The theory of accounting revolves around strategies, assumptions, procedures, and frameworks associated with the study of financial reporting and implementations of financial reporting principles in the accounting industry.
Accounting is an integral part of a business. Accounting has been in use for a long time. What accounting theories try to achieve is a better understanding of how accounting works and how it has evolved over the years.
This understanding helps in organizing all the available knowledge of accounting from over the years. It allows the field to grow and get better with time. It is also used as a point of reference for future studies and theories.
This post will help you understand what the theory of accounting, its elements, concepts, and ways of using it in managing financial transactions is. So, let us get started right away-
What is the Theory of Accounting?
The theory of accounting acts as the basis for comprehending financial transactions, reporting, and channelization of financial statements of companies using the best-suited strategies.
An understanding of accounting concepts is an advantage for people in business and accountants.
It is a collection of principles, doctrines, and concepts of accountancy.
These came into being as a result of analyzing years of accounting practices.
As accounting evolved, it branched into two types of accounting. Let us have a look upon those-
2 Types of Accounting as per Accounting Theory
1. Financial Accounting
Financial accountants focus on providing reports on the performance of the business. Financial accountants’ reports are for an external audience.
2. Management Accounting
Management accounting is about providing reports to the top brass of the company’s management. Most of the company’s decisions are taken based on these reports. Management accountants’ reports are for a company’s internal audience.
After understanding two types of accounting, let us have a look upon the objectives of the theory of accounting-
Objectives of Accounting Theory
Different objectives fulfilled by the theory of accounting are-
- Evaluation and Explanation of Accounting Principles
- Simplifying Complex Phenomena
- Solving Problems Created by Different Scenarios
- Calculating the Effect of an Event on the Future Beforehand
- Predicting Future Events
- Helping the Investigation, Explanation, and Conclusion of an Event
Key Elements of Accounting
These are the pillars that accounting theory is built upon.
These are the results that accounting theory sets to achieve, and these are what all accounting theories are based on.
6 Principles of Accounting Theory
Some principles are called the basic principles of accounting theory.
These are basic rules for how accounting should be carried out in a right and organized manner. The six basic principles of accounting theory are:
1. Cost Principle
According to the cost principle of the accounting theory, all the assets should be recorded as soon as they are acquired, whatever the asset may be.
Even office supplies come under this. Every and any asset acquired should be entered in the records as soon as it is bought.
Some assets might depreciate over time. Their cost might differ at a later instance, but the recording of the acquisition must be done right away.
Recording the purchases helps keep the business expenses in track and well organized.
2. Matching Principle
As the name itself suggests, this principle considers all the transactions done under a particular type of revenue as a single unit.
It is basically about matching expenses with revenues.
This theory holds good only in the accrual method of accounting.
For example, wages of employees should be recorded as an expense when the employees worked and not when the employees are paid for the work done.
3. Materiality Principle
This principle expects that only monetary transactions that are completed are recorded.
Accountants should refrain from recording pending deals as they might eventually not work out in favor of the business. Also, non-monetary transactions can be included in reports but are excluded from actual data and financial details.
According to the materiality principle, recording an expense can be avoided if its impact on the books is small enough that a person reviewing the book is not misled.
An accountant should be careful when deciding what can be avoided and recorded, as there are no specific guidelines regarding this. This principle also depends on how big or small a business is.
If the business is a small one, even small amounts might make an impact on the budget.
A minor expense per month, when calculated for a year, might make a significant impact on the budget, and hence should be recorded.
A recurring expense that represents less than five percent of the budget need not be recorded as per the Securities and Exchange Commission.
4. Conservatism Principle
Liabilities have a significant impact on any business.
It is better to be on the lookout and record potential liabilities not to take the business by surprise.
The conservatism principle states that all the existing and potential liabilities must be recorded the instant they are recognized.
It will help the business keep an adequate amount of cash ready to pay out the debts.
It is the best way that a company can plan for future expenses.
5. Time-Period Principle
It is the concept that a business should report the results of its operation over a standard period.
It is aimed at creating a set of variables for comparison over time.
It is also useful in trend analysis.
6. Consistency Principle
This concept stresses that once a system of accounting has been decided upon, it should be followed in all the business transactions, and changes to this system are not acceptable.
This principle is in place so that the companies do not oscillate between different systems for recording transactions.
It will make the understanding of the long-term financial results of the company difficult.
3 Assumptions behind the Theory of Accounting is Based
1. Monetary Unit Assumption
This assumption impacts companies that have an international presence if the value of the dollar will remain consistent or go up or down in the time to come.
The anticipation of currency fluctuations can help if the company plans an expansion of business, acquisition of equipment of assets, or new investment opportunities.
