Chapter 1
Introduction
Theory in Action 1.1 — The trouble with models
1. How would an investor determine whether a model such as the Fed could be ‘trusted’?
The most appropriate determination of the value of the model will be its ability to predict future value. There has never been such a model before. Even if it could predict future value, there would be investors who would then seek to outperform the model’s estimates in order to make abnormal returns — this will ultimately impact on the model.
2. Why has Wall Street adopted this model? Why is the Federal Reserve endorsement so important? Why isn’t the Stock Exchange endorsement of the model sufficient?
The market is subject to a broad range of factors, many outside the control of investors and business management. This creates a level of uncertainty that investors seek to compensate for through such models. The endorsement of a government body such as the Federal Reserve would act to support the validity of the model, particularly given the Fed’s independent status. The Stock Exchange is also a player in determining value, and has a track record of control and compliance of corporate activities that is often not perceived as independent.
3. Is it appropriate to adopt a model that compares earnings yield across 500 companies, all adopting a diverse range of reporting measures?
This is really one for the students to debate. The point is: earnings are a function of a range of decisions, and the disclosures and methods adopted to calculate earnings will differ widely. Under such circumstances, can earnings yields be compared? Perhaps they can in terms of relative performance between industries or between individual firms in a single industry.
4. What role does history play in validating the findings of the model?
Historical data will prove valuable in testing the model and may well add support for the model as a predictor of future value. The problem is that the prediction of the future based on historical information works well in hindsight. As factors change in the market the model will need to be adjusted. A question for students is: If a majority of investors adopt the model, is it self-fulfilling?
5. Why is it so hard to determine the value of a share (stock)? Does the market price of the share reflect its value? Discuss.
The share price is meant to reflect all publicly available information and to reflect the value of the firm at that point in time. Obviously share values shift as information about the company becomes public and the expected future value of operations is adjusted. It is difficult to determine true value as not all information is available to investors, and future value requires estimates of future activity, performance and factors, most of which are out of the direct control of any one company.
Theory in Action 1.2 — No accounting for human behaviour
1. Develop an explanation for the short-term views of management, which result in ‘earnings management’ by some corporates. How could you test the validity of your explanation?
The reasons for the short-term view, include:
• the relative short period that managers work with one company (normally 5 years) • the performance cycles used to evaluate and reward managers
• the focus on growth and returns by investors
• opportunities to manipulate earnings to satisfy performance and investor expectations. It is very difficult to actually test the impact of the factors identified. One way would be to compare the performance of companies with long-term management contracts versus short-term ones.
2. Is the debate about accounting regulation or illegal behaviour on the part of a few senior executives? Can having greater levels of financial disclosure and rules targeted at preventing earnings management really work if the incentives and rewards aren’t changed?
The debate is about illegal behaviour and how to control it. Some will argue that the market will ensure appropriate disclosures because if managers are found to be making improper disclosures then they will be penalised in the labour market. However, they will have to be caught, and it will have to be proved that their actions were deliberate. (There haven’t been many cases along such lines, even with the recent spate of corporate collapses.) If the incentives and rewards aren’t changed (and the disclosure of the rewards are buried in share options), then increased disclosures will not stop illegal or dishonest behaviour. Does the class agree?
3. How does an earnings figure ‘gain a power all of its own’? Is it the number as such, or the behaviours and decisions it creates? Discuss.
The earnings figure has become central in evaluating the performance of management. This makes it an important figure to investors and management, which then creates the
expectations and behaviours discussed in the chapter. The number is an outcome of decisions made by management, both in operating the business and in determining the basis for the calculation and disclosure of revenues.
4. Should a new theory of accounting disclosures encompass concepts like ‘trust’ and ‘honesty’? Explain, with reference to the need to reach a common definition of both terms across a broad range of stakeholders.
Trust and honesty are concepts that are meant to underlie market economies. It is a matter of opinion as to the degree they currently operate in in the market economy, and one for students to consider in the context of each stakeholder — investors, management, community,
Chapter 2
Theory and method
Theory in Action 2.1 — A range of accounting theories: the federal Budget
1. Why can accounting (budgeting in this case) be described as ‘sleight of hand’?
Accounting (budgeting in this case) can be described as sleight of hand on the basis that it involves estimations, assumptions and forecasts. The article implies that the government is able to use the estimation and judgement process to conjure the budget outcome it desires for political purposes. The article refers to the budget as enabling the government to manage its ‘war chest’. This is equivalent to the argument pertaining to firms’ use of provision accounts as ‘cookie jars’. The programs and activities of the government result in revenues
(expenditures) that increase (decrease) the war chest. The implication of the article is that the government is exercising conservatism in its forward estimates to justify its current fiscal stance. The conservatism deflates the forecast surplus and provides less ammunition for lobby groups to demand additional government spending. The expectation is that the actual growth rate and taxation revenue will exceed what has been forecast, thereby increasing the war chest. As the election year approaches, the government will be able to use the increase in the war chest (accumulated surpluses) to relax fiscal restraint and make appealing election promises.
2. Explain the federal Budget in relation to the following theories of accounting: (a) accounting as intracorporate politics
(b) accounting as communication–decision information (c) accounting as a social commodity
(d) accounting as ideology and exploitation.
(a) The federal Budget is used by the government as a means by which the government has, and will, conduct its decision making. The Budget forecasts are used to justify the current policies of the government. The Budget (more particularly the lack of a budget surplus) is a defence to demands for greater government spending. Funding can be denied on the basis that it would result in budget deficits and be irresponsible financial management. The conservative budget estimates can subsequently be used as a political tool to enable the government to deliver favourable policies in an election year. Future fiscal spending can be justified on the basis of the greater than predicted surplus due to higher than expected economic growth and taxation revenue.
(b) Accounting as communication–decision information
The federal Budget communicates the cumulative effects of the Commonwealth’s financial management to its constituents. The Budget conveys to taxpayers and other interested parties the summary of actions to be taken during the forthcoming fiscal year and future years as a result of intended policies. Subsequent deviations of actual versus forecast surplus (deficits) provide the government with a tool to relax (tighten) fiscal spending. Changes in policies can be justified and communicated to constituents on the basis of the change being responsive to the budget deviations. This is used by constituents to make their own voting decisions.
(c) Accounting as a social commodity
This theory purports that accounting affects the welfare of different groups in society and can be an agent for social change. The Budget outcome reflects the fiscal policies of the government, and the fiscal policies clearly can result in a redistribution of wealth in society. For example, future increases in income tax rates could be used to fund an increase in social welfare payments. The accounting underlying the Budget can hinder or aid government policies in fulfilling their social mandate.
