THEORY OF ACCOUNTS

Framework of Accounting

The Accounting Standards Council defines accounting as follows:

1. Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature,
about economic entities, that is intended to be useful in making economic decision.

The Committee on Accounting Terminology of American Institute of Certified Public Accountants defines accounting as
follows:

2. Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money,
transactions and events which are in part at least of financial character and interpreting the results thereof.

The American Accounting Association in its Statement of Basic Accounting Theory defines accounting as follows:

3. Accounting is the process of identifying, measuring and communicating economic information to permit informed
judgment and decision by users of the information.

The accounting definition provides 3 important activities in the accounting process, namely:

a. Identifying
b. Measuring
c. Communicating

Identifying- the recognition or the non-recognition of “accountable” events. Not all business activities are accountable.

Economic activity- the measurement of economic resources and obligations. Emphasized and recognized in financial
accounting.

Two classifications of economic accounting

1. External Transactions or exchange transactions are those economic events involving one entity and another
entity.
2. Internal Transactions are economic events involving the entity only.

Production- the process by which resources are transformed into products.

Casualty- is any sudden and unanticipated loss from an act of God or act of nature.

Measuring- or measurement is the process of determining the monetary amounts at which the elements of the financial
statements are to be recognized and carried in the balance sheet and income statement. The measurement bases are
historical cost (most common), current cost, realizable value and present value.

Communicating- the process of preparing and distributing accounting reports to potential users of accounting
information.

Actually it is for this reason that accounting has been called the “language of business”

QUESTIONS & ANSWERS

1. Financial Accounting concerned with general-purpose reports on financial position and financial performance.
2. Financial accounting can be broadly defined as the area of accounting that prepares general purpose financial
statements to be used by parties both internal and external to the entity.
3. The primary focus of financial accounting has been on meeting the needs of present and potential creditors of
an entity.
4. Generally accepted accounting principles derived their credibility and authority from general recognition and
acceptance by the accountancy profession.
5. Generally accepted accounting principles have been developed on the basis of such factors as usage and
practical necessity.
6. Proper application of accounting principles is most dependent upon the professional judgment of the
accountant.
7. The process of establishing financial accounting standards is a social process which incorporates political actions
of various interested user groups as well as professional research and logic.
8. Once an accounting standards has been established the standard is continually reviewed to see if medication is
necessary.
9. As independent or external auditors, CPA’s are primarily responsible for expressing an opinion as to the fairness
of financial statements.
10. The singularly unique function performed by CPA’s is the attest function.
11. The purpose of the IFRS is to promote uniform accounting standards among countries of the world.
12. The IASB was formed to develop worldwide accounting standards.
13. In the framework as underlying assumption regarding financial statements are prepared under the accrual basis.
14. The accrual basis of accounting is based primarily on revenue realization and matching.
15. These are the implications of the going concern assumption:
 The historical cost principle is credible
 Depreciation and amortization policies are justifiable and appropriate.
 The current and noncurrent classification of assets and liabilities is justifiable and significant.
16. The relatively stable economic, political and social environment supports going concern.
17. Accounting period serves as the basis for preparing financial statements at regular intervals.
18. These are the important characteristics of the financial statements that accountants currently prepare:
 Financial statements articulate with one another because measuring financial position is related to
measuring changes in financial position.
 The information in financial statements is summarized and classified to help meet users’ needs.
 Financial statements can be justified only if the benefits they provide exceeds the costs.
19. REMEMBER:
 The accrual method, which builds directly on the revenue and matching principles, ignores the timing of
cash receipts or payments in determining when to recognize revenue or expenses.
 In the accordance with the going concern assumption, the life on the entity is presumed to be indefinite.
 Accountants prepare financial statements at arbitrary points in time during an entity’s lifetime in the
accordance with the accounting concept of the accounting period.
20. Whenever accounting is involved the concept of accounting entity is applicable.
21. In recognition of economic entity consolidated financial statements are prepared, when a parent and subsidiary
relationship exists.
22. The accounting concept of going concern made the valuation of a promise to receive cash in the future at
present value valid.
23. Going concern justifies the usage of accruals and deferrals.
24. In accordance with periodicity, accountants produce financial statements at arbitrary points in time during the
lifetime of an entity.
25. The Framework for the Preparation and Presentation of Financial Statements should define the basic objectives,
terms and concepts of accounting.
26. The Framework is intended to establish the objectives and concepts for use in developing standards of financial
accounting and reporting.
27. Board of Directors is an internal user of an entity’s financial information.
28. Information needs:
 All information needs of users cannot be met by financial statements.
  As investors are providers of risk capital to the entity, the provision of the financial statements that
meet their needs will also meet most of the needs of other users that financial statements can satisfy.
29. In residual equity classifying preference dividends as expense is applicable.
30. The entity’s primary objective is fair presentation of the financial performance of the entity.
31. The information provided by financial reporting pertains to individual business entities, rather than to industries
or an economy as a whole or to members of society as consumers.
32. Financial reporting will directly provide information about entity performance but not management
performance, during a period when an entity is under the direction of a particular management.
33. To qualify as “generally accepted”, an accounting principle must receive substantial authoritative support.
34. Under generally accepted accounting principles-- income and expenses, assets and liabilities are measured
based on the occurrence of changes in the economic resources and obligations.

