Accounting Theory, Conceptual Issues in a Political and Economic Environment 8e Harry Wolk
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James Dodd John Rozycki (Instructor Manual All Chapters, 100% Original Verified, A
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+Grade) l
Chapter1: An Introduction to Accounting Theory l l l l l l
Instructor’s Manual l
CHAPTER HIGHLIGHTS L
The chapter is concerned with what accounting theory is and where it fits within the “structure” of
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financial accounting. The definition of accounting theory used in this chapter is broad and
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complements the objectives of the text. Theory itself helps to explain and predict phenomena that
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exist in a given field, and this likewise holds true in accounting. In accounting, theory can be
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developed in response to needs arising from practice, including concepts such as realization and
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matching. However, as an “infrastructure” has developed in financial accounting, theory is
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formulated in a more institutionalized way by means of the research process.
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Along with political factors and economic conditions, accounting theory contributes to the
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standard-setting process. The process of developing standards or making rules is itself largely a
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deductive process and is certainly concerned with accounting theory.
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The relationship of theory to measurement is very important. While some see measurement as
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closely related to but separate from theory (as we did in earlier editions), its importance relative to
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theory is so great that we now consider it to be part of theory. Measurement is the assignment of
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numbers to the attributes or properties of objects being measured. The different types of
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measurements and the quality or “goodness” of measurements are examined. The latter embodies
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(1) the usefulness of the measurement, illustrated here in a predictive context but showing up later in
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an assessment mode and (2) verifiability or objectivity, which is the degree of consensus among
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measurers in the statistical sense.
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The various valuation models are presented in Appendix 1-A. The models come under the scope of
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accounting theory. In addition, the different models are mentioned in several theory chapters before
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being discussed in depth in Chapter 14. Even if there is no desire to go further into inflation
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accounting in Chapter 14, it is important for students to gain a rudimentary grasp of the concepts
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involved, as illustrated in Appendix 1-A.
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QUESTIONS
Q-1 What does the term “social reality” mean and why are accounting and accounting theory
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important examples of it?
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The term social reality pertains to the measurement of social phenomena and the use of these
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measurements. The measurements may be representationally faithful (low in bias) and have a high
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degree of objectivity (verifiability). Or the opposite for either or both of these qualities may be the
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case. The important thing to grasp, however, is that important consequences stem from the
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measurement, whether they are “good” or “bad.” For example, an excellent year in terms of income
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could cause management to be highly rated by shareholders and other interested parties, resulting in
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high management bonuses, or provide increased dividends to shareholders. All of this could occur
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even though income is a “construct”: not a “real” factor but a conceptual artifact.
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This example shows why accounting is an important area relative to social reality measurements and
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constructs. Hopefully, accounting theory can improve the fairness and usefulness of these
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measurements.
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Q-2 Why do the value choices (entry value, exit value, and historical cost) fall within the domain of
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accounting theory?
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These are examples of different concepts involved with measuring income which have different
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underlying purposes. These different purposes—which affect social reality—are discussed in the
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appendix.
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Q-3 Of the three inputs to the accounting policy-making function, which do you think is the most
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important?
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Of the three inputs (economic conditions, political factors, and accounting theory) to the policy-
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making function, economic conditions is clearly the most important input. Economic conditions
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can easily influence the accounting theory track as well as the policy-making function. Inflation, for
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example, in the USA during the 1970s and 80s triggered a significant amount of theoretical work.
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lTheory responded to the actual economic environment. Another prominent example of the
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influence economic conditions has is the merger and acquisition wave of the 1960s, which lead to
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APB Opinion Nos. 16 and 17. Many other standards have also been triggered by economic
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conditions.
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Q-4 How can political factors be an input into accounting policy-making if the latter is concerned
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with governing and making the rules for financial accounting?
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Those who are affected by the rules will usually try to influence what those rules will be. The
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investment tax credit provides an excellent example. When APB Opinion No. 2 did not allow flow
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through, lobbying led to APB Opinion No. 4, which did allow immediate recognition in income of
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investment tax credits. Thestock option battles of the1990’s (and continuing today) is another
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example of the political process and its effect on rule-making. From a predictive standpoint, we
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are concerned with how and why political factors play a role in the standard- setting process.
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Q-5 Is accounting theory, as the term is defined in this text, exclusively developed and refined
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through the research process?
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Absolutely not. Many concepts such as conservatism and revenue recognition arose on a “common
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law” type of basis. They were responses to particular problems. Research has, of course, dealt with
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these issues. Any attempt to leave these concepts outside of the definition of accounting theory
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would makethe subject matter of accounting theory artificial and incomplete.
