BABCOCK UNIVERSITY,

DEPARTMENT OF ACCOUNTING,
SCHOOL OF MANAGEMENT SCIENCES,
ILISHAN REMO, OGUN STATE

COURSE: ACCOUNTING THEORY

COURSE CODE: ACCT 313

LECTURER: Dr. Akinwunmi Abiodun

TOPIC: INTRODUCTION TO ACCOUNTING THEORY

DEFINITION OF ACCOUNTING THEORY

[1] Accounting theory can be defined as assumptions, methodologies, and framework used in
the study and application of financial 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 verified and added to the regulatory frameworks that
govern financial statements and financial reporting.

Accounting as a discipline has existed since the 15th Century. Since then both businesses
and economies have greatly evolved. Accounting theory is a continuously-evolving
subject, as it must adapt to new ways of doing business, new technological standards and
gaps that are discovered in reporting mechanisms. Organizations such as the International
Accounting Standards Board, Nigerian Accounting Standard Board help create practical
applications of accounting theory, and professionals such as CPAs, ACAs, ACCAs help
companies navigate accounting standards.

[2] Accounting theory can also be defined as a set of basic concepts and assumptions and
related principles that explain and guide the accountants actions in identifying,
measuring, and communicating economic information. Accounting theory provides a
logical framework for accounting practice.

Accounting theory includes:

a. Conceptual framework
b. Accounting legislation
c. Concepts.
d. Valuation models.
e. Hypotheses and theories.

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PURPOSES OF ACCOUNTING THEORY

[1] The central purpose of accounting is to make possible the periodic matching of cost
(efforts) and revenues (accomplishments).This concept is the nucleus of accounting
theory and a benchmark that affords a fixed point of reference for accounting discussion.

[2] To have better understanding over present and to forecasting or control our future.

[3] The Companies and Allied Matters Act (CAMA) 1990 empowers Chartered Accountants
as external auditors to examine financial statements to determine their objectivity and
fairness as well as their conformity to accepted accounting principle .In view of these,
Chartered Accountants have the onerous responsibility to the public in relation to the
reliability and credibility of any financial reports.

THE FRAMEWORK OF ACCOUNTING THEORY

OBJECTIVES OF FINANCIAL STATEMENTS

THE POSTULATES OF ACCOUNTING THE THEORETICAL CONCEPTS

OF ACCOUNTING

PRINCIPLES OF ACCOUNTING

ACCOUNTING TECHNIQUES

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POSTULATES OF ACCOUNTING

The accounting postulates are self-evident statements or axioms also generally accepted by virtue
of their conformity to the objectives of financial statements that portray the economic, political,
sociological and legal environments in which accounting must operate.

1. THE BUSINESS ENTITY POSTULATE

The entity postulate holds that each enterprise is an accounting unit separate and distinct from its
owners and other firms. The business is the accounting entity. Financial statements report only
the activities, resources, and obligations of that business. The postulate enables the accountant to
distinguish between business and personal transactions: the accountant is to report the
transactions of the enterprise, rather than the transactions of the enterprise owners. The entity
postulate applies to partnerships, sole proprietorships and small and large enterprises.

2. THE GOING – CONCERN POSTULATE

Going-concern postulate or continuity postulate holds that in the absence of evidence to the
contrary, a business will continue to exist indefinitely. It assumes either that the entity is not
expected to be liquidated in the foreseeable future or that the entity will continue for an indefinite
period of time. A company is more likely to acquire long-term assets if it can assume that the
company will continue to exist indefinitely. Such a concept of stability reflects the expectation of
all parties interested in the entity. Thus, the financial statements provide a tentative view of the
financial situation of the firm and are only part of a series of continuous reports. Except for the
case of liquidation, the user will interpret the information as computed on the basis of the
assumption of the continuity of the enterprise. Accordingly, if an entity has a limited life, the
corresponding reports will specify the terminal data and the nature of the liquidation.

3. MONEY MEASUREMENT POSTULATE

A unit of measurement is necessary to account for the transactions of firms in a uniform manner.
In accounting, business entities measure economic events and transactions in monetary units
(e.g.US dollars, GB Pound and Nigeria Naira). The exchangeability of goods, services and
capital is measured in terms of money. The money measurement postulate holds that accounting
is a measurement and communication process of the activities of the firm that are measurable in
monetary terms. There will be a stable monetary unit if the currency 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 currency (inflation).

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4. PERIODICITY (ACCOUNTING PERIOD) POSTULATE

The accounting-period postulate holds that financial reports depicting changes in the wealth of
the firm should be disclosed periodically. 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.

THE THEORETICAL CONCEPT OF ACCOUNTING

The Proprietary Theory

According to the proprietary theory, the entity is the agent or representative through which the
individual entrepreneurs or shareholders operate. The viewpoint of the proprietor group as the
center of interest is reflected in the ways I which accounting records are kept and financial
statements are prepared. The primary objective of the proprietary theory is the determination and
analysis of the proprietor’s net worth. Accordingly, the accounting equation is:

Assets – Liabilities = Proprietor’s equity

In other words, the proprietor owns the assets and liabilities. If the liabilities may be considered
as negative assets, the proprietary theory may be said to be assets “centered” and consequently,
statement of financial position (Balance sheet) oriented. Assets are valued and statements of
financial position are prepared to measure the changes in the proprietary interest or wealth.

The Entity Theory

The entity theory views the entity as something separate and distinct from those who provide
capital to the entity. Simply stated, the business unit, rather than the proprietor, is the center of
accounting interest. The business unit owns the resources of the enterprise and is liable to both
the claims of the owner and the claims of the suppliers (creditors). Therefore, the accounting
equation is:

Assets = Equities

Assets = Liabilities + Shareholders’ Equity

From the equation, both the creditors and the shareholders are equity holders, although they have
different rights with respect to income, risk control and liquidation. Thus income earned is the
property of the entity until it is distributed as dividend to the shareholders. Because the business
unit is held responsible for meeting the claims of the equity holders, the entity theory is said to
be “income centered” and consequently income statement oriented.

