Lakhasly

This paper examines select normative accounting theories. Starting with the twentieth century,1
normative accounting theorists had been preoccupied with developing/constructing accounting
principles. The primary concern had been recognition and measurement issues. Hence the focus
of this paper shall be on these theorists’ proposals on accounting recognition and measurement
and the arguments/theoretical structures behind these proposals. It also compares the works
reviewed.
There are controversies among accounting academics regarding what an accounting theory is.
Watts and Zimmerman (1986: 2) posit that accounting theory seeks to explain and predict
accounting practice.2 Positivists like Watts and Zimmerman (hereinafter W & Z only) cite
economics and natural science disciplines such as physics, chemistry, etc. in the defense of
their method and call their method ‘the scientific method’ (W & Z 1986: 2), thus probably
implying that there is only one method in science. This is highly disputed by accounting
academics pursuing other strands of research (Christensen 1983; Chua 1986). Science is not a
unified structure. There is no a unique scientific method. Science knows many methods
(Feyerabend 1993). Hence, even if one wishes to study accounting as a scientific discipline,
there is more than the method advocated by W & Z (1986).3 One major criticism of W & Z’s
view of accounting theory is that it unnecessarily narrows the area of accounting research
(Chua 1986; Whittington 1987). For our purpose, we adopt the following definition of
accounting theory: “--- the business of accounting theory is to examine beliefs and customs
critically, to clarify and extend the best from experience, and to direct attention to the genesis
and outcome of accounting work” (Littleton 1953: 132). This definition accommodates
different strands of accounting research such as research in normative accounting and empirical
accounting as well as research in interpretative accounting.
A normative accounting theory seeks to prescribe some basis of accounting measurement,
particular accounting procedures, and the contents of financial reports (Ijiri 1975; W & Z
1986).4 Ijiri views normative theories as a special case of deductive theories. Deductive theories
that start with some goal assumptions and deduce accounting procedures therefrom are labeled
normative theories.5 Thus, there are two important elements of a normative theory: (a) goal
assumption, and (b) deduction. A theorist may set his own goals that are not inherent to current
accounting practice. Chambers (1966) falls in this group. Again, a theorist may inductively
derive goals from accounting practice and use those goals to suggest improvements in current
practice. Ijiri falls into this group. Such theories are also categorized as normative in this paper.
It is to be noted that not every theorist is explicit on goal statement. Some state the basic
assumptions and deduce accounting measurement from these. Paton and Littleton (1940) fall in
this group.
So far three approaches have been employed in normative accounting research. These are (a)
inductive model, (b) deductive model, and (c) the decision usefulness approach. In induction, a
general statement (X) is induced from some empirical observations, hypothetical phenomena,
or non-empirical concepts (O). The implications of X include and go beyond O. It may be
noted that many Xs may be induced from O. The contribution of an inductive model is in
coming up with an X as an explanation of O. On the other hand, the opposite process is
followed in deductive models. Here O is deduced from X. X is a set of theories, or assumptions
that have already been accepted. In a deductive model, O is a special case of X. In the decisionusefulness,
decision model approach, ‘information relevant to a decision model or criterion is
isolated and various accounting alternatives are compared to the data presumably necessary for
implementing these decision models’ (AAA 1977: 10).
Inductivists such as Hatfield (1927), Littleton (1953), Ijiri (1975), etc. examine extant
accounting practice and have tried to rationalize and, sometimes, justify major elements of
extant accounting practice. Among the inductivists, Ijiri (1975) is very explicit in his adoption
of the inductive approach to accounting theory. He expresses his preference for inductive
models over deductive models in the following words:
This type of inductive reasoning to derive goals implicit in the behavior of an existing system is not
intended to be pro-establishment or to promote the maintenance of the status quo. The purpose of such
an exercise is to highlight where changes are most needed and where they are feasible. Changes
suggested as a result of such as a study have a much better chance of being actually implemented. Goal
assumptions in normative models or goals advocated in policy discussions are often stated purely on the
basis of one’s conviction and preference, rather than on the basis of inductive study of the existing
system. This may perhaps be the most crucial reason why so many normative models or policy
proposals are not implemented in the real world. (Ijiri 1975: 28).
On the other hand, deductivists such as Paton (1922), Canning (1929), Sweeney (1936),
MacNeal (1939), Chambers (1966), etc. develop accounting models of global application
(AAA 1977). They are basically reformers and suggest new bases of accounting measurement.
Many of these deductive writers advocate current costs or values. They drew on neoclassical
economic theory6 and on their observations of economic behavior to suggest that accounting
should report current costs instead of historical costs. (AAA 1977). These deductivists do not
investigate the decision frameworks of specific classes of users. Instead they assume the
income figure generated by their model would be equally useful to all types of users.7 That is
why their model is called ‘true income’ model. (AAA 1977). In contrast, as noted earlier, the
decision model approach recognizes that different decisions may require different information.
