Accounting Theory

Jesus Obana, CPA

Accounting
Theory:
Concepts,
Assumptions and
Principles

Accounting concepts and principles are a set of

broad conventions that have been devised to
provide a basic framework for financial reporting.
As financial reporting involves significant
professional judgments by accountants, these
concepts and principles ensure that the users of
financial statements are not misled by the
adoption of accounting policies that go against
the spirit of the accountancy profession.
Accountants must actively consider whether the
accounting treatments adopted are consistent
with the accounting concepts and principles.

Qualitative Characteristics of Useful Financial

Information

The qualitative characteristics

of useful financial information
identify the types of
information that are likely to be
most useful to users in making
decisions about the entity on
the basis of the information in
the financial report
The qualitative characteristics
apply equally to financial
information in general purpose
financial statements as well as
to information provided in
other ways

Financial information is useful when

it is relevant; and

it has representational
faithfulness

The usefulness of financial

information is enhanced if it is:

comparable;

verifiable;

timely; and

understandable

Fundamental Qualitative Characteristics

Relevance

Financial information is
relevant if it is capable of
making a difference in the
decision by users
Information is capable of
making a difference if:

it has predictive value;

confirmatory value; or

both

Predictive and Confirmatory

value are interrelated

Examples:

A company discloses an
increase in EPS from $5 to $6
since the last reporting period

A default by a customer who

owes $1000 to a company
having a net assets of $10M

Materiality is an entity specific

aspect of relevance based on the
nature or magnitude of the items to
which the information relates in the
context of the entitys financial
report

Fundamental Qualitative Characteristics

Faithful representation

General purpose financial

reports represent economic
phenomena in words and
numbers to be useful

Financial information must not

only be relevant but it must
also represent faithfully the
phenomena it purports to
represent

It seeks to maximize the

underlying characteristics of
completeness, neutrality and
freedom from error

Example:

A machine leased to Company

A for the entire duration of its
useful life. Although Company
A is not the legal owner of the
machine, it may be able to
recognize an asset in its
balance sheet since the
company has control over the
economic benefits

Enhancing Qualitative Characteristics

Comparability

Information about a reporting

entity is more useful if it can be
compared with

similar information about

other entities; and
similar information about the
same entity for another
period or date

Comparability enables users to

identify and understand
similarities and differences
among items

Example:

A company that valued its

inventory on the basis of FIFO
method in the past, must
continue to do so in the future
to preserve consistency in
reported inventory balance

Enhancing Qualitative Characteristics

Verifiability

Helps to assure users that

information are faithfully
represented
It means that different
knowledgeable and
independent observers could
reach consensus, although not
in complete agreement, that a
particular depiction is a faithful
representation

Examples:

If a company tells you that total

revenue is $200k, total costs is
$125k and profit is $75k, the
math is verifiable

If a company tells its

shareholders that it is strong
because the revenue increased
by 25% last year, that claim can
be tested for verifiability

Enhancing Qualitative Characteristics

Timeliness

This means that information is

available to decision-makers in
time to be capable of
influencing their decisions

Timeliness ensures that the

financial decisions of users are
based on up to date
information

It is achieved by reporting
financial performance and
conditions with sufficient
regularity (i.e. quarterly,
semiannually, or annually)

Unreasonable delay in financial

reporting must be avoided

Examples:

In most jurisdictions,
regulatory agencies impose
restrictions on the number of
days that companies may take
to issue F/S to the public

It is emphasized in IAS 10
Events after the Reporting
Period - requires entities all
significant post balance sheet
events up to date of issue of F/S

Enhancing Qualitative Characteristics

Understandability

Classifying, characterizing and

presenting information clearly
and concisely make it
understandable
While some phenomena are
inherently complex and
difficult to understand,
excluding such information
would make F/S incomplete
and potentially misleading
F/S are prepared for users with
reasonable knowledge of
business and economic
activities

Example:

The F/S of ENRON contained

very complicated structure of
special purpose entities that
were presented in a manner
that concealed the financial
risk exposure of the company

The accounting treatments

were not comprehensible by
the capital market participants
who consistently overvalued its
stock price until its collapse in
2001

Applying the Enhancing Qualitative

Characteristics

The enhancing characteristics

should be maximized to the
extent necessary

The enhancing characteristics

CANNOT render information
useful if that information is
irrelevant or not represented
faithfully

The Cost
Constraint on
Useful Financial
Reporting

Cost is a pervasive constraint on the information

that can be provided by general purpose
financial reporting.
Reporting information imposes costs and those
costs must be justified by the benefits of
reporting that information.
The IASB assesses costs and benefits in relation
to financial reporting generally, and not solely in
relation to individual reporting entities.

Underlying
Assumption:
Going Concern

The going concern principle is the assumption

that an entity will continue in operation
indefinitely.
If this presumption is not valid, disclosure and a
different reporting basis of reporting is required
(i.e. breakup basis - a F/S based on net
realizable value).

Possible Indications of Going Concern

Problems

Deteriorating liquidity position

not backed by sufficient
financing arrangements

High financial risks arising from

increased gearing level (i.e. high
debt to equity ratio) rendering
the company vulnerable to loan
and interest payment delays

Significant trading losses

incurred for several years

Aggressive growth strategy not

back by sufficient finance leads to overtrading

Increasing level of short-term

borrowing and overdraft not
supported by increased
business
Inability to maintain liquidity
ratios as per loan covenants
Serious litigations faced by a
company which does not have
financial strength to pay the
possible settlement
Inability to develop a new
range of commercially
successful products
Bankruptcy of a major
customer

Concept of Capital

Main concepts of capital

financial capital - states that

capital is synonymous with
the net assets or equity of the
entity

physical capital - states that

capital is regarded as the
operating or productive
capacity of the entitys assets

The selection of appropriate

capital concept by an entity
should be based on the need of
the users of its F/S

Financial capital concept is

used if users are primarily
concerned with the
maintenance of nominal
invested capital or the
purchasing power of invested
capital
Physical capital concept is used
if users are mainly concerned
with the operating capability of
the entity
The concept of capital chosen
designates the goal to be
attained in determining profit

Concept of Capital Maintenance

Main concepts of capital

maintenance

financial capital maintenancestates that profit is earned

only if the financial (i.e.
invested money) amount of

* Any distributions to, contributions

the net assets at the end of
from owners should be excluded
period exceeds the net assets
The IASB would consider
at beginning of period *
revising the capital
physical capital - states that
maintenance if it were to carry
profit is earned only if the
out future work on accounting
physical productive capacity
for high inflation
or operating capability of the
assets at end of period
exceed that of the beginning
of period *

All rights reserved. 2016

CONTACT INFORMATION:
JESUS OBANA, CPA
Office: BS047
Ext. 5216
Email: jesus.obana@hct.edu.om
www.hct.edu.om
https://om.linkedin.com/in/jesusobana

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