ACCOUNTING THEORY UNDERLYING FINANCIAL ACCOUNTING

Accounting theory provides a logical framework for accounting practice... Accounting theory provides a logical framework for accounting practice.. Accounting theory provides a logical fr

ACCOUNTING THEORY

Accounting Theory Defined

173

“ a set of basic concepts

and assumptions and related

principles that explain and

guide the accountant’s actions in identifying,

measuring, and communicating economic

information.”

Accounting theory provides a logical

framework for accounting practice.

Formal Approach

Accounting theory provides a logical

framework for accounting practice.

ASSUMPTIONS

Structure of Accounting Theory

Formal Approach

Accounting theory provides a logical

framework for accounting practice.

ASSUMPTIONS

PRINCIPLESFormal Approach

Accounting theory provides a logical

framework for accounting practice.

Accounting theory is somewhat like a cloud, i.e not well-defined.

Accounting

Theory

Informal Approach

The terms "assumptions", "principles",

"rules", "concepts", "postulates",

"standards", etc are used many different ways in the profession.

Therefore, the authors' classification of these terms is not important to us in

this course.

i.e., you do not have to understand the

authors’ theory structure - just know the

meaning and relevance of the items/“ideas”

on the following slides.

Structure of Accounting Theory

Informal Approach

Each business has an

identity separate from its

owners.

The business is the

accounting entity.

Financial statements report

only the activities, resources,

and obligations of that

business.

Each business has an

identity separate from its

owners.

The business is the

accounting entity.

Financial statements report

only the activities, resources,

and obligations of that

business.

Business Entity “Idea”

In the absence of evidence to the

contrary, we assume that a

business will continue to exist

indefinitely.

For example, a company is more

likely to acquire long-term assets if

it can assume that the company will

continue to exist indefinitely.

It is fundamental to the matching

principle.

In the absence of evidence to the

contrary, we assume that a

business will continue to exist

indefinitely.

For example, a company is more

likely to acquire long-term assets if

it can assume that the company will

continue to exist indefinitely.

It is fundamental to the matching

principle.

MONEY MEASUREMENT

Business entities measure economic

events and transactions in monetary

units

In the United States, the unit of

measurement is the dollar

Business entities measure economic

events and transactions in monetary

units

In the United States, the unit of

measurement is the dollar

Stable Dollar or

Stable Monetary Unit

Assumes that the dollar maintains a

relatively stable value.

In countries with high inflation, this

assumption may not be valid.

Assumes that the dollar maintains a

relatively stable value.

In countries with high inflation, this

assumption may not be valid.

Stable Monetary Unit

Assumes that the dollar maintains a

relatively stable value.

In countries with high inflation, this

assumption may not be valid.

Accountants do not adjust the

accounts for the changing value of

the dollar (i.e., inflation)

Assumes that the dollar maintains a

relatively stable value.

In countries with high inflation, this

assumption may not be valid.

Accountants do not adjust the

accounts for the changing value of

the dollar (i.e., inflation)

Stable Dollar or Stable Monetary Unit

Continuous business activity is divided

into arbitrary time periods as exemplified

by this time line

Business activity is best reported in

annual, quarterly or monthly periods.

Continuous business activity is divided

into arbitrary time periods as exemplified

by this time line

Business activity is best reported in

annual, quarterly or monthly periods.

Periodicity

Substance Over Form

The substance of a transaction or

economic event is more important

than its legal form.

Other Basic Ideas

Other Basic Ideas

Substance Over Form

The substance of a transaction or

economic event is more important

than its legal form.

e.g., next semester, we will

study that even though parent

and subsidiary companies are

legally separate entities, GAAP

says that a set of consolidated

financial statements must be

prepared as if they were one

company, i.e., one economic

entity.

Requires that a company use the same accounting principles from one period

to the next It does not require that all

companies use the same principles.

A change from one acceptable

accounting principle to another must

be disclosed in the notes to the notes

financial statements.