(d) Accounting as ideology and exploitation
This theory contends that accounting is part of the ideology apparatus of capitalist society. Supporters of this theory would argue that the federal Budget is a mechanism for powerful and elite interest groups to lobby the government and extract wealth at the expense of employees and society at large. A Budget that is sympathetic to business (that is, through favourable tax reforms) at the expense of individuals (that is, through increases in
personal taxation) could be viewed as the budgeting process being ideological and exploitive.
Theory in Action 2.2 — Role of accounting and importance of pragmatic,
semantic and syntactic elements
1. From the report, use a syllogism to develop a very brief inductive theory arguing why the Ford plant needs to close down.
(a) Explain the role of syntactics in your theory. (b) Explain the role of semantics in your theory. (c) Explain the role of pragmatics in your theory.
The article discusses Ford’s decisions to close some of its assembly plants in the USA including the Hazelwood plant. The decision is a result of Ford’s restructure plan aimed at restoring the firm’s profitability. An inductive theory can be formulated as follows:
Premise 1: The Ford’s Hazelwood plant assembly is unprofitable and will be closed. Premise 2: Other unprofitable Ford assembly plants are to be closed.
Conclusion: Ford will close all unprofitable assembly plants.
(a) Syntactics refers to the logical relations in this theory. This concerns the rules of the language employed — for example, the rules of grammar for English or the rules of mathematics for a mathematically expressed theory.
The syllogism stated is illogical in that the analytical proposition that Ford will close all unprofitable assembly plants is not a logical, or necessary, conclusion from the series of individual observations of closure. The syllogism recognises that unprofitable assembly plants are being closed, leading to the conclusion that all unprofitable operations will be closed. Given that the Hazelwood plant and other plants targeted for closure are
unprofitable, the conclusion drawn (that is, the closure of the unprofitable plants) is an inductive approach. If the premises espoused are true then the conclusion derived is not necessarily true because there may always be one unprofitable plant that does not close. This is the problem of the ‘inductive leap’.
(b) Semantics is sometimes referred to as rules of correspondence or operational definitions. It connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic. The semantic accuracy of a premise needs to be established by reference to real world descriptive accuracy. The syllogism stated above may not satisfy the semantic test. Ford may not necessarily be closing all unprofitable assembly plants. It is the rationalisation of assembly plants that will restore Ford’s profitability. The policy of the Ford Company may not necessarily be to close all assembly plants that are contributing to the company’s operating losses. The accounting records suggest that the Hazelwood plant is economically unviable, and, accordingly, the decision has been made to close the assembly plant. However, other factors may enter into the decision-making process and the same fate may not apply to all assembly plants currently operating unfavourably.
(c) Pragmatics pertains to the effect of words or symbols on the behaviour of people. The accounting records for the Hazelwood assembly plant reflect operating losses. This information has been the basis of, and justification for, management’s decision to close the plant. The decision prompted by the accounting information has resulted in Missouri rallying to try and convince Ford that the operations can be viable. The US Department of Commerce’s Economic Development Administration has provided $500 000 to the State in their quest to make Ford reconsider its decision. In doing so, the State will be
suggesting strategies that will restore the Hazelwood plant to a profitable state.
2. From the report, use a syllogism to develop a very brief deductive theory arguing why a government should provide a grant to Ford.
(a) Explain the role of syntactics in your theory. (b) Explain the role of semantics in your theory. (c) Explain the role of pragmatics in your theory.
The article discusses the grant of $500 000 received by Missouri from the US Department of Commerce’s Economic Development Administration to help develop a strategy to convince Ford to reverse its closure decision. A deductive theory can be formulated as follows: Premise 1: The fundamental task of government is to protect jobs.
Premise 2: Ford’s decision to close its unprofitable Hazelwood operation will result in 2600 job losses.
Premise 3: Jobs can be protected by the government providing subsidies and grants to allow firms to continue unprofitable operations.
Conclusion: The government will provide a grant to Ford to enable the Hazelwood plant to continue operating so that jobs can be protected.
(a) As previously discussed, syntactics refers to the logical relations in this theory. This concerns the rules of the language employed — for example, the rules of grammar for English or the rules of mathematics for a mathematically expressed theory.
The syllogism stated in the deductive theory is logical in that the analytical proposition that the government should provide a grant to Ford can be logically derived from the premises formulated. The syllogism recognises that government’s fundamental obligation is to protect jobs. If grants protect against job losses then the Ford Company should receive a government grant to enable it to continue operating in Missouri and protect workers’ jobs. The conclusion is logical based on the grammatical rules linking the
premises to the conclusion. If the premises espoused are true then the conclusion derived would necessarily follow.
(b) Semantics is sometimes referred to as rules of correspondence or operational definitions. It connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic. The semantic accuracy of a premise needs to be established by reference to real-world descriptive accuracy. The syllogism stated above would not satisfy the semantic test. The fundamental objective of the government is not to protect jobs. There are many objectives of government, including economic growth and development, and the provision of services such as health and education. It is not representative of the real world that any firm facing financial difficulty has the right to receive a government grant in order for it to continue operating so that workers will not lose their jobs. Although the closure of the
Hazelwood plant will have a devastating impact on the local economy, it would not be financially responsible for the government to fund all unprofitable and unsustainable businesses.
(c) Pragmatics pertains to the effect of words or symbols on the behaviour of people. Ford’s decision has prompted the state of Missouri to try and convince Ford that the operations can be viable. The US Department of Commerce’s Economic Development
Administration has provided a $500 000 to the State in their quest to make Ford reconsider its decision. The decision by Ford would have a devastating effect on the people employed at the Hazelwood plant, businesses in the supply chain and the local economy. The response of the government in providing grant funding to assist in the development of a strategic report aimed at reversing Ford’s decision can be interpreted as impression management on behalf of the government. They hope to be seen to be proactive and supportive of the State in the State’s attempts to protect the livelihoods of its residents.
Theory in Action 2.3 — Alternative theory development approaches applied
to Australian reporting system
Explain how you could incorporate Greg Larsen’s comments into the following approaches to theory development:
(a) Kuhn’s revolutions
(b) Lakatos’s research programs (c) Popper’s falsificationism.
Before considering how the comments attributable to Greg Larsen, CEO of CPA Australia, can be incorporated into theory development approaches, it will be useful to revise the theory development approaches with students.
(a) Kuhnian revolution. According to this paradigm, scientific theories and progress in science have a revolutionary character. Larsen comments that ‘it’s time to
comprehensively rethink this approach so that we not only address current issues but also build a system that is more robust and capable of meeting future challenges’. Such
comments could be interpreted as recognising that financial reporting is in crisis, given the lack of confidence in accounting information and poor corporate governance practices. This crisis warrants a complete rethink of the financial reporting framework, ultimately
producing a new financial reporting framework and new corporate governance mechanisms.
