5-1

CHAPTER 5

ACCOUNTING THEORY
UNDERLYING FINANCIAL
ACCOUNTING

5-2

Accounting Theory Defined

. . . a set of basic concepts
and assumptions and related
principles that explain and
guide the accountants
actions in identifying,
measuring, and
communicating economic
information.
173

Structure of Accounting Theory

Formal Approach
Accounting theory provides a logical
framework for accounting practice.

5-3

Structure of Accounting Theory

Formal Approach
Accounting theory provides a logical
framework for accounting practice.

ASSUMPTIONS

5-4

Structure of Accounting Theory

Formal Approach
Accounting theory provides a logical
framework for accounting practice.

PRINCIPLES

ASSUMPTIONS

5-5

Structure of Accounting Theory

Formal Approach
Accounting theory provides a logical
framework for accounting practice.
RULES

PRINCIPLES

ASSUMPTIONS

5-6

Structure of Accounting Theory

Informal Approach

Accounting
Theory
Accounting theory is somewhat like a cloud, i.e. not well-defined.

5-7

Structure of Accounting Theory

Informal Approach
The terms "assumptions", "principles",
"rules", "concepts", "postulates",
"standards", etc. are used many different
ways in the profession.
Therefore, the authors' classification of
these terms is not important to us in this
course.

i.e., you do not have to understand the authors

theory structure - just know the meaning and
relevance of the items/ideas on the following
slides.

5-8

5-9

Business Entity Idea

Each
Each business
business has
has an
an

identity
identity separate
separate from
from its
its
owners.
owners.

The
The business
business is
is the
the
accounting
accounting entity.
entity.
Financial statements report
Financial statements report

only
only the
the activities,
activities, resources,
resources,
and
and obligations
obligations of
of that
that
business.
business.

5-10

Going-Concern

In
In the
the absence
absence of
of evidence
evidence to
to the
the

contrary,
contrary, we
we assume
assume that
that aa
business
business will
will continue
continue to
to exist
exist
indefinitely.
indefinitely.

For example, a company is more

For example, a company is more

likely
likely to
to acquire
acquire long-term
long-term assets
assets ifif
itit can
can assume
assume that
that the
the company
company will
will
continue
continue to
to exist
exist indefinitely.
indefinitely.

It
It is
is fundamental
fundamental to
to the
the matching
matching

principle.
principle.

5-11

MONEY MEASUREMENT

Business
Business entities
entities measure
measure economic
economic

events
events and
and transactions
transactions in
in monetary
monetary
units.
units.
In the United States, the unit of
In the United States, the unit of

measurement
measurement is
is the
the dollar.
dollar.

Stable Dollar or
Stable Monetary Unit

5-12

Stable Dollar or
Stable Monetary Unit

Assumes
Assumes that
that the
the dollar
dollar maintains
maintains aa

relatively
relatively stable
stable value.
value.

In countries with high inflation, this

In countries with high inflation, this

assumption
assumption may
may not
not be
be valid.
valid.

5-13

Stable Dollar or
Stable Monetary Unit

Assumes
Assumes that
that the
the dollar
dollar maintains
maintains aa

relatively
relatively stable
stable value.
value.

In countries with high inflation, this

In countries with high inflation, this

assumption
assumption may
may not
not be
be valid.
valid.

Accountants
Accountants do
do not
not adjust
adjust the
the

accounts
accounts for
for the
the changing
changing value
value of
of
the
the dollar
dollar (i.e.,
(i.e., inflation)
inflation)

5-14

5-15

Periodicity

Continuous
Continuous business
business activity
activity is
is divided
divided

into
into arbitrary
arbitrary time
time periods
periods as
as exemplified
exemplified
by
by this
this time
time line.
line.

Business
Business activity
activity is
is best
best reported
reported in
in

annual,
annual, quarterly
quarterly or
or monthly
monthly periods.
periods.

5-16

Other Basic Ideas

Substance Over Form

The substance of a transaction or
economic event is more important
than its legal form.

5-17

Other Basic Ideas

Substance Over Form

The substance of a transaction or
economic event is more important
than its legal form.

e.g., next semester, we will

study that even though parent
and subsidiary companies are
legally separate entities, GAAP
says that a set of consolidated
financial statements must be
prepared as if they were one
company, i.e., one economic
entity.