Consistency

Requires that a company use the same accounting principles from one period

to the next It does not require that all

companies use the same principles.

A change from one acceptable

accounting principle to another must

be disclosed in the notes to the

financial statements.

Other Basic Ideas

Double-Entry Bookkeeping

Every transaction will have both a debit

effect and a credit effect on the primary

financial statements.

Total debits must equal total credits. equal

Articulation

The primary financial statements are

fundamentally related to each other

as shown on page 19.

Double-Entry Bookkeeping

Every transaction will have both a debit

effect and a credit effect on the primary

financial statements.

Total debits must equal total credits. equal

Articulation

The primary financial statements are

fundamentally related to each other

as shown on page 19.

Other Basic Ideas

All transactions are recorded at their historical cost at the time of the transaction.

Major Principles/Ideas

for accrual accounting.

The most important principle It provides the basis

for accrual accounting.

Major Principles/Ideas

When does this

happen?

When title passes.

Revenues are recorded when they are earned

Exceptions to Revenue Recognition Principle

180 181

 Cash basis of revenue recognition

 Installment basis of revenue recognition

(Need only know concept, not how to apply)

 Percentage-of-completion basis of

revenue recognition

 Revenue recognition at completion of

production

(Need only know concept, not how to apply)

 Cash basis of revenue recognition

 Installment basis of revenue recognition

(Need only know concept, not how to apply)

in the process of earning revenues

Expenses should

be recorded as they are incurred

in the process of earning revenues

Major Principles/Ideas

The rules are different for recognition of gains and losses.

Major Principles/Ideas

Gain and Loss Recognition

Gains are recognized/recorded at the

time they are realized.

For example, an increase in the value of land cannot be recognized as a gain until the land is actually sold sold

Gains are recognized/recorded at the

time they are realized.

For example, an increase in the value of land

cannot be recognized as a gain until the land is

actually sold

Gain and Loss Recognition

Gains are recognized/recorded at the

time they are realized.

For example, an increase in the value of land cannot be recognized as a gain until the land is actually sold sold

Losses are recognized when they

become apparent.

For example, a decrease in the value of inventory would be recognized as a loss when

it becomes apparent.

Gains are recognized/recorded at the

time they are realized.

For example, an increase in the value of land

cannot be recognized as a gain until the land is

actually sold

Losses are recognized when they

become apparent.

For example, a decrease in the value of

inventory would be recognized as a loss when

it becomes apparent.

important enough

to influence a stakeholder.

Disclose in the

financial statements or related notes, all information

important enough

to influence a stakeholder.

Major Principles/Ideas

Cost-Benefit Consideration

Optional information should

be included in the primary

financial statements only if

the benefits of providing it

exceed the costs.

For example, providing a listing of every

sales transaction may be interesting,

but the cost of providing that information to every shareholder

might bankrupt the company.

Optional information should

be included in the primary

financial statements only if

the benefits of providing it

exceed the costs.

For example, providing a listing of every

sales transaction may be interesting,

but the cost of providing that information to every shareholder

might bankrupt the company.

An item is material if knowledge of the

item would affect the decision of an

informed user, therefore, this is a

somewhat nebulous concept.

Material items must be reported.

An item can be material either in amount

or in nature.

Materiality in amount is relative to the size

of the amounts on a company’s fin stmts.

(e.g $50,000,000 may not be material …)

An item is material if knowledge of the

item would affect the decision of an

informed user, therefore, this is a

somewhat nebulous concept.

Material items must be reported.

An item can be material either in amount

or in nature.

Materiality in amount is relative to the size

of the amounts on a company’s fin stmts.

(e.g $50,000,000 may not be material …)

Transactions should

be recorded so that net assets and net income are not overstated.

Anticipate losses, but

do not anticipate

gains.

Transactions should

be recorded so that net assets and net income are not overstated.

Anticipate losses, but

do not anticipate

gains.

Virtual Keypad Questions

Conclusion