ACCOUNTING THEORY UNDERLYING FINANCIAL ACCOUNTING

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ACCOUNTING THEORY UNDERLYING FINANCIAL

ACCOUNTING

CHAPTER 5CHAPTER 5

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Accounting Theory DefinedAccounting Theory Defined

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“. . . a set of basic conceptsand assumptions and related

principles that explain andguide the accountant’sactions in identifying,

measuring, andcommunicating economic

information.”

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Accounting theory provides a logical framework for accounting practice.

Structure of Accounting Theory Structure of Accounting Theory FormalFormal ApproachApproach

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ASSUMPTIONS


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ASSUMPTIONS

PRINCIPLES


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ASSUMPTIONS

PRINCIPLES

RULES


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

AccountingTheory

Structure of Accounting Theory Structure of Accounting Theory InformalInformal ApproachApproach

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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 Structure of Accounting Theory InformalInformal ApproachApproach

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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”Business Entity “Idea”

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Going-ConcernGoing-Concern

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.

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MONEY MEASUREMENTMONEY 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.

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Stable Dollar orStable Dollar orStable Monetary UnitStable Monetary Unit

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Assumes that the dollar maintains a relatively stable value. In countries with high inflation, this

assumption may not be valid.




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



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


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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.

PeriodicityPeriodicity

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Substance Over Form The substance of a transaction or

economic event is more important than its legal form.

Other Basic IdeasOther Basic Ideas

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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.

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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 notes to the 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 notes to the financial statements.


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Double-Entry Bookkeeping Every transaction will have both a debit

effect and a credit effect on the primary financial statements.

Total debits must equalequal total credits.

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 equalequal total credits.

Articulation The primary financial statements are

fundamentally related to each other as shown on page 19.


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Major Principles/IdeasMajor Principles/Ideas

Exchange-Price or Historical Cost

Matching Revenue Recognition Expense Recognition Gain and Loss

Recognition Full Disclosure




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All transactions are recorded at their historical

cost at the time of the transaction.

All transactions are recorded at their historical

cost at the time of the transaction.


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Exchange-Price or Cost



Exchange-Price or Cost



The most important

principle. It provides the basis

for accrual accounting.

The most important

principle. It provides the basis

for accrual accounting.


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Revenues are recorded when they are earned (i.e., realized).

When does this happen?

When title passes.

Revenues are recorded when they are earned (i.e., realized).

When does this happen?

When title passes.


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Exceptions to Exceptions to Revenue Recognition PrincipleRevenue 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) Percentage-of-completion basis of

revenue recognition Revenue recognition at completion of

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

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Expenses should be recorded as

they are incurred in the process of

earning revenues.

Expenses should be recorded as

they are incurred in the process of

earning revenues.


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The rules are different for

recognition of gains and losses.

The rules are different for

recognition of gains and losses.


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Gain and Loss RecognitionGain 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 soldsold.



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Gain and Loss RecognitionGain and Loss Recognition



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.



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.

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Disclose in the financial

statements or related notes, all

information important enough

to influence a stakeholder.

Disclose in the financial

statements or related notes, all

information important enough

to influence a stakeholder.


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Cost-Benefit ConsiderationCost-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.

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MaterialityMateriality

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 …)

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ConservatismConservatism

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.

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Summary of Significant Summary of Significant Accounting PoliciesAccounting Policies

Appears in the notes to the financial statements.

Includes a discussion of the major accounting policies.

Appears in the notes to the financial statements.

Includes a discussion of the major accounting policies.

pp

. 195

-197

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A good framework is the best foundation.

Almost FinishedAlmost Finished

You may

skip from

p. 186 (F

ASB

Framework

Project) to

p. 195

(Summary of

Significant

Accounting

Policies).

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Virtual Keypad Questions

ConclusionConclusion

ACCOUNTING THEORY UNDERLYING FINANCIAL ACCOUNTING

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