5-18

Other Basic Ideas

Consistency
Consistency

Requires
Requires that
that aa company
company use
use the
the same
same

accounting
accounting principles
principles from
from one
one period
period
to
to the
the next.
next. ItIt does
does not
not require
require that
that all
all
companies
companies use
use the
the same
same principles.
principles.

A
A change
change from
from one
one acceptable
acceptable
accounting
accounting principle
principle to
to another
another must
must
be
be disclosed
disclosed in
in the
the notes
notes to
to the
the
financial
financial statements.
statements.

5-19

Other Basic Ideas

Double-Entry
Double-Entry Bookkeeping
Bookkeeping
Every
Every transaction
transaction will
will have
have both
both aa debit
debit
effect
effect and
and aa credit
credit effect
effect on
on the
the primary
primary
financial
financial statements.
statements.
Total
Total debits
debits must
must equal
equal total
total credits.
credits.

Articulation
Articulation
The
The primary
primary financial
financial statements
statements are
are
fundamentally
fundamentally related
related to
to each
each other
other
as
as shown
shown on
on page
page 19.
19.

5-20

Major Principles/Ideas

Exchange-Price
Exchange-Price or
or

Historical
Historical Cost
Cost

Matching
Matching

Revenue
Revenue Recognition
Recognition

Expense
Expense Recognition
Recognition

Gain
Gain and
and Loss
Loss
Recognition
Recognition

Full
Full Disclosure
Disclosure

5-21

Major Principles/Ideas

Exchange-Price
Exchange-Price or
or

Historical
Historical Cost
Cost

Matching
Matching

Revenue
Revenue Recognition
Recognition

Expense
Expense Recognition
Recognition

Gain
Gain and
and Loss
Loss
Recognition
Recognition

Full
Full Disclosure
Disclosure

All
All transactions
transactions
are
are recorded
recorded at
at
their
their historical
historical
cost
cost at
at the
the time
time of
of
the
the transaction.
transaction.

5-22

Major Principles/Ideas

Exchange-Price
Exchange-Price or
or

Cost
Cost

Matching
Matching

Revenue
Revenue Recognition
Recognition

Expense
Expense Recognition
Recognition

Gain
Gain and
and Loss
Loss
Recognition
Recognition

Full
Full Disclosure
Disclosure

The
The most
most
important
important
principle.
principle. ItIt
provides
provides the
the basis
basis
for
for accrual
accrual
accounting.
accounting.

5-23

Major Principles/Ideas

Exchange-Price
Exchange-Price or
or

Historical
Historical Cost
Cost

Matching
Matching

Revenue
Revenue Recognition
Recognition

Expense
Expense Recognition
Recognition

Gain
Gain and
and Loss
Loss
Recognition
Recognition

Full
Full Disclosure
Disclosure

Revenues
Revenues are
are
recorded
recorded when
when
they
they are
are earned
earned
(i.e.,
(i.e., realized).
realized).
When
When does
does this
this
happen?
happen?
When
When title
titlepasses.
passes.

Exceptions to
Revenue Recognition Principle

Cash
Cash basis
basis of
of revenue
revenue recognition
recognition

Installment
Installment basis
basis of
of revenue
revenue recognition
recognition

(Need
(Need only
only know
know concept,
concept, not
not how
how to
to apply)
apply)

Percentage-of-completion
Percentage-of-completion basis
basis of
of

revenue
revenue recognition
recognition

Revenue
Revenue recognition
recognition at
at completion
completion of
of
production
production
(Need
(Need only
only know
know concept,
concept, not
not how
how to
to apply)
apply)
180

181

5-24

5-25

Major Principles/Ideas

Exchange-Price
Exchange-Price or
or

Historical
Historical Cost
Cost

Matching
Matching

Revenue
Revenue Recognition
Recognition

Expense
Expense Recognition
Recognition

Gain
Gain and
and Loss
Loss
Recognition
Recognition

Full
Full Disclosure
Disclosure

Expenses
Expenses should
should
be
be recorded
recorded as
as
they
they are
are incurred
incurred
in
in the
the process
process of
of
earning
earning revenues.
revenues.

