Financial Accounting Theory and Analysis, 15th Edition

4The Status, Development and Uses of Financial Reporting

To have a science is to have recognized a domain and a set of phenomena in that domain, and next to have defined a theory whose inputs and outputs are descriptions of phenomena (the first are observations, the second are predictions), whose terms describe the underlying reality of the domain.¹ In Chapter 2, the Financial Accounting Standards Board's (FASB's) Conceptual Framework Project was introduced as the state‐of‐the‐art theory of accounting. However, this theory does not explain how accounting information is used because very little predictive behavior is explained by existing accounting theory. Over the years, accountants have done a great deal of theorizing, providing new insights and various ways of looking at accounting and its outcomes. However, a distinction can be made between theorizing and theory construction. Theorizing is the first step to theory construction, but it is often lacking because its results are untested or untestable value judgments.²

In the following sections, we first explore the conditions and circumstances that influence financial reporting. We then introduce various research methods that can be utilized to develop and apply accounting theories. Next, we discuss how investors use accounting information and examine several theories on the outcomes of its use, including fundamental analysis, the efficient market hypothesis (EMH), the capital asset pricing model (CAPM), agency theory, human ...