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.

Understanding the learning objectives

  • The major underlying assumptions or concepts of accounting are (1) business entity, (2) going concern (continuity), (3) money measurement, (4) stable dollar, (5) periodicity, and (6) accrual basis and periodicity. 
  • Other basic accounting concepts that affect the accounting for entities are (1) general-purpose financial statements, (2) substance over form, (3) consistency, (4) double entry, and (5) articulation. 
  • The major principles include exchange-price (or cost), revenue recognition, matching, gain and loss recognition, and full disclosure. Major exceptions to the realization principle include cash collection as point of revenue recognition, installment basis of revenue recognition, and the percentage-of-completion method of recognizing revenue on long-term construction projects. 
  • Modifying conventions include cost-benefit, materiality, and conservatism. 
  • The FASB has defined the objectives of financial reporting, qualitative characteristics of accounting information, and elements of financial statements. 
  • Financial reporting objectives are the broad overriding goals sought by accountants engaging in financial reporting. 
  • Qualitative characteristics are those that accounting information should possess to be useful in decision making. The two primary qualitative characteristics are relevance and reliability. Another qualitative characteristic is comparability. 
  • Pervasive constraints include cost-benefit analysis and materiality.  The FASB has identified and defined the basic elements of financial statements. 
  • The FASB has also described revenue recognition criteria and provided guidance as to the timing and nature of information to be included in financial statements. 
  • The summary of significant accounting policies aid users in interpreting the financial statements. 
  • To a large extent, accounting theory determines the nature of those policies.