,
resulting in high management bonuses, or provide increased dividends to shareholders. All of
this could occur even though income is a “construct”: not a “real” factor but a conceptual
artifact.
This example shows why accounting is an important area relative to social reality measurements
and constructs. Hopefully, accounting theory can improve the fairness and usefulness of these
measurements.
Accounting Theory (8th edition) Page 1 of 14
,Chapter 1: An Introduction to Accounting Theory Instructor’s Manual
Q-2 Why do the value choices (entry value, exit value, and historical cost) fall within the
domain of accounting theory?
These are examples of different concepts involved with measuring income which have different
underlying purposes. These different purposes—which affect social reality—are discussed in the
appendix.
Q-3 Of the three inputs to the accounting policy-making function, which do you think is the
most important?
Of the three inputs (economic conditions, political factors, and accounting theory) to the policy-
making function, economic conditions is clearly the most important input. Economic conditions
can easily influence the accounting theory track as well as the policy-making function. Inflation,
for example, in the USA during the 1970s and 80s triggered a significant amount of theoretical
work. Theory responded to the actual economic environment. Another prominent example of
the influence economic conditions has is the merger and acquisition wave of the 1960s, which
lead to APB Opinion Nos. 16 and 17. Many other standards have also been triggered by
economic conditions.
Q-4 How can political factors be an input into accounting policy-making if the latter is
concerned with governing and making the rules for financial accounting?
Those who are affected by the rules will usually try to influence what those rules will be. The
investment tax credit provides an excellent example. When APB Opinion No. 2 did not allow
flow through, lobbying led to APB Opinion No. 4, which did allow immediate recognition in
income of investment tax credits. The stock option battles of the 1990’s (and continuing today)
is another example of the political process and its effect on rule-making. From a predictive
standpoint, we are concerned with how and why political factors play a role in the standard-
setting process.
Q-5 Is accounting theory, as the term is defined in this text, exclusively developed and refined
through the research process?
Absolutely not. Many concepts such as conservatism and revenue recognition arose on a
“common law” type of basis. They were responses to particular problems. Research has, of
course, dealt with these issues. Any attempt to leave these concepts outside of the definition of
accounting theory would make the subject matter of accounting theory artificial and incomplete.
Accounting Theory (8th edition) Page 2 of 14
,Chapter 1: An Introduction to Accounting Theory Instructor’s Manual
Q-6 What type of measurement is the measurement of objectivity in Equation (1.1): nominal,
ordinal, interval, or ratio scale?
It is ordinal, due to the squaring effect on each individual deviation from the mean. The zero
point, however, is unique. Hence, there would be perfect consensus among measurers. It would
mean that each individual measurement would be the same for all measurers.
Q-7 The measurement process itself is quite ordinary and routine in virtually all situations.
Comment on this statement.
This is not necessarily the case. Measurements can be extremely complex. For example,
measuring the temperature of the earth’s atmosphere is extremely difficult. The increasing
temperature has led both to the hypothesis of the greenhouse effect and to the theory that the
warming global temperatures are simply a fluctuation, a naturally occurring variation.
Measuring the success of a man’s life can be perplexing. How does accumulation of Bill Gates’
monetary wealth compare with the accomplishments of Ghandi, Nelson Mandela, or Wolfgang
Amadeus Mozart? What does one actually measure to determine success?
Measurements in accounting are significantly less complex, but should not be taken lightly. For
example, determining the replacement cost or exit value of a firm’s machinery and equipment is
not an easy task. Determining net income or earnings during a specified period of time may be
more complicated that it appears to be on the surface.
Q-8 Can assessment measures be used for predictive purposes?
Though an assessment measure concerns an attribute or characteristic of an object at the present
time, it could be used as a surrogate for a prediction measure if none exists. For example, the
best indicator of the current ratio of a firm in a year may be the current ratio today, if budgets
have not been prepared.
Q-9 A great deal of interest is generated each week during the college football and college
basketball seasons by the ratings of the teams by the Associated Press and United Press
International. Sports writers or coaches are polled on what they believe are the top 25
teams in the country. Weightings are assigned (25 points for each first place vote, 24 for
each second place vote, . . . one for each 25th place vote) and the results are tabulated.
The results appear as a weekly listing of the top 25 teams in the nation. Do you think that
these polls illustrate the process of measurement? Discuss.
An argument can be made that a number is assigned to a team on the basis of a property that
might be called the “goodness” or “strength” of a team. However, these measurements do not
Accounting Theory (8th edition) Page 3 of 14
, Chapter 1: An Introduction to Accounting Theory Instructor’s Manual
have a great deal of precision. How good a team is relative to other teams is a property or
quality that is extremely intangible compared to other measurements such as median weight of
interior linemen, average speed of running backs per 100 meters, etc. Unquestionably, the
measurements are indirect.
The qualifications of the measurers are also open to question. Do sportswriters really “know”
football? Constraints are also present because the voters may have seen very few teams and they
may also have regional biases. The numbering scale used is basically ordinal because 1 is
considered to be better than 2, which is better than 3. However, the “goodness” of the interval
between rankings is not uniform. For example, a voter may feel it is a virtual “toss-up” between
1 and 2, both of which he considers to be vastly superior to 3. As a result, the aggregating
process is open to serious question.
It is also not clear whether the pollsters are making assessment or prediction measures. The
measures would be prediction measures if the voter presumes that 1 would beat 2 if they played
the following week. We suspect, however, that an assessment measure is being made. The
property being assessed is the team’s record to date. Hence, a team with a 6-0-0 record is usually
ranked higher than a team with a 5-0-1 record.
Q-10 Accounting practitioners have criticized some proposed accounting standards on the
grounds that they would be difficult to implement because of measurement problems.
They therefore conclude that the underlying theory is inappropriate. Assuming that the
critics are correct about the implementational difficulties, would you agree with their
thinking? Discuss.
This question brings together the relationship among theory, policy, and practice. It also brings
up Larson’s warning of the necessity to differentiate between theory and measurement even
though we believe that Larson’s statement is too strong. Hence, even though the practitioners
may be correct about the measurement process recommended by the proposed standard, it does
not necessarily mean that the underlying theory is inappropriate. Some theories may indeed lead
to dead ends in terms of implementation. More time may also need to be taken to make the
measurements operational.
Q-11 Some individuals believe that valuation methods proposed by a standard-setting body
such as FASB should be based on those measurement procedures having the highest
degree of objectivity as defined by Equation (1.1). Thus, some assets might be valued on
the basis of replacement cost and others on net realizable value. Do you see any problems
with this proposal? Discuss.
The problem here is basically the opposite of that presented in question 10. In this case, part of
the measurement problem might be solved, but at the cost of sacrificing the theoretical base.
Hence, the cart is put before the horse, conceptually speaking. However, there are other
measurement problems presented by this proposal. It is questionable whether replacement cost
dollars and net realizable value dollars can be meaningfully added together, even if computed for
Accounting Theory (8th edition) Page 4 of 14