Four Phases of Accounting

1. Recording
2. Classifying
3. Summarizing
4. Interpreting

35. Interpreting, the phase whereby the liquidity, solvency and profitability of an entity are significantly portrayed.

Four Types of Money Prices

1. Price in a current purchase exchange

2. Price in past purchase exchange
3. Price based on future exchange
4. Price in a current sale exchange

36. Price based on future exchange, the measurement which uses such concepts as present value, discounted cash
flow and value in use.

Qualitative Characteristics

 These are the qualities or attributes that make financial accounting information useful to the users.
 In deciding which information to include in financial statements, when to include it and how to present it, the
objective is to ensure that the information is useful to the users in making economic decisions.

The Framework’s 4 principal qualitative characteristics:

1. Relevance
2. Reliability
3. Understandability
4. Comparability

QUESTIONS & ANSWERS

1. Neutrality- the financial accounting information is directed toward the common needs of users and is
independent of presumptions about particular needs and desires of specific users.
2. Decision Usefulness is the overriding qualitative characteristics of accounting information.
3. True. Materiality of items depends on their individual or collective influence on the economic decisions of users.
4. Verifiability enhances the reliability of accounting information.
5. Historical cost has been the valuation basis most commonly used in accounting because of its reliability.
 6. Accounting inventory by applying the lower of cost or net realizable value is an example of the application of
conservatism.
7. Financial information exhibits consistency when accounting entities give similar events the same accounting
treatment each period.
8. The ability through consensus among measurements to ensure that information represents what it purports to
represent is an example of the concept of Verifiability.
9. Objectivity is assumed to be achieved when an accounting transaction involves an arm’s length transaction
between two independent parties.
10. Proponents of historical costs maintain that in comparison with all other valuation alternatives for general
purpose financial reporting, statements prepared using historical costs are more objective.
11. The consistency standard of reporting requires that the effect of changes in accounting upon income be properly
disclosed.
12. Consistency relates to both relevance and reliability.

Qualitative Characteristics of Relevance

 The relevance of information is affected by its nature and materiality.

 To be useful, information must be relevant to the decision-making needs of users
 The predictive and confirmatory roles of information are interrelated.
 Relevance is the capacity of the information to influence an economic decision.

Reliability of Information

 The information must represent faithfully the transactions it purports to represent.

 Transactions must be accounted for in accordance with their economic substance rather than legal form.
 The information must be neutral, that is, free form bias.
 The information must be complete within the bounds of materiality and cost.

13. Comparability. An important implication of this qualitative characteristics is that users are informed of the
accounting policies employed, changes in those policies and the effects of such changes.

Constraints on Relevance & Reliability

 In achieving a balance between relevance and reliability, the overriding consideration is how best to satisfy the
economic decision-making needs of users.
 The balance between benefit and cost is a pervasive constraint rather than a qualitative characteristics.
 In practice, a balancing or trade-off between qualitative characteristics is often necessary.

Statements Concerning Materiality

 Information is material if its omission and misstatement could influence the economic decisions of users taken
on the basis of the financial statement.
 Materiality depends on the relative size of the item or error judge in the particular circumstances of its omission
or misstatement.
 Materiality is a “quantitative threshold” linked very closely to the quantitative characteristics of relevance.
 Materiality is dependent on professional judgment because no threshold limit is defined in the framework or
accounting standard.

14. Corporate management is most likely to prepare the most accurate financial forecast for a corporate entity
based on empirical evidence.
Comparability of Financial Information

 For information to be useful, it is important that it can be compared with similar information of previous periods
or with that produced by another entity.
 For information to be comparable, it should be consistently prepared.
15. Allowing entities to estimate rather than physically count inventory at interim periods is an example of a trade-
off between timeliness and verifiability.
16. The most useful information to investors in predicting future cash flows is current earnings based on accrual
basis accounting.
17. Verifiability is the characteristic that is demonstrated when a high degree of consensus can be secured among
independent measures using the same measurement methods.
18. Neutrality means that there should be no attempt on the part of the preparers of financial reports to induce a
predetermined outcome of a particular mode or behaviour.
19. Cost-benefit constraint relates to both relevance and reliability.
20. The accrual basis of accounting is most useful for predicting the long-term financial performance on an entity.
21. The consistency standard of reporting requires that changes in circumstances or in the nature of the underlying
transactions should be disclosed.
22. Application of the full disclosure principle is demonstrated by the use of supplementary information presenting
the effects of changing prices.
23. An application of the principle of conservatism- an expected loss on a long-term construction-type contract is
recognized in full immediately.
24. The conservative approach in the measurement of financial position is best illustrated when the inventory is
measured at cost or net realizable value, whichever is lower.

