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
 5-3

Structure of Accounting Theory

Formal Approach

Accounting theory provides a logical

framework for accounting practice.
 5-4

Structure of Accounting Theory

Formal Approach

Accounting theory provides a logical

framework for accounting practice.

ASSUMPTIONS
 5-5

Structure of Accounting Theory

Formal Approach

Accounting theory provides a logical

framework for accounting practice.

PRINCIPLES

ASSUMPTIONS
 5-6

Structure of Accounting Theory

Formal Approach

Accounting theory provides a logical

framework for accounting practice.

RULES

PRINCIPLES

ASSUMPTIONS
 5-7

Structure of Accounting Theory

Informal Approach

Accounting
Theory

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

 5-8

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.
 5-9

Business Entity “Idea”

 Each business has an
Each business has an
identity
identity separate
separate from
from its
its
owners.
owners.
 The business is the
The business is the
accounting
accounting entity.
entity.
 Financial statements report
Financial statements report
only
only the
the activities,
activities, resources,
resources,
and
and obligations
obligations ofof that
that
business.
business.
 5-10

Going-Concern
 In the absence of evidence to the
In the absence of evidence to the
contrary,
contrary, we
we assume
assume that
that aa
business
business will
will continue
continue to
to exist
exist
indefinitely.
indefinitely.
 For example, a company is more
For example, a company is 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.
 It is fundamental to the matching
It is fundamental to the matching
principle.
principle.
 5-11

MONEY MEASUREMENT
 Business entities measure economic
Business entities measure economic
events
events and
and transactions
transactions in
in monetary
monetary
units.
units.
 In the United States, the unit of
In the United States, the unit of
measurement
measurement is
is the
the dollar.
dollar.
 5-12

Stable Dollar or
Stable Monetary Unit
 5-13

Stable Dollar or
Stable Monetary Unit
 Assumes that the dollar maintains a
Assumes that the dollar maintains a
relatively
relatively stable
stable value.
value.
 In countries with high inflation, this
In countries with high inflation, this
assumption
assumption may
may not
not be
be valid.
valid.
 5-14

Stable Dollar or
Stable Monetary Unit
 Assumes that the dollar maintains a
Assumes that the dollar maintains a
relatively
relatively stable
stable value.
value.
 In countries with high inflation, this
In countries with high inflation, this
assumption
assumption may
may not
not be
be valid.
valid.
 Accountants do not adjust the
Accountants do not adjust the
accounts
accounts for
for the
the changing
changing value
value of
of
the
the dollar
dollar (i.e.,
(i.e., inflation)
inflation)
 5-15

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

 Business activity is best reported in

Business activity is best reported 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 that a company use the same
Requires that a company use the same
accounting
accounting principles
principles fromfrom 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 change from one acceptable
A change from one 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 onon page
page 19.
19.
 5-20

Major Principles/Ideas
Exchange-Price or
Exchange-Price or
Historical
Historical Cost
Cost
 Matching
Matching
Revenue Recognition
Revenue Recognition
Expense Recognition
Expense Recognition
Gain and Loss
Gain and Loss
Recognition
Recognition
Full Disclosure
Full Disclosure
 5-21

Major Principles/Ideas
 Exchange-Price
Exchange-Price oror All
All transactions
transactions
Historical
Historical Cost
Cost are
are recorded
recorded at at
Matching their
their historical
historical

Matching cost
cost at at the
the time
time of
of
 Revenue
Revenue Recognition
Recognition the
the transaction.
transaction.
 Expense
Expense Recognition
Recognition
 Gain
Gain and
and Loss
Loss
Recognition
Recognition
 Full
Full Disclosure
Disclosure
 5-22

Major Principles/Ideas
 Exchange-Price
Exchange-Price or
or The
The most
most
Cost
Cost important
important
 Matching
Matching principle.
principle. ItIt
Revenue provides
provides the
the basis

Revenue Recognition
Recognition basis
for
for accrual
accrual
 Expense
Expense Recognition
Recognition accounting.
accounting.
 Gain
Gain and
and Loss
Loss
Recognition
Recognition
 Full
Full Disclosure
Disclosure
 5-23

Major Principles/Ideas
 Exchange-Price
Exchange-Price oror
Historical
Historical Cost
Cost
 Matching
Matching Revenues
Revenues are are
 Revenue
Revenue Recognition
Recognition recorded
recorded when when
they
they areare earned
earned
 Expense
Expense Recognition
Recognition (i.e.,
(i.e., realized).
realized).
 Gain
Gain and
and Loss
Loss When
When does does this
this
Recognition
Recognition happen?
happen?
 Full
Full Disclosure
Disclosure When
Whentitle
titlepasses.
passes.
 5-24

