Creative Accounting and the Need for a Theory of Accounting

The rise of “creative accounting” practices, an euphemism for hiding some unfavorable financial details and highlighting favorable ones to create an impression of sound financial health has resulted in the accounting profession taking more hits to its credibility.

It is a well known fact that the recent economic crisis witnessed firms that hid some of their liabilities “off the books” or “off-balance sheet” items, the way in which the accounting profession functions has come under renewed scrutiny by the regulators. The lack of theory in accounting has indeed been a bane for the profession as can be seen from the “fragmented” nature of the profession in different countries and within the same country as well in some cases.

This has led to a situation where the professional bodies of accountants had to step in frequently to adjudicate on matters of the reliability of a particular theory over the other.

Just as the medical profession had to engage in expensive and long drawn battles in the courts over the methods employed by them, the accountants too found themselves arguing about the correctness of their methods.

The issue at the root of this crisis is the lack of a unified theory and the fractious nature of the interpretation that accountants often do when confronted with an accounting problem.

Theories of Accounting

If we examine the theories of accounting that have developed over the course of the 20th century, we find that the period was characterized by the adoption of descriptive, normative and positive theories that underpinned the conceptual framework for accounting.

The descriptive theories represented the first serious attempt to codify the body of knowledge prevalent in accounting norms by recourse to description of the accounting practices rather than prescribing what ought to be done or predicting and explaining what needs to be done. The descriptive theories of accounting developed in the 1920’s and were in vogue till the 1960’s when researchers took a fancy to the normative or prescriptive theories of accounting.

The normative theories of accounting developed in the period of the 1960’s and 1970’s and did not assume that what is being done by the majority was right as was the case with the descriptive theories. The normative theories arose to satisfy the post World War Two boom in corporate capitalism and hence were the product of an era that emphasized deductive arguments based on estimating future growth and prescribing a set of actions that the firms could undertake with regards to increasing their revenues.

Hence, the development of the normative accounting theories was characterized by a focus on estimation rather than observation that fit in nicely with the prevalent worldview of those decades where growth was the mantra and firms needed to make decisions as to the usefulness of a particular course of action from the financial perspective.

The return of positive theories that emphasized rationality and the reliance on sophisticated tools that tested the predictions versus the results meant that researchers and the accountants could again take recourse to the “rational” means of accounting.

Why Do Researchers Shift from Theory to Theory ?

There can be many reasons why researchers shift from one theory to the other. They can range from the researchers having different perspectives of the role of theory in practice to the researchers own values and biases influencing their choice of theory and the fact that they might try to denigrate their rivals with the superiority of their theories.

If we examine each of these reasons in detail, we find that the way in which the researchers have chosen to embrace this theory or the other, like for instance, the adoption of positive theories and then the normative theories and a return to positive theories represent what Thomas Kuhn has referred to as “paradigm shifts” that happen in discrete jumps when one theory is replaced by the another in response to sufficient evidence backing the new theory.

Similarly, the researchers in the accounting profession have responded to the changing needs placed on them by businesses and the demands of the times that they were in and hence different theories have arisen as a result.

If the early decades of the 20th century witnessed the adoption of descriptive theories that went with the consensus view only to be replaced in the “boomer” years with theories that attempted to map the future and then a “return” to the positive theories that test the hypotheses against actual results as a way to predict and explain the accounting methods.

Hence, we can discern a cyclical shift from induction to deduction to a combination of both with emphasis on testing the results against the predictions.

It is our opinion that the accounting profession has responded to the changes in regulatory requirements as well as advances in technology in the way they chose particular methods over the others.

The overriding feeling that one gets by examining the readings is that a unified approach to the methods and techniques of the profession would do good for the accountants as well as the business community in general.

Impact on Corporate and Economic Crises

As mentioned in the preceding sections, the accounting profession has been rocked by a series of scandals from the beginning of the modern accounting practice. For instance, the Great Depression of the 1930’s impacted the accounting profession by highlighting the lack of theory and regulation of the profession.

Among the many factors that are thought to have been responsible for the Great Depression are the ones related to the role of ethics in accounting practices, the echo of which we find repeating in the current economic crisis. Now as then, there are calls for increased regulation and oversight by organizations like the SEC (Securities and Exchange Commission) as well as a need for transparency by the accountants themselves. It is ironic that the accountants are being called to be accountable which is akin to “who will mandate the lawmakers” analogy.

Conclusion

It is clear from the above discussion that it is high time for the accounting professionals of the world to arrive at a consensual approach towards the practice, if not the theory, of accounting.

Though this statement might seem contradictory as the practice follows the theory, a nuanced reading of it would reveal that the issues of “interpretation” and “perception” have dogged the accounting profession.

Hence, it is hoped that the adoption of accounting theories that validate their predictions with actual results would lead to a more coherent approach to the accounting methods in vogue.

Before concluding the article, it would be pertinent to remember the damage that the Enron scandal caused the accounting profession and the resultant erosion of trust in the profession. In conclusion, I tend to agree with the assertion by Sterling about the need for theory in accounting and the harm the lack of such theory has done to the profession.

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