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 accountant’s
actions in identifying,
measuring, and
communicating economic
information.”
173
5-3
Structure of Accounting Theory
Formal Approach
Accounting theory provides a logical
framework for accounting practice.
5-4
Structure of Accounting Theory
Formal Approach
Accounting theory provides a logical
framework for accounting practice.
ASSUMPTIONS
5-5
Structure of Accounting Theory
Formal Approach
Accounting theory provides a logical
framework for accounting practice.
PRINCIPLES
ASSUMPTIONS
5-6
Structure of Accounting Theory
Formal Approach
Accounting theory provides a logical
framework for accounting practice.
RULES
PRINCIPLES
ASSUMPTIONS
5-7
Structure of Accounting Theory
Informal Approach
Accounting
Theory
Accounting theory is somewhat like a cloud, i.e. not well-defined.
5-8
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.
5-9
Business Entity “Idea”
Each business has an
identity separate from its
owners.
 The business is the
accounting entity.


Financial statements report
only the activities, resources,
and obligations of that
business.
5-10
Going-Concern

In the absence of evidence to the
contrary, we assume that a
business will continue to exist
indefinitely.


For example, a company is more
likely to acquire long-term assets if
it can assume that the company will
continue to exist indefinitely.
It is fundamental to the matching
principle.
5-11
MONEY MEASUREMENT

Business entities measure economic
events and transactions in monetary
units.

In the United States, the unit of
measurement is the dollar.
5-12
Stable Dollar or
Stable Monetary Unit
5-13
Stable Dollar or
Stable Monetary Unit

Assumes that the dollar maintains a
relatively stable value.

In countries with high inflation, this
assumption may not be valid.
5-14
Stable Dollar or
Stable Monetary Unit

Assumes that the dollar maintains a
relatively stable value.


In countries with high inflation, this
assumption may not be valid.
Accountants do not adjust the
accounts for the changing value of
the dollar (i.e., inflation)
5-15
Periodicity

Continuous business activity is divided
into arbitrary time periods as exemplified
by this time line.

Business activity is best reported in
annual, quarterly or monthly 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
 Requires
that a company use the same
accounting principles from one period
to the next. It does not require that all
companies use the same principles.
 A change from one acceptable
accounting principle to another must
be disclosed in the notes to the
financial statements.
5-19
Other Basic Ideas
Double-Entry Bookkeeping
Every transaction will have both a debit
effect and a credit effect on the primary
financial statements.
Total debits must equal total credits.
Articulation
The primary financial statements are
fundamentally related to each other
as shown on page 19.
5-20
Major Principles/Ideas
Exchange-Price or
Historical Cost
Matching
Revenue Recognition
Expense Recognition
Gain and Loss
Recognition
Full Disclosure
5-21
Major Principles/Ideas
Exchange-Price or
Historical Cost
Matching
Revenue Recognition
Expense Recognition
Gain and Loss
Recognition
Full Disclosure
All transactions
are recorded at
their historical
cost at the time of
the transaction.
5-22
Major Principles/Ideas
Exchange-Price or
Cost
Matching
Revenue Recognition
Expense Recognition
Gain and Loss
Recognition
Full Disclosure
The most
important
principle. It
provides the basis
for accrual
accounting.
5-23
Major Principles/Ideas
Exchange-Price or
Historical Cost
Matching
Revenue Recognition
Expense Recognition
Gain and Loss
Recognition
Full Disclosure
Revenues are
recorded when
they are earned
(i.e., realized).
When does this
happen?
When title passes.
5-24
Exceptions to
Revenue Recognition Principle
Cash basis of revenue recognition
Installment basis of revenue recognition
(Need only know concept, not how to apply)
Percentage-of-completion basis of
revenue recognition
Revenue recognition at completion of
production
(Need only know concept, not how to apply)
180
181
5-25
Major Principles/Ideas
Exchange-Price or
Historical Cost
Matching
Revenue Recognition
Expense Recognition
Gain and Loss
Recognition
Full Disclosure
Expenses should
be recorded as
they are incurred
in the process of
earning revenues.
5-26
Major Principles/Ideas
Exchange-Price or
Historical Cost
Matching
Revenue Recognition
Expense Recognition
Gain and Loss
Recognition
Full Disclosure
The rules are
different for
recognition of
gains and losses.
5-27
Gain and Loss Recognition

Gains are recognized/recorded at the
time they are realized.
For example, an increase in the value of land
cannot be recognized as a gain until the land is
actually sold.
5-28
Gain and Loss Recognition

Gains are recognized/recorded at the
time they are realized.
For example, an increase in the value of land
cannot be recognized as a gain until the land is
actually sold.

Losses are recognized when they
become apparent.
For example, a decrease in the value of
inventory would be recognized as a loss when
it becomes apparent.
5-29
Major Principles/Ideas
Exchange-Price or
Historical Cost
Matching
Revenue Recognition
Expense Recognition
Gain and Loss
Recognition
Full Disclosure
Disclose in the
financial
statements or
related notes, all
information
important enough
to influence a
stakeholder.
5-30
Cost-Benefit Consideration
Optional information should
be included in the primary
financial statements only if
the benefits of providing it
exceed the costs.
For example, providing a listing of
every sales transaction may be
interesting, but the cost of providing
that information to every shareholder
might bankrupt the company.
5-31
Materiality
An item is material if knowledge of the
item would affect the decision of an
informed user, therefore, this is a
somewhat nebulous concept.
 Material items must be reported.
 An item can be material either in amount
or in nature.

Materiality in amount is relative to the size
of the amounts on a company’s fin. stmts.
(e.g. $50,000,000 may not be material …)
5-32
Conservatism
Transactions should
be recorded so that
net assets and net
income are not
overstated.
Anticipate losses, but
do not anticipate
gains.
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Summary of Significant
Accounting Policies
 Appears
in the notes
to the financial
statements.
 Includes a
discussion of the
major accounting
policies.
5-34
Almost Finished
A good
framework
is the best
foundation.
5-35
Conclusion
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