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Q-6 What type of measurement is the measurement of objectivity in Equation (1.1): nominal,
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ordinal, interval, or ratio scale?
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It is ordinal, due to the squaring effect on each individual deviation from the mean. The zero point,
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however, is unique. Hence, there would be perfect consensus among measurers. It would mean that
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each individual measurement would be the same for all measurers.
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Q-7 The measurement process itself is quite ordinary and routine in virtually all situations.
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Comment on this statement.
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This is not necessarily the case. Measurements can be extremely complex. For example,
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measuring the temperature of the earth’s atmosphere is extremely difficult. The increasing
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temperature has led both to the hypothesis of the greenhouse effect and to the theorythat the warming
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global temperatures are simply a fluctuation, a naturally occurring variation.
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Measuring the success of a man’s life can be perplexing. How does accumulation of Bill Gates’
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monetary wealth compare with the accomplishments of Ghandi, Nelson Mandela, or Wolfgang
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Amadeus Mozart? What does one actually measure to determine success?
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Measurements in accounting are significantly less complex, but should not be taken lightly. For l l l l l l l l l l l l l
example, determining the replacement cost or exit value of a firm’s machinery and equipment is not an
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easy task. Determining net income or earnings during a specified period of time may be more
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complicated that it appears to be on the surface.
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Q-8 Can assessment measures be used for predictive purposes?
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Though an assessment measure concerns an attribute or characteristic of an object at the present time,
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it could be used as a surrogate for a prediction measure if none exists. For example, the best
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indicator of the current ratio of a firm in a year may be the current ratio today, if budgets have not
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been prepared.
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Q-9 A great deal of interest is generated each week during the college football and college
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basketball seasons by the ratings of the teams by the Associated Press and United Press
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International. Sports writers or coaches are polled on what they believe are the top 25 teams
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in the country. Weightings are assigned (25 points for each first place vote, 24 for each
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second place vote, . . . one for each 25th place vote) and the results are tabulated. The results
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appear as a weekly listing of the top 25 teams in the nation. Do you think that these polls
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illustrate the process of measurement? Discuss.
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An argument can be made that a number is assigned to a team on the basis of a property that might be
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called the “goodness” or “strength” of a team. However, these measurements do not
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have a great deal of precision. How good a team is relative to other teams is a property or quality
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that is extremely intangible compared to other measurements such as median weight of interior
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linemen, average speed of running backs per 100 meters, etc. Unquestionably, the measurements
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are indirect.
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The qualifications of the measurers are also open to question. Do sportswriters really “know”
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football? Constraints are also present because the voters mayhave seen very few teams and they may
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also have regional biases. The numbering scale used is basically ordinal because 1 is considered to
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be better than 2, which is better than 3. However, the “goodness” of the interval between rankings is
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not uniform. For example, a voter may feel it is a virtual “toss-up” between 1 and 2, both of which he
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considers to be vastly superior to 3. As a result, the aggregating process is open to serious question.
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It is also not clear whether the pollsters are making assessment or prediction measures. The
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measures would be prediction measures if the voter presumes that 1 would beat 2 if they played the
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following week. We suspect, however, that an assessment measure is being made. The property
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being assessed is the team’s record to date. Hence, a team with a 6-0-0 record is usually ranked higher
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than a team with a 5-0-1 record.
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Q-10 Accounting practitioners have criticized some proposed accounting standards on the l l l l l l l l l
grounds that they would be difficult to implement because of measurement problems. They
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therefore conclude that the underlying theory is inappropriate. Assuming that the critics are
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correct about the implementational difficulties, would you agree with their thinking?
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Discuss.
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This question brings together the relationship among theory, policy, and practice. It also brings up
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Larson’s warning of the necessity to differentiate between theory and measurement even though we
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believe that Larson’s statement is too strong. Hence, even though the practitioners may be correct
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about the measurement process recommended by the proposed standard, it does not necessarily
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mean that the underlying theory is inappropriate. Some theories may indeed lead to dead ends in
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terms of implementation. More time may also need to be taken to make the measurements
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operational.
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Q-11 Some individuals believe that valuation methods proposed by a standard-setting body such
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as FASB should be based on those measurement procedures having the highest degree of
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objectivity as defined by Equation (1.1). Thus, some assets might be valued on the basis of
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replacement cost and others on net realizable value. Do you see any problems with this
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proposal? Discuss.
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The problem here is basically the opposite of that presented in question 10. In this case, part of the
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measurement problem might be solved, but at the cost of sacrificing the theoretical base.
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Hence, the cart is put before the horse, conceptually speaking. However, there are other
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measurement problems presented by this proposal. It is questionable whether replacement cost
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dollars and net realizable value dollars can be meaningfully added together, even if computed for
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