(b) Lakatosian. This theory suggests that scientific theory consists of a negative and positive heuristic. The former represents the hard core of the research program that is
unquestionable and the latter the outer core that is subject to refinement. Larsen’s comment — that Australia’s financial reporting system has served Australia well — suggests that the basic objectives, qualitative characteristics and accounting definitions form the negative heuristic. What is needed is a tinkering with the positive heuristic, particularly in relation to simplifying and improving the framework, which will restore confidence in the financial reporting process.
(c) Popper’s falsification. Development of theory according to this philosophy involves testing hypotheses that are capable of rejection. Once falsified, the hypotheses can be rejected and the knowledge base is advanced. The existence of financial reporting fraud and corporate collapses suggests that the accounting theories underlying the preparation and presentation of financial information are inappropriate. Before these premises are dismissed, Popper argues that testable hypothesis capable of falsification would have to be developed and tested. Larsen’s comments related to the need for reform are based on a few corporate collapses, albeit significant companies, and there would need to be scientific evidence that the current reporting framework is too complex and fails to provide a clear and consistent process that is understood by the average stakeholder. Popper’s notion of theory development would require CPA Australia’s assertions to strengthen individual factors that are impacting on the reporting framework (for example, greater rigour in the roles of corporate directors, audit committees and financial
accountants) to be tested.
Questions
1. What is theory? What role(s) can theory play in relation to accounting?
A theory is concerned with predicting or explaining some phenomena or with prescribing a course of behaviour. It is a collection of propositions and conclusions that are designed to illustrate the principles of a subject. Other terms such as ‘hypothesis’ or ‘supposition’ are often used instead of theory. The simplest form of a theory is a statement of a belief expressed in a language, such as written language or mathematical language.
One definition of a theory is a deductive system of statements of decreasing generality connected together logically (see the definition by Braithwaite in the text). Other definitions emphasise the empirical nature of theories (see the definition by Popper in the text). Theory formulation is usually the first stage of the scientific method.
There are three recognised parts to a theory: the syntactic, semantic and pragmatic relations (see figure in text). Instructors should briefly review and explain each part.
At this point instructors may use a number of theories that have evolved in accounting and which probably reflect the different ‘views of the world’ or the way accountants see problems as individuals. For example, theories of accounting can be described and classified as:
• political theories (pragmatic theories)
• communication — decision making (pragmatic, syntactic and semantic theories) • accounting as an economic good (pragmatic)
• accounting as magic or mythology (pragmatic)
• accounting as a social commodity to exploit or aid policies or as a social club for accountants (pragmatic)
See the chapter for further brief descriptions.
2. What are the following relations in a theory: syntactic, semantic, pragmatic? Must all relations exist?
Syntactic. This represents the logical relations in the theory. This concerns the rules of the
language employed — for example, the rules of grammar for English or the rules of mathematics for a mathematically expressed theory. Syntactical relations connect together and explain the important concepts of the theory.
A syntactical methodology relies on the construction of a syllogism that forms an analytical proposition and requires a logical test to validate its truth. An example in accounting is the double-entry system. A trial balance will always balance by virtue of the construction of the rules of debits and credits and the logic of the mathematics. Other examples should be given to students to illustrate some syntactic theories, which are the mathematical relationships in accounting — such as the theory of matching, cost allocation, income determination and balance sheet theories.
Semantics. Semantics is sometimes referred to as rules of correspondence or operational
definitions. It connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic. In accounting, semantic theory concerns itself with the correlation of propositions to objects or events and manifests itself in terms of
measurement theories — for example, measuring the effects of inflation on assets and liabilities and adjusting the accounts reflects these adjustments. Theorists in this area argue that by applying these adjustments, the accounts now have semantic content and can be related to the real world (which they see as being market prices).
Pragmatic. This relation pertains to the effect of words or symbols on the behaviour of
people. Not all theories have a pragmatic orientation, but the nature of accounting makes this relation an important one. One objective of accounting affirms that we are interested in how users react to accounting information. For example, the analysis of the reactions of investors and other users to published financial reports is an important area of research in accounting theory. Also the study of pragmatics in accounting leads us to form political and social theories about the reactions of people to financial information and the effects that published accounting reports have on individuals and society at large.
No, strictly speaking, not all relations are required in theory formulation. We may have separate syntactical, semantic and pragmatic theories and a number of branches of scientific enquiry can be classified under each heading — for example, mathematics (syntactical), physics (semantic), political science (pragmatics). However, the instructor should now pose a question on whether all these relations exist in accounting. The answer is yes, to varying degrees, and also according to the perceptions of the student (and the instructor) of the
importance of each relation. Students should then have some understanding of the complexity of defining and studying ‘accounting theory’.
3. What are the roles of ‘explanation’ and ‘prediction’ in an accounting theory?
There are alternative interpretations in accounting theory. An overall theory of accounting can be an ‘instrument’ for recognising and measuring income and capital. Essentially, it is a set of rules, a ‘blueprint’, for constructing specific accounting systems for the recognition and measurement of the income and capital of the particular entity. The results of a specific accounting system of a particular firm provide an ‘explanation’ of what happened to the firm or serve as a basis for ‘prediction’ of what may happen, but the overall theory itself provides no explanation or prediction of the economic events of any particular firm. This is in contrast to a theory in the sciences where theory provides an explanation of a given phenomenon and/or serves as a basis for prediction.
An alternative interpretation given under positive theories of accounting is that the place of ‘explanation’ is to provide logical answers to the reasons why accountants adopt certain accounting procedures. For example, ‘explanation’ offers reasons as to why accountants use an apparently outdated historical cost system to measure assets and liabilities and provides reasons for the political reactions of accountants to alternate inflation accounting systems. ‘Prediction’ provides an ex ante estimate of the behaviour or reaction of accountants to the imposition of certain accounting standards. In an ex post sense ‘prediction’ provides a prediction of the unobserved behaviour of accountants — that is, how many accountants use LIFO versus FIFO; how many accountants use conservative procedures; etc.
4. Label each of the following arguments (see pages 43–4) as: • positive or normative
• valid or invalid
• providing true, untrue, or possibly true conclusions.
(a) The argument is normative, in that the conclusion argues that we should change the accounting methods and output report produced according to the prescriptive judgement of the writer. Compare this to a positive approach, which would ask the empirical questions: Why do accountants manipulate data under the accrual system? or Is accrual data more useful than cash flow data? The argument is also deductive, making a general conclusion from two premises.
The argument may or may not be valid. Both premises need to be more rigorously examined before any conclusion is warranted. At the moment, they are both untested, based on anecdotal argument and far from scientific.