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
 5-25

Major Principles/Ideas
 Exchange-Price
Exchange-Price oror
Historical
Historical Cost
Cost
 Matching
Matching
 Revenue
Revenue Recognition
Recognition Expenses
Expenses should
should
 Expense
Expense Recognition
Recognition be
be recorded
recorded asas
they
they are
are incurred
incurred
 Gain
Gain and
and Loss
Loss in
in the
the process
process ofof
Recognition
Recognition earning
earning revenues.
revenues.
 Full
Full Disclosure
Disclosure
 5-26

Major Principles/Ideas
 Exchange-Price
Exchange-Price oror
Historical
Historical Cost
Cost
 Matching
Matching
 Revenue
Revenue Recognition
Recognition
 Expense
Expense Recognition
Recognition The
The rules
rules are
are
 Gain
Gain and
and Loss
Loss different
different for
for
Recognition
Recognition recognition
recognition of of
gains
gains and
and losses.
losses.
 Full
Full Disclosure
Disclosure
 5-27

Gain and Loss Recognition

 Gains are recognized/recorded at the
Gains are recognized/recorded at the
time
time they
they are
are realized.
realized.
For
Forexample,
example, an anincrease
increasein
in the
thevalue
valueofof land
land
cannot
cannot beberecognized
recognizedasasaagain
gainuntil
untilthe
theland
landis
is
actually
actually sold.
sold
sold.
sold
 5-28

Gain and Loss Recognition

 Gains are recognized/recorded at the
Gains are recognized/recorded at the
time
time they
they are
are realized.
realized.
For
Forexample,
example, an anincrease
increasein
in the
thevalue
valueofof land
land
cannot
cannot beberecognized
recognizedasasaagain
gainuntil
untilthe
theland
landis
is
actually
actually sold.
sold
sold.
sold
 Losses are recognized when they
Losses are recognized when they
become
become apparent.
apparent.
For
Forexample,
example, aadecrease
decrease in
inthe
the value
valueofof
inventory
inventorywould
wouldbe berecognized
recognizedas asaaloss
losswhen
when
itit becomes
becomesapparent.
apparent.
 5-29

Major Principles/Ideas
 Exchange-Price
Exchange-Price oror
Historical
Historical Cost
Cost
 Matching
Matching Disclose
Disclose inin the
the
Revenue financial
financial

Revenue Recognition
Recognition
statements
statements or or
 Expense
Expense Recognition
Recognition related
related notes,
notes, all
all
 Gain
Gain and
and Loss
Loss information
information
Recognition
Recognition important
important enough
enough
to
to influence
influence aa
 Full
Full Disclosure
Disclosure stakeholder.
stakeholder.
 5-30

Cost-Benefit Consideration
Optional
Optional information
information should
should
be
be included
included in
in the
the primary
primary
financial
financial statements
statements only
only ifif
the
the benefits
benefits of
of providing
providing itit
exceed
exceed the
the costs.
costs.

For
Forexample,
example,providing
providingaalisting
listingof
of
every
everysales
salestransaction
transactionmay
maybebe
interesting,
interesting,but
butthe
thecost
costof
of providing
providing
that
that information
informationtotoevery
everyshareholder
shareholder
might
mightbankrupt
bankruptthe
thecompany.
company.
 5-31

Materiality
 An item is material if knowledge of the
An item is material if knowledge of the
item
item would
would affect
affect the
the decision
decision ofof an
an
informed
informed user,
user, therefore,
therefore, this
this is
is aa
somewhat
somewhat nebulous
nebulous concept.
concept.
 Material items must be reported.
Material items must be reported.
 An item can be material either in amount
An item can be material either in amount
or
or in
in nature.
nature.
Materiality
Materiality in
in amount
amount isis relative
relative to
to the
the size
size
of
of the
the amounts
amounts onon aa company’s
company’s fin. fin. stmts.
stmts.
(e.g.
(e.g.$50,000,000
$50,000,000may
maynot
not be
bematerial
material…)
…)
 5-32

Conservatism
Transactions
Transactions should
should
be
be recorded
recorded so
so that
that
net
net assets
assets and
and net
net
income
income are
are not
not
overstated.
overstated.
Anticipate
Anticipate losses,
losses, but
but
do
do not
not anticipate
anticipate
gains.
gains.
 5-33

Summary of Significant
Accounting Policies
 Appears

Appears in
in the
the notes
notes
to
to the
the financial
financial
statements.
statements.
 Includes

Includes aa
discussion
discussion of of the
the
major
major accounting
accounting
policies.
policies.

195
-197
pp.
 5-34

Almost Finished

A good
framework ay
m
is the best u
i
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Yo p fro ASB
sk 86 (F ork
1 ew to
.

foundation.
p ram ct)
F oje 95 f
r 1
P p. ar y t o
m m can
u fi g
(S igni ntin .
S cou es)
i
Ac olic
P
 5-35

Conclusion
Virtual Keypad Questions