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

Demonstration problem

For each of the following transactions or circumstances and the entries made, state which, if any, of the assumptions, concepts, principles, or modifying conventions of accounting have been violated. For each violation, give the entry to correct the improper accounting assuming the books have not been closed.

During the year, Dorsey Company did the following:

  • Had its buildings appraised. They were found to have a market value of USD 410,000, although their book value was only USD 380,000. The accountant debited the Buildings and Accumulated Depreciation - Buildings accounts for USD 15,000 each and credited Paid-in Capital - From Appreciation. No separate mention was made of this action in the financial statements. 
  • Purchased new electric pencil sharpeners for its offices at a total cost of USD 60. These pencil sharpeners were recorded as assets and are being depreciated over five years.

Solution to demonstration problem 

  • The cost principle and the modifying convention of conservatism may have been violated. Such write-ups simply are not looked on with favor in accounting. To correct the situation, the entry made needs to be reversed:
Paid-in Capital    30,000
Building   15,000
Accumulated Depreciation - Building    15,000 
  • Theoretically, no violations occurred, but the cost of compiling insignificant information could be considered a violation of acceptable accounting practice. As a practical matter, the USD 60 could have been expensed on materiality grounds.