A better conclusion would be to hypothesise that cash flow data provides (potentially) different accounting information that may be incrementally valuable. Or else cash flow data may be more useful in different circumstances, such as the prediction of financial distress. A positive theorist would also formulate empirical hypotheses that are capable of empirical observation or falsification.
(b) The argument is positive in that it is descriptive (‘share prices are affected by earnings’) in nature and also the hypothesis is testable — that is, we can test to see if share prices are positively correlated with future expected earnings.
The argument is constructed from inductive reasoning — beginning with specific observations (that is, 100 Australian firms) to form a general theory or conclusion regarding the impact of accounting earnings on share prices.
The argument or syntactics used is invalid in that the reasoning used follows a logical order, but the conclusion does not necessarily follow from the premises.
Evaluating the validity of the argument that constitutes the theory is not an evaluation of the ‘truth’ of the theory in terms of accuracy to real-world observed phenomena. But rather, if the premises were true, then the conclusion would necessarily follow. In this case, the premise is only based on 100 observations. Further, even if it did, as long as one company did not experience a strong correlation between share prices and earnings then the general conclusion (all) does not follow. To be completely valid, the argument must state that the whole population of listed companies has been observed and tested. Another flaw in the argument is that the premises may only refer to a ‘one-off’ situation where share prices and earnings are associated. The conclusion refers to the general situation. It is possible that share prices and earnings are only associated in certain time periods or economic conditions. This is a prime example of inductive research where the researcher must be careful not to make generalisable conclusions.
The argument also provides a possibly true conclusion. If the companies examined are representative of all Australian companies, then the hypothesis stated would be, prima
facie — true in general, but not necessarily all the time. Repeated tests supporting the
conclusion would have to be performed to confirm the truth of the statement. As long as there is one Australian company whose share price does not follow earnings, the
conclusion is false.
To improve the argument, simply state that the argument is supported for the population examined. Note: Other situation specific arguments can also be developed.
(c) This argument is positive, as it is testable and descriptive.
The argument is also deductive. It reasons from the general to explaining/predicting a specific accounting method choice.
The argument is valid in that if accountants adopt methods that increase income and expensing interest decreases income relative to capitalisation, then it logically follows that accountants would capitalise interest payments made.
The conclusion reached is clearly untrue in that interest payments are generally expensed unless they relate to a qualifying asset.
Also, while positive accounting theory suggests that in the presence of debt covenants and bonus schemes managers may have an incentive to increase reported income, it is only in some situations for some firms. There are other contracting incentives (for example political costs) for firms to reduce reported earnings.
(d) The argument is pragmatic positive as it is observable and descriptive of the behaviour of accountants over a number of centuries.
It is also true that historical cost accounting provides a system of allocating costs over different reporting periods (accrual accounting). In this sense it is a deductive argument. A point of logical contention, however, is whether the allocation of costs is truly systematic (in a deductive sense), because a number of the ways in which the costs are allocated appear to be done in an ad hoc fashion without inductive reference to events that occur in the real world of asset valuation.
The conclusion is not valid without undertaking a contextual analysis. What is the best measure? Does this vary over time? For different industries?
However, it may be valid if we precisely define what purpose accounts are used for — for example, taxation purposes. Then historical costs may be the simplest and most cost efficient system developed in the practical marketplace.
5. Which of the following are valid arguments and which are true predictions? Comment on the syntactic, semantic and pragmatic relations with respect to each argument.
(a) The argument is valid since the syntactic relations, if true, would mean that the conclusion reached would also be true.
However, the ‘truth’ or falsity of the conclusion that Firm X should report the selling prices of its assets in its accounting reports to indicate the firm’s ability to meet its debts is a matter of contention among accountant theorists. For example, Chambers contends that exit price accounting, whereby assets are reported at their current selling price, is the most appropriate method of asset valuation as it demonstrates a firm’s ability to operate in the ‘real world’ in terms of meeting financial constraints, obtaining credit and the like. Gynther would advocate use of current buying prices.
However, under GAAP, historical cost is the accepted means of asset valuation.
As such, the conclusion reached cannot be affirmed as true or false. Rather, it is a matter of opinion. Note, also, that this normative theory cannot be tested to demonstrate the truth or otherwise of the hypothesis.
With regard to semantics, clear definitions/terms have been used that correspond to generally understood real-world meanings.
With regard to the pragmatic relations, the argument takes on a prescriptive view of what accounting reports should communicate. Particularly ‘accounting reports should indicate …’ presumes that users of financial reports seek information regarding a firm’s ability to meet debt commitments.
(b) The syntactics are valid. The argument follows a logical and clear reasoning. However, the hypothesis is clearly untrue as we know that accounts payable is not an asset account but rather a liability account, and that the accounts payable account will have a credit balance. After all, if it has a debit balance it is effectively an account receivable.
Thus the semantics used are clearly incorrect in that the classification of accounts payable as an asset is inconsistent with the observed classification of payables as a liability.
No pragmatic relations are specified.
(c) The argument is valid as the syntactic relations follow a logical and sound reasoning. The conclusion, or prediction reached, is ‘true’ in that we know from real-world observations that land and buildings are classified as assets and assets have debit balances. Thus, the semantic relations are also valid as the classifications developed in the argument
correspond to observed classifications of land and buildings as assets and assets as debit balances.
No pragmatic relationships are specified.
(d) The hypothesis, or prediction reached, is true in that we observe that the creditor’s account does not have a debit balance. However, the argument is invalid. Just because the
creditor’s account is not an asset account, it does not necessarily logically follow that it doesn’t have a debit balance. Assets are not the only accounts that have debit balances. For example, expense accounts also have debit balances.
Thus, the syntactic relations could have been more appropriately specified to:
• Assets and expenses and distributions of owners’ equity are the only accounts with debit balances.
• The creditor’s account is not an asset or an expense or a distribution of owners’ equity.
• The creditor’s account does not have a debit balance.
The semantic relations used correspond to observable classifications, and no pragmatic relations are used.
6. On casual observation, the meaning of ‘scientific method’ seems to be generally understood. Philosophers of science, however, have put forward different interpretations of what they understand to be ‘scientific method’. In your own words, describe what you think is meant by ‘scientific method’.
The answers given by students to this question will be varied, but the tutor should aim to impart a knowledge of the different forms of scientific methods and the way in which science is seen to advance: • syntactics • induction • falsification • research programs • paradigm revolution • anything goes
• different ontologies (see next chapter).
A discussion of the methods used and the advantages/disadvantages would be analysed. (See the text for a more detailed description.)
7. According to falsificationists, some theories and hypotheses are better than others. According to their view of science, what makes some theories better than others, and why?
Not all hypotheses are of equal value under the falsificationists’ view of science. Vague hypotheses are difficult to falsify and add very little to knowledge. Cautious hypotheses, even if confirmed, add very little to the current state of knowledge. On the other hand bold
hypotheses that are controversial and/or conflict with the current state of scientific
knowledge, and which cannot be falsified, may lead to a revision or expansion in scientific thought or research.
