Accounting Theory

Other basic concepts

Other basic accounting concepts that affect accounting for entities are (1) general-purpose financial statements, (2) substance over form, (3) consistency, (4) double entry, and (5) articulation. We discuss these basic accounting concepts next.

Accountants prepare general-purpose financial statements at regular intervals to meet many of the information needs of external parties and top-level internal managers. In contrast, accountants can gather special-purpose financial information for a specific decision, usually on a one-time basis. For example, management may need specific information to decide whether to purchase a new computer system. Since special-purpose financial information must be specific, this information is best obtained from the detailed accounting records rather than from the financial statements.

In some business transactions, the economic substance of the transaction conflicts with its legal form. For example, a contract that is legally a lease may, in fact, be equivalent to a purchase. A company may have a three-year contract to lease (rent) an automobile at a stated monthly rental fee. At the end of the lease period, the company receives title to the auto after paying a nominal sum (say, USD 1). The economic substance of this transaction is a purchase rather than a lease of the auto. Thus, under the substance-over-form concept, the auto is an asset on the balance sheet and is depreciated instead of showing rent expense on the income statement. Accountants record a transaction's economic substance rather than its legal form.

Consistency generally requires that a company use the same accounting principles and reporting practices through time. This concept prohibits indiscriminate switching of accounting principles or methods, such as changing inventory methods every year. However, consistency does not prohibit a change in accounting principles if the information needs of financial statement users are better served by the change. When a company makes a change in accounting principles, it must make the following disclosures in the financial statements: (1) nature of the change; (2) reasons for the change; (3) effect of the change on current net income, if significant; and (4) cumulative effect of the change on past income.

Chapter 2 introduced the basic accounting concept of the double-entry method of recording transactions. Under the double-entry approach, every transaction has a two-sided effect on each party engaging in the transaction. Thus, to record a transaction, each party debits at least one account and credits at least one account. The total debits equal the total credits in each journal entry.

When learning how to prepare work sheets in Chapter 4, you learned that financial statements are fundamentally related and articulate (interact) with each other. For example, we carry the amount of net income from the income statement to the statement of retained earnings. Then we carry the ending balance on the statement of retained earnings to the balance sheet to bring total assets and total equities into balance.

In Exhibit 27 we summarize the underlying assumptions or concepts. The next section discusses the measurement process used in accounting.