Standard Adequate Disclosure

 Financial accounting information that meets the qualitative objectives of financial accounting also meets the
reporting standard of adequate disclosure.
 Adequate disclosure is concerned not only with the kind of information contained in financial statements
but also with the manner in which that information is presented.
 The disclosure standard calls for financial reporting of any financial facts significant enough to influence the
judgment of an informed reader of the statements.

The rule is that "the accountant shall disclose a material fact known to him which is not disclosed in the financial
statements but disclosure of which is necessary in order that the statements would not be misleading.”

RECOGNITION PRINCIPLES

Under the Framework, recognition means the process of reporting an asset, liability, income or expense on the face of
the financial statements of an entity.

Elements of the Financial Statements

-quantitative information shown in the statement of financial position and income statement

Elements directly related to the measurement of financial position:

a. Assets
b. Liabilities
c. Equity

Elements directly related to the measurement of financial performance:

d. Income
 e. Expense

QUESTIONS & ANSWERS

Statements Concerning Assets

 Physical form is not essential to the existence of an asset.

 An asset result from past event.
 There is a close association between incurring an expenditure and generating asset but two do not necessarily
coincide.

Statements Concerning Liability

 An essential characteristic of a liability is that the entity has a present obligation.

 An obligation may be legally enforceable as a consequence of a binding contract or statutory requirement.
 An obligation normally arises when the asset is delivered or the entity enters into an irrevocable agreement to
acquire the asset.

An expense is recognized immediately in the income statement either:

 When an expenditure produces no future economic benefits

 When cost incurred ceases to qualify for recognition as an asset in the balance sheet.

Measurement Attributes that are currently used in practice:

1. Present value
2. Net Realizable value
3. Current Replacement cost
 Inflation-adjusted cost

1. Present value is generally considered to be the most relevant financial attribute of assets.
2. Asset measurements in financial statements reflect several financial attributes.

Asset valuation bases that are considered current value measure

 Replacement cost
 Exit value
 Discounted cash flow

3. The primary measurement basis currently used to value assets in external financial statements of an entity is the
market price of the assets held by an entity at the date the assets were required.
4. According to GAAP, cash equivalent of asset given up or the asset received, whichever is more clearly evident is
an amount that an entity should measure its assets in the statement of financial position.
5. Net assets is another term for equity.

Consistent with generally accepted accounting principles as they relate to asset evaluation

 Assets are originally recorded at cost.

 Accountants assume that assets such as supplies, buildings and equipment will be used in the business
operations rather than sold.
 Accountants base asset valuation upon objective and verifiable evidence rather than on personal opinion.
 Subtracting total liabilities from total assets results in the current market value of an entity.
 6. One of the basic features of financial accounting is direct measurement of economic resources and obligations
and changes in them in terms of money.

Recognition of Revenue

 Revenue from recognition of services shall be recognized by reference to the stage of completion of the
transaction at the end of the reporting period.
 Royalty revenue shall be recognized on an accrual basis in accordance with the substance of the relevant
agreement.
 Dividend revenue shall be recognized when the shareholder’s right to received payment is established.
 Interest revenue shall be recognized on a time proportion basis that does not take into account the effective
yield on the asset.

7. In elements of financial performance, revenues are inflows or other enhancements of assets or settlements of
liabilities form ongoing major or central operation.
8. According to the Framework, the term income includes gain resulting from the sale of a productive asset to
another party in an arm’s length transaction.
9. The revenue principle states that revenue shall be recognized at a point when an exchange transaction involving
goods and services has occurred and the earning process is essentially complete.
10. Normally, revenue is recognized when the title to the goods changes.

Depending on the nature of the entity, revenue may be recognized based on different acceptable criteria. The following
are the acceptable basis for recognition of revenue:

 Passage of Time
 Performance of Service
 Completion of percentage of a project
 Upon signing of contract
11. The revenue must be earned, measurable and collectible – condition for the recognition of the revenue.
12. Under the general rule on revenue recognition, revenue is recognized when the earning process is complete and
a valid promise of payment has been received.

These are the methods for determining the stage of completion of the contract involving the rendering of the services:

 Costs incurred to date as a percentage of the estimated total costs of the transaction
 Survey of work performed
 Services performed to date as a percentage of the total services to be performed under the contract
 Advances received to date as a percentage of the total amount receivable

13. The installment method of recognizing revenue should be used only in cases in which no reasonable basis exists
for estimating the collectability of receivables.
14. When using the installment sales method total revenue and costs are recognized at the point of sale, but gross
profit is deffered in proportion to the cash that is uncollected from the sale.
15. The cost recovery method is used only when circumstances surrounding a sale are so uncertain that earlier
recognition is impossible.