Examples of vague hypothesis: Aderian psychology, many principles in accounting (for example, matching).
Examples of cautious hypothesis: all accounting should be conservative, the lower of cost or market rule, revenue realisation.
Examples of both hypotheses: Darwinian hypothesis, inflation adjustments to accounting, positive hypotheses (for example, the efficient market hypothesis, market accounting).
8. Is observation reliable? Give examples involving accounting reports.
Observation is the cornerstone of an inductivist’s approach to science. According to induction, science starts with observation. Observation (which is neutral and objective) supplies a secure basis on which scientific knowledge can be built; and scientific knowledge is derived from observation statements by induction. However, observation is not always reliable. Observation can be an interpretative activity, which can be influenced by the individual’s personal biases or perceptions, or a function of cultural or social upbringing. Students may give examples such as the measurement of the lengths of different objects or even measuring the ‘value’ of assets or income (discussion can then centre on whether
observed income is reliable). Tutors should also discuss the possibility of making large and repeated observations to get a measure of central tendency. This is called the retreat to probability and is a modified version of induction.
Under this viewpoint, scientific knowledge is not proven knowledge, but it represents
knowledge that is probably true. The greater the number of observations forming the basis of an induction and the greater variety of conditions under which these observations are made, the greater the probability that the resulting generalisations are true.
This, however, raises the further problem of how to specify acceptable probability parameters, and in this case the fallback is usually to analytic statistics and standard errors.
9. What is a paradigm? Give some examples from accounting.
A paradigm is a model for the formulation and resolution of research problems. It can be a theory, hypothesis, frame of reference, school of thought, or a principle by which a group of investigators operate. It offers an approach, a mode of thinking, a way to raise questions and to frame answers. In accounting, examples are historical cost, current cost, exit price, the efficient markets hypothesis, agency theory and information economics. Each serves as a basis for research.
10. Outline and discuss the problems associated with induction, syntactics and falsification. How does science progress under each of these methods?
• Induction. One problem with induction is that truth or falsity can only be known by
reference to empirical evidence. However, empirical evidence is subject to bias because of:
– the conditioning of the observer – the preciseness of measurement
– defining the composition of the evidence – the number of ‘suitable’ observations.
Repetition of the experiment in a wide variety of conditions and evidence should not conflict with the derived universal law. In this sense the way we observe, gather data, conduct the experiment and evaluate the results will limit the generalisation of any inductive research. Science progresses by incremental and cautious steps that are
reinforced by further repeated experimentation. Progress can be slow under this approach and tends to be cautious. (See also question 6.)
Instructors can also illustrate the process of induction to accounting by reference to descriptive and psychological pragmatics:
– descriptive pragmatism — continually observes the behaviour of accountants and perpetuates their accounting rules and principles. Criticisms include:
(i) no logical assessment of rules and principles (ii) preconditioned responses
(iii) focus on pragmatics not semantics (measurement).
– psychological pragmatism — observe the reactions of users to financial accounting outputs. If users react then this is construed as evidence of useful information. Criticisms include:
(ii) preconditioned responses
(iii) may not be any responses when there should be.
• Syntactics. The major problem with syntactics is that the truth value of any proposition is
ascertained by logic or reasoning alone. If the underlying accepted premises of the logic have no reference to the real world or are false, then the conclusions have either no pragmatic usefulness or the conclusion is incorrect. The tutor should mention here the reaction of logical positivism against metaphysical or abstract theorising (see text). Logical positivism argued that all theoretical statements should be capable of being reduced to statements that can be immediately observed and that anything that cannot be empirically verified is meaningless. The reaction was against romantic theorising that had no practical application. Logical argument should be precise and serviceable.
Science progresses via logical debate and counter-debate — the proof or disproof of assumed premises or by domination of different schools of thought (see Kuhnian revolution) and the rejection or acceptance of logical points. However, syntactics alone cannot act as a source of true statements about the world. Syntactics alone are only concerned with the derivation of statements from other given statements. This is the real weakness of syntactics as a stand-alone method.
As an example of syntactics in accounting theory, the instructor can use the theory of double-entry and historical costs that has been confirmed and verified by auditors many times. The criticisms of this approach are:
– all manipulations are correct as long as the rules of mathematical bookkeeping are applied
– there are many acceptable sets of ‘equations’
– no semantic verification — not descriptive of real world objects or events. • Falsification. Falsification emphasises bold or speculative hypothesis. Under this
approach science progresses by trial and error. The non-falsification of bold hypothesis or the falsification of cautious hypothesis mark significant advances in science.
11. (a) What are the differences between a Kuhnian revolution and a Lakatosian research program, and how does science progress under each?
(b) What is ‘normal science’ within Kuhn’s framework for scientific development? (c)Do your answers to (a) and (b) have any relevance to accounting theory? Explain.
(a) The descriptions of a Kuhnian revolution and a Lakatosian research program should be a component of tutorial discussion. Refer to pages 39–41 of the text to support discussion. The former argues that scientific theory is revolutionary with the abandonment of one theory and acceptance of another. The Lakatosian research program is progressive, involving a refinement process rather than an abandonment process.
(b) According to Kuhn, a scientific progress occurs in stages. The stages are identified below: • Pre-science: period where there are no generally accepted ideas or scientific principles — disorganised and unstructured.
• Normal science: domination by a single paradigm that is generally adopted by the scientific community — much of the work is involved in puzzle-solving activity within the accepted paradigm. This stage is compatible with the Lakatosian research program as there is an accepted paradigm equivalent to the negative heuristic in Lakatosian research programs.
• Anomalies: a period occurs when the number of anomalies grows and there is a loss of confidence in the dominant paradigm, and different schools of thought begin to emerge.
• Schools of thought emerge and a crisis revolution occurs with competing debate and research between alternative schools of thought.
• Crisis revolution and the emergence of a new dominant paradigm. One paradigm eventually replaces the old paradigm in a ‘revolution’ as scientists support the new paradigm. Dominance by the new paradigm ushers in another period of normal science.
(c) The Kuhn and Lakatosian research programs are applicable to accounting theory
development. The Lakatos approach permits research programs to be inactive rather than dismissing alternative theories when reshaping the positive heuristic. An example of this as it relates to accounting theory is the normative theories regarding measurement that abounded in the 1960s and 1970s. In recent times attention on measurement has been revived with fair value accounting being advocated. The use of various paradigms (for example capital market based, contracting and behavioural) is also an example of refining the positive heuristic using different research methods that contribute in different ways to theory development.
