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.

Objectives of financial reporting

Financial reporting objectives are the broad overriding goals sought by accountants engaging in financial reporting. According to the FASB, the first objective of financial reporting is to:

provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.

Interpreted broadly, the term other users includes employees, security analysts, brokers, and lawyers. Financial reporting should provide information to all who are willing to learn to use it properly.

The second objective of financial reporting is to:

provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends [owner withdrawals] or interest and the proceeds from the sale, redemption, or maturity of securities or loans. Since investors' and creditors' cash flows are related to enterprise cash flows, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.

This objective ties the cash flows of investors (owners) and creditors to the cash flows of the enterprise, a tie-in that appears entirely logical. Enterprise cash inflows are the source of cash for dividends, interest, and the redemption of maturing debt.

Third, financial reporting should:

provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners' equity), and the effects of transactions, events, and circumstances that change its resources and claims to those resources.

We can draw some conclusions from these three objectives and from a study of the environment in which financial reporting is carried out. For example, financial reporting should: 

  • Provide information about an enterprise's past performance because such information is a basis for predicting future enterprise performance. 
  • Focus on earnings and its components, despite the emphasis in the objectives on cash flows. (Earnings computed under the accrual basis generally provide a better indicator of ability to generate favorable cash flows than do statements prepared under the cash basis).

On the other hand, financial reporting does not seek to: 

  • Measure the value of an enterprise but to provide information useful in determining its value. 
  • Evaluate management's performance, predict earnings, assess risk, or estimate earning power but to provide information to persons who wish to make these evaluations.

These conclusions are some of those reached in Statement of Financial Accounting Concepts No. 1. As the Board stated, these statements "are intended to establish the objectives and concepts that the Financial Accounting Standards Board will use in developing standards of financial accounting and reporting". How successful the Board will be in the approach adopted remains to be seen.