This approach has received varying degrees of emphasis in the accounting literature since the
1950s.8 It has been used in A Statement of Basic Accounting Theory (ASOBAT) issued by
American Accounting Association (AAA). The conceptual framework for financial reporting
issued by the Financial Accounting Standards Board (FASB) is also an example of the decision
model approach.
This paper reviews five important works within the tradition of inductive–deductive models.
These are:
MacNeal, Kenneth. 1939 (Reprinted in 1970). Truth in Accounting.
Paton, W. A. and A. C. Littleton. 1940. An Introduction to Corporate
Accounting Standards.
Littleton, A. C., 1953. Structure of Accounting Theory.
Chambers, R. J. 1966. Accounting, Evaluation and Economics Behavior.
Ijiri, Yuji. 1975. Theory of Accounting Measurement.
Though we have mentioned inductive models and deductive models separately, it should be
noted that it is very difficult to classify a work as being inductive or deductive only. Some
works have used both models simultaneously. Ijiri’s (1975) work illustrates this. He induced
the goal underlying current accounting practice and argues in a normative vein that this goal
should be retained. Using deductive logic, he then recommends particular basis of
measurement.
MacNeal (1939)
MacNeal (1939) is a revolutionary. His work contains a vehement attack against the present
accounting practice. He thinks that the function of accounting is to report economic truth. But
financial statements, he argues, do not present truth.9 They are misleading to the investors and
creditors. In particular, he says that the historical cost principle and the conservatism
convention prevent financial statements from presenting true financial position and the
operating results of the firm.10
He links the development of accounting principles to the business and economic conditions
obtaining in medieval Europe and by reconstruction, he shows that accounting principles were
the natural outgrowth of the then conditions which have ceased to exist now. But accounting
principles have not kept pace with the changed conditions.
MacNeal evaluates three justifications offered in favor of the cost principles. First, cost
represents the value of a fixed asset to a going concern, called ‘the going value’ theory. Second,
it is impractical and expensive to revalue assets every year. Third, even if revaluations of fixed
assets were done every year that would not provide significant information to the users.
The ‘going value’ theory states that cost represents the value of service of an asset to the owner
at the time of the purchase. Since the service potential of the asset can not change unless there
is any change in its physical condition, the value of the asset to the owner can not change after
the purchase. Hence, fixed assets should be shown at costs in the balance sheet even after the
purchase. Since fixed assets are purchased not for sale, but for productive use in the business,
market prices are not relevant for the valuation of the asset. MacNeal disagrees with this
position. To him, value means economic value that is determined by the interaction of demand
and supply in a free and competitive market. Cost represents the economic value at the time of
purchase only if it is determined by demand and supply in a free and competitive market that is
sufficiently broad and active. Otherwise costs can not be economic values even at the time of
purchase. After the purchase, if the relative forces of demand and supply change, the economic
value would also change. MacNeal further argues that the ‘going value’ theory was appropriate
when there was a permanent owner-manager and ventures had limited lives so that the ownermanager
was interested only in knowing the cost to date of the venture. Now there are
numerous individuals who hold shares in modern corporations and are ignorant of the state of
affairs of the firm and must rely on the information communicated by management.
Furthermore, ownership of corporate firms changes frequently. Since each share involves a
claim against the assets, the equitable ownership also changes with changes in shareholders. It
is important to ensure equity and fairness to the changing shareholders. The present practice of
not reporting unrealized market prices prevents shareholders from the assessing the true value
of their shareholding and is, thus, an obstacle to ensuring equity. Hence, the ‘going value’
theory is inappropriate and does injustice to the changing stockholders.
MacNeal argues that if fixed assets are revalued at year-end, it becomes a matter of routine
later. Hence, the question of impracticality and expense does not stand in the way of reporting
present economic values. He further claims that present economic values are useful to investors
and creditors in investment and credit decisions.
The argument in favor of the conservatism convention is that it ensures that the earnings and
net worth of the firm are at least as good as that represented in the financial statements.
MacNeal argues that this assurance was important for creditors who supplied the funds and
rested their credit decisions on the status of current assets. The conservatism convention
provided a safety margin for these creditors in times of financial distress of the firm. Now trade
credit constitutes a very small portion of the total funds obtained by the firm. Toady the most
important party at interest is the small, uninformed securityholder. Thus the conservatism
convention has lost its relevance today.