The Kuhn research paradigm involves replacing one theory with another when the anomalies associated with the dominant theory at the time become too systematic and large to dismiss. This can be applied to accounting theory development once again, in the context of historical cost accounting being the accepted paradigm. The failure of historical cost to reflect economic reality and enhance decision making, as documented via recent corporate collapses, will re-ignite the debate as to whether this paradigm is appropriate.
12. What does Feyerabend mean by the statement ‘anything goes’? Do you think that Feyerabend’s interpretation can be applied to accounting theories and research?
The meaning of Feyerabend’s statement ‘anything goes’ is a belief that there is no universal scientific method that will guide scientific research or knowledge gathering. There are two major strands to this argument — methodologies within science and methodologies outside accepted science.
Comparative scientific methodologies:
• Within science it is hypothesised that none of the methods of science that so far have been proposed are successful and have failed to provide rules that are adequate for guiding the activities of scientists. Furthermore, it is unrealistic to believe that science can and should be run according to fixed and universal rules and methods. This is unrealistic because it takes a simplistic view of the talents of man and the varied circumstances that encourage or cause development.
• Any attempt to force universal rules or methods is detrimental to scientific endeavour that attempts to explain and predict dynamic variables (this is especially the case in social theories) and makes science less adaptable and more dogmatic. Therefore, all scientific methodologies have their limitations and the only rule that survives is ‘anything goes’; or as Chalmers has interpreted the statement — ‘everything stays’. This approach is even expanded to include methodologies outside of the scientific approach.
Outside of accepted scientific methodologies:
• Feyerabend also complains that defenders of the ‘scientific methodology’ typically judge it to be superior to other forms of knowledge without adequately investigating those other forms. He observes that critical rationalists examine scientific method in great detail but their attitude to other forms of knowledge gathering is very different — even superficial. As examples he argues that when evaluating such areas as Marxism, astrology or
witchcraft, scientists usually make superficial examinations or use shoddy arguments to dismiss these theories — in contrast to the rigorous examination of scientific
methodology.
• Feyerabend, by contrasting science with other less structured forms of knowledge gathering, contends that the latter cannot be ruled out by recourse to some general criterion of scientificity and rationality.
• Feyerabend is basically arguing for a freedom of individuals to research without methodological constraints, and in a broader context encourages individuals to choose between scientific and other forms of knowledge gathering. Institutionalisation of science and research is seen to be inconsistent with the complexities of the world and a
humanitarian attitude. Applied to accounting:
• The Feyerabend approach can be applied to accounting if we accept that there is no universal scientific method to which all forms of accounting research should conform. This is especially the case if the version of the scientific method applied in accounting is some crude form of empiricism or inductivism, or an incomplete and naive syntactic model.
In fact the observation of a variety of accounting theories that follow different methodologies may be seen as a healthy outcome of the ‘anything goes’ philosophy. The instructor should recall the varied theories of accounting (which include accounting as magic) described in the text.
13. Describe the following authoritative bases: dogmatic, self-evident, scientific. Which category do you think accounting standards fall into?
The dogmatic basis is used when we believe in a statement because of confidence in the person or group issuing the statement. This confidence may be due to religious or political belief, or to the credentials, position or charisma of the speaker or writer. We employ this basis frequently, since we cannot be expected to personally ‘test’ everything. We believe in what we read in the newspapers, in textbooks we use in school, in what our teachers tell us, etc. The weakness of this basis is that personal opinion, rather than evidence, is the critical factor. Introspective evidence is acceptable.
The self-evident basis is used when we believe in a statement because it appears to be sensible or obviously true, based on our general knowledge and experience. For example, the
statement ‘children love to eat candy’ would be accepted as self-evidently true by most people. They would not feel an empirical study needs to be conducted. The weakness of this basis is that what is sensible or obvious to one person is not to another. What appears to be so obvious may turn out to be incorrect.
The scientific basis is used when we believe in a statement because of the logical relationship of the terms and the objective, empirical evidence in support of the statement. The demand for objective, empirical evidence is the significant factor. The scientific basis was formulated to overcome the weaknesses of the other two.
14. What is ‘truth’ in science? What is truth in accounting?
Truth refers to a statement that has been confirmed through scientific testing. If the statement is ‘analytical’, the testing is a logical one. Mathematical statements are of this type. Their truth is determined by proving that mathematical rules have been followed. This testing reveals whether the analysis is valid rather than true. If an argument is valid and its premises are true, then the conclusion is also true. If the statement is empirical, then persuasive, objective empirical evidence exists to support it. A decision must be made by the experts of the given field of study from which the statement evolves concerning the persuasiveness of the evidence. If by ‘absolute’ we mean ‘certain’, then truth in science is not absolute, because it is inferred knowledge based on a finite amount of evidence.
From a behavioural point of view, certainty is a matter of degree and conviction. We behave as though a statement is absolutely true, because we are personally convinced by the
evidence. But this type of behaviour can occur with the dogmatic and self-evident bases as well.
15. An issue that has troubled the business community in recent years is whether the provision of non-audit services by auditors impairs auditor independence. Using the steps described in figure 2.4 on page 36, develop a research program to test whether auditors are less likely to qualify a client’s accounts the greater the level of non-audit services that they provide to the client.
To answer this question it is suggested that the students critique academic literature
investigating the extent to which the supply of non-audit services results in reduced auditor independence as measured by the extent to which the probability of a qualified audit report is reduced. By reviewing the literature students will gain an appreciation of the research
programs and methodologies employed to test the proposition. The relevant articles to which students can be assigned to critique and present their critique are:
Case Study 2.1 — Selected company profile: Microsoft
1. Draw from the article to explain how accounting can be seen to provide techniques for exploiting and extracting wealth in support of elite groups at the expense of society at large.
One accounting theory is that accounting is part of the ideological apparatus of capitalist society, providing techniques for exploiting and extracting wealth in support of elite groups at
the expense of society at large. Microsoft is an enormous company with significant market power. The financial position and performance of the firm indicates this — its market capitalisation is $270 billion, sales turnover is $25 billion and its net profit is $7 billion. The sheer size and market dominance of Microsoft enables it to exert influence over its suppliers and customers. Positioned as such a dominant firm in the computer industry, it has the ability to set prices. It can extract favourable contracts with suppliers on the basis that the suppliers would be reliant on Microsoft’s business. Similarly the strong demand that they have created for their products provides them with market power to ensure that computer manufacturers and retailers carry and support their products. Being the dominant player in the supply chain provides the leverage for Microsoft to gain favourable supplier terms and selling prices thereby generating high contribution margins and profits for the firm.
Another example of accounting allowing Microsoft to extract wealth is its success in arguing against the break-up of the group. Arguing that any imposed break-up would be detrimental to shareholder value creation and customers, Microsoft was able to avoid the break-up. The argument for the proposed break-up was that Microsoft had assumed too dominant a position in the computer industry and this was resulting in anti-competitive behaviour.
