Accounting Theory

This chapter will introduce you to the fundamental theories and rules that guide the system of accounting. The key tenets of accounting are explained, including: double entry, substance over form, the matching principle, the revenue recognition principle, cost-benefit, materiality, and conservatism, as is their impact on the overall application of GAAP (Generally Accepted Accounting Principles). The underlying intent behind creating financial reports is for the information in the reports to be reliable enough to support sound business decision-making. By the time you finish this chapter, you should have a better understanding of the overall structure of accounting rules and guiding principles.

The measurement process in accounting

Earlier, we defined accounting as "the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by the users of the information". 2 In this section, we focus on the measurement process of accounting.

Accountants measure a business entity's assets, liabilities, and stockholders' equity and any changes that occur in them. By assigning the effects of these changes to particular time periods (periodicity), they can find the net income or net loss of the accounting entity for those periods.

Accountants measure the various assets of a business in different ways. They measure cash at its specified amount. Chapter 9 explains how they measure claims to cash, such as accounts receivable, at their expected cash inflows, taking into consideration possible uncollectibles. They measure inventories, prepaid expenses, plant assets, and intangibles at their historical costs (actual amounts paid). After the acquisition date, they carry some items, such as inventory, at the lower-of-cost-or- market value. After the acquisition date, they carry plant assets and intangibles at original cost less accumulated depreciation or amortization. They measure liabilities at the amount of cash that will be paid or the value of services that will be performed to satisfy the liabilities.

Accountants can easily measure some changes in assets and liabilities, such as the acquisition of an asset on credit and the payment of a liability. Other changes in assets and liabilities, such as those recorded in adjusting entries, are more difficult to measure because they often involve estimates and/or calculations. The accountant must determine when a change has taken place and the amount of the change. These decisions involve matching revenues and expenses and are guided by the principles discussed next.

Assumption or Concept
Description Importance
Business entity
Each business has an existence separate from its owners, creditors, employees, customers, other interested parties, and other businesses.
Defines the scope of the business such as a horse stable or physical fitness center. Identifies which transactions should be recorded on the company's books.
Going concern (continuity)
An entity will continue to operate indefinitely unless strong evidence exists that the entity will terminate.
Allows a company to continue carrying plant assets at their historical costs in spite of a change in their market values.
Money measurement
Each business uses a monetary unit of measurement, such as the dollar, instead of physical or other units of measurement.
Provides accountants with a common unit of measure to report economic activity. This concept permits us to add and subtract items on the financial statements.
Stable dollar
The dollar is accepted as a reasonably stable unit of measure.
Permits us to make no adjustments in the financial statements for the changing value of the dollar. This assumption works fairly well in the United States because of our relatively low rate of inflation.
Periodicity (time periods)
An entity's life can be subdivided into months or years to report its economic activities. Permits us to prepare financial statements that cover periods shorter than the entire life of a activities. Thus, we know how well a business is performing before it terminates its operations. The need for adjusting entries arises because of this concept and the use of accrual accounting.
General-purpose financial
One set of financial statements serves the needs of all users.
Allows companies to prepare only one set of financial statements instead of a separate set for each potential type of user of those statements. The financial statements should be free of bias so they do not favor the interests of any one type of user.
Substance over form
Accountants should record the economic substance of a transaction rather than its legal form.
Encourages the accountant to record the true nature of a transaction rather than its apparent nature. This approach is the accounting equivalent of "tell it like it is". An apparent lease transaction that has all the characteristics of a purchase should be recorded as a purchase.
Generally requires that a company use the same accounting principles and reporting practices every accounting period.
Prevents a company from changing accounting methods whenever it likes to present a better picture or to manipulate income. The inventory and depreciation chapters (Chapters 7 and 10) both mention the importance of this concept.
Double entry
Every transaction has a two-sided effect on each company or party engaging in the transaction.
Uses a system of checks and balances to help identify whether or not errors have been made in recording transactions. When the debits do not equal the credits, this inequality immediately signals us to stop and find the error.
Financial statements are fundamentally  related and articulate (interact) with each other. Changes in account balances during an accounting period are reflected in financial statements that are related to one another. For instance, earning revenue increases net income on the income statement, retained earnings on the statement of retained earnings, and assets and retained earnings on the balance sheet. The statement of retained earnings ties the income statement and balance sheet together.

Exhibit 27: The underlying assumptions or concepts