MacNeal employs a deductive model. He claims that managers, creditors and stockholders
want to know the present net worth of the entity. Creditors need this information because this
helps them assess the probability of being repaid. Stockholders need this information because
this helps them compare the possessions of their company with those of other companies whose
stock they may intend to buy. Managers, creditors and stockholders are also interested in
having information regarding all of the profits/losses made by the entity. Financial statements
can serve these information needs well if they report present economic values. By economic
values, he means market prices (i.e., exit price) established through the free play of demand and
supply in a market that is free and competitive, and sufficiently broad and active. Where free,
competitive, and sufficiently broad and active market does not exist (e.g., in the case of work in
progress, most finished goods, specialized building and equipment, etc.), present economic
values should be estimated by the present replacement costs of the particular asset.11 Historical
cost should be used only in the case of nonmarketable and nonreproducible assets (e.g.,
intangibles, mineral deposits, etc.). For MacNeal, it is an irony that the resulting total asset
figure in the balance sheet would not make any meaningful sense since the total asset figure
would be a curious mixture of market prices, replacement costs, and historical costs.
MacNeal suggests that depreciation be calculated on the present economic value of assets,
rather than on their historical costs. He defines depreciation as the loss in value of assets due to
physical wear and tear. But in the illustrations12 what he actually does is allocate the present
economic value of assets in a systematic value. Here we see some inconsistencies between his
theory of depreciation and illustrations. For if depreciation is defined as the loss in value due to
physical wear and tear, it could, and should, be measured by direct reference to the market price
of used asset if such price is available. It is to be noted that in that case appreciation might have
to be recorded instead of depreciation. This is because the market price of used assets might
exceed the original cost of the asset.
It is also to be noted that MacNeal does not allocate the market price of an asset fully as
depreciation expense over its life. Changes in market prices of assets are decomposed into
depreciation expense, capital profits and capital losses. The sum of depreciation expense,
capital profits and capital losses over the whole life of an asset equal its historical cost.
Liabilities should be shown at amounts representing their legal claims on the assets of the
entity. Money value liabilities13 should be shown at their face values. Bond discount and
premium are not amortized, rather they are treated as capital loss and profits, respectively. Real
value liabilities are to be shown at their present economic values at the balance sheet date.
MacNeal justifies the reporting of money value liabilities at their face amounts on the ground
that face amounts of liabilities are the amounts that will have to be paid.
If an issuer defaults in the payment of interest, his bonds may be declared immediately payable at
their face amounts, and no attention will be paid to the discounts at which they may originally have
been sold. If the issuer retires his bonds before maturity, he must pay their face amounts plus the
premium specified in the trust deed, regardless of whether the bonds were originally sold at a
discount. (MacNeal 1939: 282)
The above logic does not go with the going concern assumption. It is true that the face amount
will have to be paid if the liabilities are to be paid any time before maturity. But the going
concern assumption that MacNeal uses implies that the entity will continue without any
material curtailment in operation in the foreseeable future. Thus, the assumption is that the
liabilities will not have to be paid at the balance sheet date (Paton and Littleton 1940).
MacNeal offers another argument in favor of treating bond discount and premium as capital
loss and profit, respectively. Amortizing discounts and premiums conceals the amount of
periodic cash interest payments. Continuity of an entity depends sometimes on its ability to pay
interest and, thus, reporting cash interest is important to the users of financial statements. He is
right, albeit partially. The importance of reporting cash interest payments does not preclude
showing theoretical interest14 in the income statement as break-up of theoretical interest can be
shown in notes to financial statements. MacNeal uses the term ‘theoretical interest’ in a
somewhat derogatory sense, implying that it has no usefulness whatsoever. But it can not be
denied that discounts and premiums increase and decrease the effective interest of bond issue.
And the income statement would include both realized and unrealized current and capital
profits and losses. MacNeal suggests a form of income statement in which there are two major
sections. One section reports current profits, i.e., profits from business operation and the second
section reports capital profits or losses.15 Current profits or losses are to be closed to earned
surplus and capital profits are to be closed to capital surplus.16 The total of profits reported in
two sections would be the total net profit from all sources.
Income statement designed as above would report all profits from whatever sources they may
come. This would rectify the present practice of income determination. Income as presently
reported is a curious mixture of realized profit and some unrealized profit and loss. This state of
income determination was responsible for the legal confusion and contradiction that existed
during MacNeal’s time regarding what profit was. Attribution of the failure of the court to
comprehend what accounting profit is to the accounting practice of income determination
misses the important point that accounting and all of its products are social reality that must be
understood in their own terms. This is because is accounting profit is self-referential. Hence to
understand what accounting profit is, one must understand the accounting process of income
determination.17
Similarly, MacNeal’s assertion that financial statements should report economic truth overlooks
the important point that accounting reports not only economic reality, it also creates new
economic reality (Hines 1988). True profit is a figure that we do not know. We know only what
is reported. And the reported profit is a reality that is the creation of accounting.