5-26

Major Principles/Ideas

Exchange-Price
Exchange-Price or
or

Historical
Historical Cost
Cost

Matching
Matching

Revenue
Revenue Recognition
Recognition

Expense
Expense Recognition
Recognition

Gain
Gain and
and Loss
Loss
Recognition
Recognition

Full
Full Disclosure
Disclosure

The
The rules
rules are
are
different
different for
for
recognition
recognition of
of
gains
gains and
and losses.
losses.

5-27

Gain and Loss Recognition

Gains
Gains are
are recognized/recorded
recognized/recorded at
at the
the

time
time they
they are
are realized.
realized.

For
Forexample,
example, an
anincrease
increasein
in the
thevalue
valueof
ofland
land
cannot
cannot be
berecognized
recognizedas
asaagain
gainuntil
untilthe
theland
landis
is
actually
sold
actuallysold.
sold.
sold

5-28

Gain and Loss Recognition

Gains
Gains are
are recognized/recorded
recognized/recorded at
at the
the

time
time they
they are
are realized.
realized.

For
Forexample,
example, an
anincrease
increasein
in the
thevalue
valueof
ofland
land
cannot
cannot be
berecognized
recognizedas
asaagain
gainuntil
untilthe
theland
landis
is
actually
sold
actuallysold.
sold.
sold

Losses
Losses are
are recognized
recognized when
when they
they

become
become apparent.
apparent.

For
Forexample,
example, aadecrease
decrease in
inthe
the value
valueof
of
inventory
inventorywould
wouldbe
berecognized
recognizedas
asaaloss
losswhen
when
itit becomes
becomesapparent.
apparent.

5-29

Major Principles/Ideas

Exchange-Price
Exchange-Price or
or

Historical
Historical Cost
Cost

Matching
Matching

Revenue
Revenue Recognition
Recognition

Expense
Expense Recognition
Recognition

Gain
Gain and
and Loss
Loss
Recognition
Recognition

Full
Full Disclosure
Disclosure

Disclose
Disclose in
in the
the
financial
financial
statements
statements or
or
related
related notes,
notes, all
all
information
information
important
important enough
enough
to
to influence
influence aa
stakeholder.
stakeholder.

5-30

Cost-Benefit Consideration
Optional
Optional information
information should
should
be
be included
included in
in the
the primary
primary
financial
financial statements
statements only
only ifif
the
the benefits
benefits of
of providing
providing itit
exceed
exceed the
the costs.
costs.
For
Forexample,
example,providing
providing aalisting
listingof
of
every
everysales
salestransaction
transactionmay
maybe
be
interesting,
interesting,but
butthe
the cost
costof
of providing
providing
that
thatinformation
informationto
toevery
everyshareholder
shareholder
might
mightbankrupt
bankruptthe
the company.
company.

5-31

Materiality

An
An item
item is
is material
material ifif knowledge
knowledge of
of the
the

item
item would
would affect
affect the
the decision
decision of
of an
an
informed
informed user,
user, therefore,
therefore, this
this is
is aa
somewhat
somewhat nebulous
nebulous concept.
concept.

Material
Material items
items must
must be
be reported.
reported.

An
An item
item can
can be
be material
material either
either in
in amount
amount
or
or in
in nature.
nature.
Materiality
Materiality in
in amount
amount is
is relative
relative to
to the
the size
size
of
of the
the amounts
amounts on
on aa companys
companys fin.
fin. stmts.
stmts.
(e.g.
(e.g.$50,000,000
$50,000,000may
maynot
not be
bematerial
material)
)

5-32

Conservatism
Transactions
Transactions should
should
be
be recorded
recorded so
so that
that
net
net assets
assets and
and net
net
income
income are
are not
not
overstated.
overstated.
Anticipate
Anticipate losses,
losses, but
but
do
do not
not anticipate
anticipate
gains.
gains.

Summary of Significant
Accounting Policies
to
to the
the financial
financial
statements.
statements.

Includes
Includes aa
discussion
discussion of
of the
the
major
major accounting
accounting
policies.
policies.

pp.
195
-197

Appears
Appears in
in the
the notes
notes

5-33

5-34

Almost Finished

A good
framework
is the best
foundation.

y
a
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sk 86 (F ork
w to
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.
p a m c t)
Fr oje 95
f
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P p. ar y t
m can
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fi
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(S igni ntin .
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i
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5-35

Conclusion
Virtual Keypad Questions