These points illustrate how it could be perceived that Microsoft’s dominant position and hypergrowth has resulted in enormous wealth creation for shareholders, including its founders, at the expense of its customers, suppliers and competitors.
2. How can accounting have served as an agent for social change in the antitrust investigation that Microsoft faced?
The hypergrowth of the company as represented by its turnover, profitability and cash resources can be used to support Microsoft’s dominant market position. The industry is restricting because competitors are unable to compete on equal terms with Microsoft. The firm has been accused of colluding with PC manufacturers, stealing competitors’ ideas and turning them into money-spinners, and putting competitors out of business. The growth in Microsoft’s key financial indicators, relative to those of its competitors, can be used to support this view and push for reforms to reduce Microsoft’s industry dominance. This is illustrated by the agreement reached allowing manufacturers to include competing software (to Windows) on machines with a Microsoft licence.
3. How can accounting serve as an historical record in relation to Microsoft?
The financial reports of Microsoft can be used as a means by which the company conducts its decision making. The financial reports also indicate the success accruing to the firm as a result of pursuing its strategic direction.
4. If you were a competitor of Microsoft, how would you react to the accounting information contained in this article?
A competitor of Microsoft would use the accounting information to illustrate the monopolistic position of Microsoft, citing Microsoft’s excessive profits, substantial turnover and cash stockpile. Competition is viewed as being healthy, with the gains accruing to consumers. Competitors have expressed discontent at the standover tactics employed by Microsoft and their ability to profit from concepts, ideas and products developed by competitors.
Accordingly they are arguing for the activities of Microsoft to be curtailed to introduce greater competition into the computer industry.
Case Study 2.2 — Ripples from Enron
1. What were the accounting and auditing problems associated with the collapse of Enron?
The accounting and auditing problems at Enron have been well documented and essentially result from conflicts of interest. They include:
• inadequate accounting rules governing the use of special purpose entities to shield liabilities from public observation
• undetected financial abuses including accounting policy changes • greedy managers with significant stock-based compensation
• ineffective corporate governance, particularly by the board of directors and audit committee
• lack of auditor independence — for Enron, Arthur Andersen’s audit and tax service fees were US$34.2M whereas non-audit service fees were US$13.3M.
2. Many argue that Enron and several other high-profile corporate financial crashes demonstrated major problems inherent in accounting standards and the way audits are conducted.
(a) Are these arguments developed inductively or deductively? Explain. If possible, provide a syllogism that demonstrates your answer.
(b) Given your answer to (a), what are the problems in accepting the arguments that there are major problems inherent in accounting standards?
(a) Arguments that Enron and several other high profile corporate financial crashes demonstrate major problems inherent in accounting standards and the way audits are conducted are developed inductively. The arguments are based on observing corporate collapses and investigating the factors contributing to the unsuspected demise of the corporations and then extrapolating the findings to the general population. A syllogism that demonstrates this inductive theory development is:
Premise 1: Enron and HIH auditors lacked independence.
Premise 2: Enron and HIH falsified accounting records to portray a healthy financial performance.
Conclusion: Accounting records will be falsified in all firms where audit independence is lacking.
(b) The syllogism is neither syntactically correct, in that the conclusion does not necessarily follow logically from the premises, nor is it semantically correct. There are many
judgements and estimations to be made in the preparation of financial statements.
Auditing is a risky business and the failure rate of the auditing task is very low despite this risk. The conclusion stated above may not be representative of real world experiences — auditors may lack independence in appearance but this may not impair their competency and findings in relation to the audit function (that is, independence in fact). Similarly it
does not imply that firms, cognisant of a lack of audit independence, will engage in misleading and fraudulent accounting practices.
In defence of auditing, it is cited that up until October 2002, 99.9 % of the audits in American companies were okay. Critics of such a statistic claim that the true proportion of good versus bad audits is unknown. It is not until a company is financially distressed that a bad audit is unveiled. Many people believe that the Enron scandal is symptomatic of accounting irregularities, poor corporate governance and unethical business and personal practices.
3. What role has accounting played in the collapse of Andersen? Is this an example of dogmatic, self-evident, or pragmatic criteria being applied to assess the reputation of Andersen as a professional organisation?
Auditors are one of the key corporate governance agents, and stakeholders rely on their professional and independent assessment as to the financial state of firms. As the auditor of Enron, Andersen failed to report accounting irregularities (despite being aware of such irregularities). Their apparent preoccupation with protecting their own revenue base and business at the expense of looking out for the investor ultimately lead to their demise. Arthur Andersen was barred from conducting and reporting on the audits of SEC-registered
companies after August 2002 as a result of shredding documents related to the Enron collapse. The shredded documents would have been damning to Arthur Andersen as they would have exposed their contribution in assisting Enron to perpetrate the accounting
deception. Despite the documents being shredded, the mere fact that the firm had engaged in unethical behaviour resulted in irreparable damage to their credibility and reputation.
The role of Andersen in assisting Enron’s misrepresentations as to its financial performance and position is based on dogmatic criteria. The reputation costs imposed on Andersen are a result of people believing the criticism levelled at Andersen from authoritative sources such as regulators and financial commentators.
4. The Enron case has caused revisiting of accounting regulation and theory. Is this an example of Kuhn’s revolutions applied to accounting? Explain.
The fallout from Enron and other high-profile corporate collapses and questionable accounting practices has resulted in proposed reforms (some of which have been
implemented) to accounting standards, corporate governance and auditing practices and principles. The reforms are aimed at restoring investor confidence in the accounting, auditing and financial system by removing obvious conflicts of interest that have been detrimental to investors. This can be interpreted as an example of Kuhn’s revolutions. The corporate scandals resulted in a crisis in investor confidence, thereby prompting a rethink of the accounting, governance and auditing paradigms. This has forged the profession into a new stage of theory development with new auditing, regulatory, governance and accounting rules being pronounced. The ability of the new paradigms to protect investors from future corporate collapses and consequences associated with unethical behaviour is yet to be tested. As noted by Kuhn and reproduced on page 41 of the text: ‘new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it’.
5. Drawing from this chapter’s description of theories of accounting, explain whether and/or how the Enron case can be viewed in terms of:
(a) accounting as an historical record (b) accounting as magic
(c) accounting as ideology and exploitation.
(a) The Enron facts do not support accounting being an historical record. The accounts were falsified and misleading to investors and resulted in sub-optimal decision making. It was subsequently revealed that Enron’s accounts were not a faithful portrayal of the entity’s transactions and were not prepared adhering to qualitative characteristics of objectivity, consistency and conservatism. The professionalism of the Enron executives was lacking and their unethical and unscrupulous behaviour, stemming from greed, contributed to the dissemination of unreliable and unfaithful accounting information.