2. Going Concern Assumption or Continuity Assumption
This accounting assumption assumes that a company will exist for a long time.
It assumes that the company will not go bankrupt.
It is based on this assumption that the company defers some expenses like depreciation.
Deferring the addition of these records to a later date can only happen when it is assumed that the company stays afloat at that later date.
3. Economic Entity Assumption
This assumption says that transactions of the company or business and the personal transactions of the owner or owners of the business must be maintained and recorded as two different entities.
The transactions entered into on behalf of the company should be recorded and maintained as an independent entity.
Any transaction the owner/s makes on their behalf is maintained as another independent entity.
Theory of Accounting Concepts
The theory of accounting works upon four different concepts that are used for specifying and explaining the guidelines important for account management of a business.
Let us go through them here and now-
1. Accruals Concept of Accounting Theory
It tells that the revenue from a transaction and transactions that result in liabilities are accounted for when they take place, even in the case when the cash or the property is not exchanged between associated entities.
For instance, if a wholesaler orders and receives 6 months worth of watches for $500 in January, then if he does not make payment for watches until February, he should record the $500 liability in January and should not wait until February, as he owns the watches and he is liable to make their payments.
Similarly, the supplier will be accounting for the sale of those watches to that wholesaler.
2. Consistency Concept
As per this concept, when one accounting method is applied, then the same one ought to be used through all the next periods of accounting purposes.
Your accounting method should only be changed if it is mandatory.
For instance, if an accountant starts using a double-entry accounting method in January, it is essential that he consistently applies that for the additional time of the accounting period. Without any valid reasons,
The consistency concept of the theory of accounting must be followed.
3. Going Concern Concept
While managing the accounts of a business, the accountant should assume that the business is viable and will be operational soon.
In case the accountant finds that the business won’t be functional in the future, he should state the precise reason behind this assumption in the financial report.
If the accountant feels that the business will not survive in the future, but he does not have enough proof for this opinion, he should share this as a disclaimer in the report.
4. Prudence Concept
As per this concept of the theory of accounting, liabilities should be accounted for in the balance sheet, even in a case, there is only a little chance for such liabilities to take place.
However, this concept also tells that revenues should be accounted for in the financial statements only in the case that the business comprises the title for those revenues, plus also has already got or will get cash or related assets in the future. And if there is any doubt or lack of legal base for revenue recognition, it should not be accounted for.
The prudence concept behind the theory of accounting helps in ensuring businesses make provisions for the potential losses as well, along with realized losses. Hence, the business won’t add revenues that are just anticipated but not earned actually.
Accounting theory aims at providing the following functions.
- To collect, represent, and store a business organization’s financial data.
- To supply information to be used for different types of financial reports and statements. To provide critical financial information on which the company’s strategic planning and decisions are based on.
- To provide the company with an effective method to control the efficient and accurate recording and processing of financial data.
The knowledge of a proper accounting theory has its benefits. It is in the best interest of accountants as it helps keep an organized, functional, accessible, and up to date record of the financial transactions that a company undertakes.
1. A Better Approach to Accounting
It gives an accountant a better perspective in doing their work logically rather than mechanically.
2. Increased Efficiency
Thorough knowledge of rules and principles increases the efficiency of an accountant. It is easier to figure out and record each transaction efficiently—time spent figuring out what goes where can be used more productively.
3. Easy Defect Detection
When you do something in an orderly way, and according to existing rules and principles, detecting a mistake in the process becomes more straightforward.
4. Helps in Choosing the Most Effective Method
There may be various methods for recording transactions that are prevalently in use. It is upon the accountant to choose the one most viable and functional for the company’s needs. Sound knowledge of the principles helps the accountant make the best choice available.
5. Easy Solution to Accounting Issues
A good understanding of accounting theory helps in finding solutions to specific problems encountered in accounting.
6. Better Fulfillment of Requirements
Accountants can understand client requirements better and provide better service to their clients if they have a good knowledge of accounting theory.
7. Justifiable Records
If the accountant understands accounting theory and has based his records on these principles, he will always justify his treatments based on the ground of logic.
A company is heavily dependent on its accounting system.
A reliable and efficient accounting system is crucial to the successful management, growth, and expansion of a business. The critical decisions of a company are based on the reports provided by the accounting department.
It is necessary for the people running the company and people outside the company or other companies who are interested in investing or doing business with the company.
Maintaining a reliable accounting system requires an astute knowledge of accounting theory. It is only apparent that accountants or anyone wanting to carry out a successful business know the nitty-gritty of accounting theory.
Now, after reading the whole post, what is your accounting theory definition? Share with us in the comments below.