ACCOUNTING THEORY UNDERLYING FINANCIAL ACCOUNTING

5-1

CHAPTER 5

ACCOUNTING THEORY
UNDERLYING FINANCIAL
ACCOUNTING


5-2

Accounting Theory Defined
“. . . 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.”
173


Structure of Accounting Theory
Formal Approach
Accounting theory provides a logical
framework for accounting practice.

5-3

Structure of Accounting Theory
Formal Approach
Accounting theory provides a logical
framework for accounting practice.

ASSUMPTIONS

5-4


Structure of Accounting Theory
Formal Approach
Accounting theory provides a logical
framework for accounting practice.

PRINCIPLES

ASSUMPTIONS

5-5


Structure of Accounting Theory
Formal Approach
Accounting theory provides a logical
framework for accounting practice.
RULES

PRINCIPLES

ASSUMPTIONS

5-6


Structure of Accounting Theory
Informal Approach

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

5-7


Structure of 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.

5-8

5-9

Business Entity “Idea”
Each
Each business
business has
has an
an
identity
identity separate
separate from
from its
its
owners.
owners.
The
The business
business is
is the
the
accounting
accounting entity.
entity.
Financial
Financial statements
statements report
report
only

only the
the activities,
activities, resources,
resources,
and
and obligations
obligations of
of that
that
business.
business.


5-10

Going-Concern
In
In the
the absence
absence of
of evidence
evidence to
to the
the
contrary,
contrary, we
we assume
assume that
that aa
business

business will
will continue
continue to
to exist
exist
indefinitely.
indefinitely.
For
For example,
example, aa company
company is
is more
more
likely
likely to
to acquire
acquire long-term
long-term assets
assets ifif
itit can
can assume
assume that
that the
the company
company will
will
continue
continue to
to exist
exist indefinitely.

indefinitely.

ItIt is
is fundamental
fundamental to
to the
the matching
matching
principle.
principle.


5-11

MONEY MEASUREMENT
Business
Business entities
entities measure
measure economic
economic
events
events and
and transactions
transactions in
in monetary
monetary
units.
units.
In
In the

the United
United States,
States, the
the unit
unit of
of
measurement
measurement is
is the
the dollar.
dollar.


Stable Dollar or
Stable Monetary Unit

5-12


Stable Dollar or
Stable Monetary Unit
Assumes
Assumes that
that the
the dollar
dollar maintains
maintains aa
relatively
relatively stable
stable value.

value.
In
In countries
countries with
with high
high inflation,
inflation, this
this
assumption
assumption may
may not
not be
be valid.
valid.

5-13


Stable Dollar or
Stable Monetary Unit
Assumes
Assumes that
that the
the dollar
dollar maintains
maintains aa
relatively
relatively stable
stable value.
value.

In
In countries
countries with
with high
high inflation,
inflation, this
this
assumption
assumption may
may not
not be
be valid.
valid.

Accountants
Accountants do
do not
not adjust
adjust the
the
accounts
accounts for
for the
the changing
changing value
value of
of
the
the dollar
dollar (i.e.,

(i.e., inflation)
inflation)

5-14


5-15

Periodicity
Continuous
Continuous business
business activity
activity is
is divided
divided
into
into arbitrary
arbitrary time
time periods
periods as
as exemplified
exemplified
by
by this
this time
time line.
line.

Business
Business activity

activity is
is best
best reported
reported in
in
annual,
annual, quarterly
quarterly or
or monthly
monthly periods.
periods.


5-16

Other Basic Ideas
Substance Over Form
The substance of a transaction or
economic event is more important
than its legal form.


5-17

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.


5-18

Other Basic Ideas
Consistency
Consistency
Requires
Requires that
that aa company
company use
use the
the same
same
accounting
accounting principles
principles from
from one
one period
period
to
to the

the next.
next. ItIt does
does not
not require
require that
that all
all
companies
companies use
use the
the same
same principles.
principles.
A
A change
change from
from one
one acceptable
acceptable
accounting
accounting principle
principle to
to another
another must
must
be
be disclosed
disclosed in
in the
the notes

notes to
to the
the
financial
financial statements.
statements.


5-19

Other Basic Ideas
Double-Entry
Double-Entry Bookkeeping
Bookkeeping
Every
Every transaction
transaction will
will have
have both
both aa debit
debit
effect
effect and
and aa credit
credit effect
effect on
on the
the primary
primary
financial

financial statements.
statements.
Total
Total debits
debits must
must equal
equal total
total credits.
credits.

Articulation
Articulation
The
The primary
primary financial
financial statements
statements are
are
fundamentally
fundamentally related
related to
to each
each other
other
as
as shown
shown on
on page
page 19.
19.

5-20

Major Principles/Ideas
Exchange-Price
Exchange-Price or
or
Historical
Historical Cost
Cost
Matching
Matching
Revenue
Revenue Recognition
Recognition
Expense
Expense Recognition
Recognition
Gain
Gain and
and Loss
Loss
Recognition
Recognition
Full
Full Disclosure
Disclosure

5-21

Major Principles/Ideas
Exchange-Price
Exchange-Price or
or
Historical
Historical Cost
Cost
Matching
Matching
Revenue
Revenue Recognition
Recognition
Expense
Expense Recognition
Recognition
Gain
Gain and
and Loss
Loss
Recognition
Recognition
Full
Full Disclosure
Disclosure

All
All transactions
transactions

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


5-22

Major Principles/Ideas
Exchange-Price
Exchange-Price or
or
Cost
Cost
Matching
Matching
Revenue
Revenue Recognition

Recognition
Expense
Expense Recognition
Recognition
Gain
Gain and
and Loss
Loss
Recognition
Recognition
Full
Full Disclosure
Disclosure

The
The most
most
important
important
principle.
principle. ItIt
provides
provides the
the basis
basis
for
for accrual
accrual
accounting.
accounting.

5-23

Major Principles/Ideas
Exchange-Price
Exchange-Price or
or
Historical
Historical Cost
Cost
Matching
Matching
Revenue
Revenue Recognition
Recognition
Expense
Expense Recognition
Recognition
Gain
Gain and
and Loss
Loss
Recognition
Recognition
Full
Full Disclosure
Disclosure

Revenues

Revenues are
are
recorded
recorded when
when
they
they are
are earned
earned
(i.e.,
(i.e., realized).
realized).
When
When does
does this
this
happen?
happen?
When
Whentitle
titlepasses.
passes.


Exceptions to
Revenue Recognition Principle

 Cash
Cash basis
basis of

of revenue
revenue recognition
recognition

 Installment
Installment basis
basis of
of revenue
revenue recognition
recognition

(Need
(Need only
only know
know concept,
concept, not
not how
how to
to apply)
apply)


 Percentage-of-completion
Percentage-of-completion basis
basis of
of

revenue
revenue recognition
recognition


 Revenue
Revenue recognition
recognition at
at completion
completion of
of
production
production

(Need
(Need only
only know
know concept,
concept, not
not how
how to
to apply)
apply)
180

181

5-24


5-25

Major Principles/Ideas
Exchange-Price

Exchange-Price or
or
Historical
Historical Cost
Cost
Matching
Matching
Revenue
Revenue Recognition
Recognition
Expense
Expense Recognition
Recognition
Gain
Gain and
and Loss
Loss
Recognition
Recognition
Full
Full Disclosure
Disclosure

Expenses
Expenses should
should
be
be recorded
recorded as
as

they
they are
are incurred
incurred
in
in the
the process
process of
of
earning
earning revenues.
revenues.