(b) The Enron case can be viewed as a case of accounting magic. The interpretation of the appropriate accounting for Enron’s special purpose reporting entities could be viewed as a sleight-of-hand accounting trick to present the firm’s financial position in a particular way. Accounting treatments were selected on the basis on presenting the financial information in a favourable manner to support the firm’s share price. The accounting choices meant that the Enron accounts were made to appear to be something that they were not. This has been described as ‘smoke and mirrors’ accounting.
(c) The accounting practices at Enron can be viewed as exploitation. The partnerships created to hide Enron’s financial problems also enabled company executives to gain financial rewards at the expense of investors. A number of Enron executives partly owned the partnerships in which corporate debt was hidden and were provided with handsome rewards as a result of their involvement. For example, the former chief financial officer made more than $30 million from the two partnerships that he ran, and other Enron employees profited greatly from these entities. All of the partnerships were approved by the board of directors, the external auditors and Enron’s lawyers. These legal structures put in place permitted the executives, auditors and lawyers to extract wealth at the expense of the investors. The cost of a corporate collapse of such magnitude is also borne by society at large.
Chapter 3
Accounting theory construction
Theory in Action 3.1 — A positive approach to poor performance
1. The article describes a market reaction to accounting profit news. To describe this involves an example of which approach to theory:
(a) pragmatic, syntactic or semantic? Explain your answer. (b) positive or normative? Explain your answer.
Share prices react to unanticipated increases or decreases in earnings, because these represent
new information that will cause investors to revise their expectations regarding the firm’s
future cash flows. In an efficient capital market, changes in expectations of a firm’s cash flows will lead to changes in the firm’s share price if share prices represent a capitalisation of
future cash flows. The article describes how the shares in Sonic Healthcare declined by 16.1% after the firm unveiled a first half-year profit reflecting a material decline in performance that had not been expected by the market.
(a) Describing this reaction to a profit announcement is an example of a semantic approach to theory, in particular output semantics. An output of the accounting system (that is, the profit figure) is being tested against an external reference (that is, share price).
(b) A positive theory of accounting refers to testing or relating accounting theories back to the ‘experiences’ or ‘facts’ of the real world. Describing, explaining and predicting the
reaction of share prices to the release of accounting profits is an example of positive accounting theory set within a capital-market-based paradigm. The article describes the share price reaction of one firm (inductive reasoning) and it is not necessarily
generalisable to claim that all share prices react to the release of accounting profits. The fact that the share price of Sonic Healthcare has reacted to accounting information
supports the contention that, in this instance, accounting profit, calculated using historical costs principles, is useful to the capital market.
2. EBITA is said to be a better measure of underlying performance than net profit after tax because it excludes a highly subjective, non-cash expense that does not relate to operations items (goodwill amortisation), and because it excludes
interest and tax, neither of which are affected directly by the operating activities of the firm, and both of which are affected by financing decisions as well as (or more than) operations.
(a) Do you agree that EBITA is a better measure of underlying performance than profit after tax? Explain your answer.
(b) Is your answer to (a) mainly pragmatic, syntactic or semantic in nature? Explain. (c) Is your answer to (b) normative or positive in nature?
EBITDA represents earnings before interest, tax, depreciation and amortisation. It is often used as a proxy for cash flows when assessing firm performance. The rationale for its use in determining the profitability of firms’ investment decisions is that interest expense will reflect firms’ financing decisions, taxation is exogenous to firms, and depreciation and amortisation are non-cash items that do not relate to operations items.
(a) Analysts often use EBITDA when assessing underlying profitability and the success of firms’ investment decisions. This suggests that EBITDA has properties superior, or complementary to profit after tax. Students can argue the merits of both profit metrics (see also Case Study 3.2). Essentially this discussion should entail (1) advantages and disadvantages of cash-based versus accrual-based performance measures, (2) the nature of depreciation and amortisation, and (3) the use made of underlying performance measures (for example, in assessing financial performance and firm value). If EBITDA is being used to reflect a cash-based profit figure, then cash flow from operations would be a more objective measure.
(b) The traditional focus and emphasis on profit after tax is an example of pragmatic reasoning. The behaviour of accountants in focusing and emphasising profit after tax is descriptive pragmatics — future accounting procedures are ‘copied’ from existing accounting procedures. Given that profit after tax is a statutory profit line item (whereas EBITDA is not required to be disclosed on the face of the statement of financial
profit after tax as more useful in reflecting underlying performance. However, the
attention and emphasis given to EBITDA suggests that it is more reflective of underlying performance and useful when trying to ascertain future cash flows and estimate firm value. This would be an example of semantic theory — it is reflective of real-world phenomena. It is also pragmatic if ‘usefulness’ is the criterion by which the value of the measure is assessed, rather than its correspondence with real-world phenomena.
The exclusion of depreciation and amortisation in measuring underlying profitability is consistent with criticisms associated with the imprecision of accounting definitions. (c) The answer to (b) is normative. It is a value judgement as to whether EBITDA is a better
measure of underlying performance relative to profit after tax. Although normative, the assertion that one is superior to the other could be empirically tested. If it can be explained and predicted why one measure is used relative to the other, the theory becomes positive. For example, it may be that the correlation between EBITDA and share price is greater than that between profit after tax and share price. Such empirical testing results in positive theories as to the more useful measure of underlying accounting performance that is most reflected in investors’ decisions.
Theory in Action 3.2 — Normative and positive theories of Enronitis
1. What is ‘Enronitis’?
Enronitis is a generic label (a metaphor) used to describe the ‘disease’ attributable to recent corporate collapses (for example, poor corporate governance and inappropriate accounting). Investigations as to Enron’s collapse found that weak corporate governance, greedy
managers, questionable accounting and lack of audit and analyst independence contributed to the collapse. Other firms in many countries have since been identified as afflicted with this disease. The loss of confidence accompanying corporate collapses and the unveiling of accounting irregularities is the consequence. Investors generally penalise any firm suspected of using deceptive accounting practices similar to Enron.
2. Pick two of the ten points covered by President Bush.
(a) For each of the two points, develop a theory in simple steps that gives rise to them.
(b) Explain whether each theory is more positive or normative in nature. (c) How could you test each theory?
The article cites ten points covered by President Bush in the plan to improve corporate governance in America. In attempting this question, students can select any two of the ten points listed. The following suggested solution discusses (1) corporate leaders should be required to tell the public promptly whenever they buy or sell company stock for personal gain; and (2) investors should have complete confidence in the independence and integrity of companies’ auditors.
Corporate leaders should be required to tell the public promptly whenever they buy or sell company stock for personal gain.
