Introduction to Financial Accounting Theory

An accounting theory is a notion that uses speculations, methodologies, and frameworks in the study of financial reporting (as well as how financial reporting principles are applied in the accounting industry). 

Basically, accounting theories serve as a basis for the understanding of financial reporting and how companies channel their financial statements using the appropriate strategies. 

Financial Accounting Theory

What Is Accounting Theory?

Accounting theory is a set of assumptions, frameworks, and methodologies used in the study and application of financial reporting principles. The study of accounting theory involves a review of both the historical foundations of accounting practices, as well as the way in which accounting practices are changed and added to the regulatory framework that governs financial statements and financial reporting.

KEY TAKEAWAYS

  • Accounting theory provides a guide for effective accounting and financial reporting.
  • Accounting theory involves the assumptions and methodologies used in financial reporting, requiring a review of accounting practices and the regulatory framework.  
  • The Financial Accounting Standards Board (FASB) issues generally accepted accounting principles (GAAP) which aim to improve comparability and consistency in accounting information.
  • Accounting theory is a continuously evolving subject, and it must adapt to new ways of doing business, new technological standards, and gaps that are discovered in reporting mechanisms.

How is Accounting Theory Used?

Accounting theories are basically the skeleton for accounting practices. That is, an accounting theory guides accounting practices. 

All accounting theories rest on the tenets or framework of accounting provided by the Financial Accounting Standards Board (FASB). This board is responsible for stating the acceptable practices of financial reporting as well as the key objectives of financial reporting. 

The FASB is an autonomous organization that oversees the preparation of financial statements by both private and public enterprises. 

Key Elements of Accounting Theory

There are some crucial elements in accounting theory that make it an indispensable framework for accounting practices. The key elements include the following;

  • Relevance – this is a crucial element of an accounting theory. Information provided by accounting theories is relevant in all aspects.
  • Usefulness – accounting theory is useful for the compilation of financial reports or statements. It helps corporate businesses make informed decisions as regards finance.
  • Reliability – an accounting theory is reliable. It follows the standards of generally accepted accounting principles (GAAP).
  • Consistency – is another key element of accounting theory.

Advantages

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.

A Better Approach to Accounting

It gives an accountant a better perspective in doing their work logically rather than mechanically.

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.

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.

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.

Easy Solution to Accounting Issues

A good understanding of accounting theory helps in finding solutions to specific problems encountered in accounting.

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.

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.

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:

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 into the records as soon as it is bought.

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.

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.

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.

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.

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 understanding the long-term financial results of the company difficult.

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