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The Fund Theory

Under the fund theory, the basis of accounting is neither the proprietor nor the entity, but a group
of assets and related obligations and restrictions, called “a fund”, that governs the use of the
assets. Thus, the fund theory views the business unit as consisting of economic resources (funds)
and related obligations and restrictions regarding the use of these resources. The accounting
equation is:

Assets = Restrictions of Assets

The accounting unit is defined in terms of assets and the uses to which these assets are
committed. Liabilities represent a series of legal and economic restrictions on the use of the
assets. The fund theory is therefore asset-oriented in the sense that its primary focus is on the
administration and the appropriate use of the assets. The fund theory is useful primarily to
government and nonprofit organizations. Hospitals, university, governmental agencies for
example are engaged in multifaceted operations that warrant separate funds.

THE ACCOUNTING PRINCIPLES

The accounting principles are general decision rules derived from both the objectives and the
theoretical concepts of accounting, that govern the development of accounting techniques.

ACCOUNTING PRINCIPLES

COST REVENUE MATCHING

RECOGNITION

ACCOUNTING
PRINCIPLES

CONSISTENCY FULL DISCLOSURE

UNIFORMITY
AND
COMPARABILITY

CONSERVATISM MATERIALITY

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1. THE COST PRINCIPLE: According to the cost principle, the acquisition cost or historical
cost is the appropriate valuation basis for recognition of the acquisition of all goods and services,
expenses and equities. In other words, an item is valued at the exchange price at the date of
acquisition and it’s recorded in the financial statements at that value.

Cost-Benefit Consideration: Also, 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.

2. THE REVENUE PRINCIPLE: Revenue results from the sale of goods and the rendering of
services and is measured by the charge made to customers, clients or tenants for goods and
services furnished to them. It also includes gains from the sale or exchange of assets (other than
stock in trade), interest and dividends earned on investments, and other increases in the owners’
equity except those arising from the capital contributions and capital adjustments.

Revenue Recognition: the revenue principle requires that revenue should only be earned when
the revenue has been realized. For revenue to be realized, two conditions must be met:

(a) The earning process of the revenue is essentially complete and

(b) there is an objective evidence as to the amount of revenue earned. Such objective evidence
includes the price billed to a customer.

There are four exceptions to revenue recognition.

a. Cash basis of revenue recognition.

b. Installation basis of revenue recognition (need only to know concept, not how to apply)
C. Percentage-of-completion basis of revenue recognition
d. Revenue recognition at completion of production (need only to know concept, not how to
apply).

3. THE MATCHING PRINCIPLE: This is the most important principle because, it provides
the basis for accrual accounting concept. The principle holds that expenses should be recognized
in the same period as the associated revenues. Revenues are recognized when they are earned
meaning when title passes. Expenses should be recognized as they are incurred in the process of
earning revenues. 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 .e.g. a decrease in the value of inventory would be
recognized as a loss when it becomes apparent.

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4. THE CONSISTENCY PRINCIPLE: Consistency principle holds that similar economic
events should be recorded and reported in a consistent manner from period to period. This
implies that a company uses the same accounting principles from one period to the next. All
companies do not use the same principles. Application of the consistency principle makes
financial statements more comparable and more useful. The consistency principle does not
preclude a firm from changing accounting principle when this is justified by changing
circumstances, or if the alternative principle is preferable (the rule of preferability). However, a
change from one acceptable accounting principle to another must be disclosed in the notes to the
financial statements.

5. THE FULL DISCLOSURE PRINCIPLE: There is a general consensus in accounting that

there should be “full” “fair” and adequate disclosure of accounting data. Full disclosure principle
requires that financial statements be designed and prepared to portray accurately the economic
events that have affected the firm for the period and to contain sufficient information to make
them useful and not misleading to the average investors. More explicitly, the disclosure principle
implies that no information of substance should or of interest to the average investor will be
omitted or concealed. Disclosure in the financial statements or related notes are information
important enough to influence a stakeholder.

6. THE CONSERVATISM PRINCIPLE: The conservatism principle holds that when

choosing among two or more acceptable accounting techniques, some preference is shown for
the option that has the least favourable impact on the shareholders’ equity. More specifically, the
principle implies that the lowest values of assets and revenues and the highest values of liabilities
and expenses should be reported which means that transactions should be recorded so that net
assets and net income are not overstated. You must anticipate losses, but do not anticipate gains.
The conservatism principle therefore dictates that the accountant displays a generally pessimistic
attitude when choosing accounting techniques for financial reporting.

7. THE MATERIALITY PRINCIPLE: The principle holds that transactions having

insignificant economic effects may be handled in the most expeditious manner whether or not
they conform to the Generally Accepted Accounting Principles (GAAP), and need not be
disclosed. An individual item should be judged material if the knowledge of the item could
reasonably be deemed to have influence on the users of financial statements. That is, an item is
material if knowledge of the item would affect the decision of an informed user. Therefore, this
is a somewhat nebulous concept (nebulous-lacking definite form). Material items must be
reported. An item can be material either in amount or in nature. Materiality in amount is relative

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to the size of the amounts on a company’s financial statements. (N50,000,0000 may not be
material in a company of balance value of N10trillion).

8. THE UNIFORMITY AND COMPARABILITY PRINCIPLE: The uniformity principle

refers to the use of the same accounting principles for related items by different firms over a
period of time. This is different from the consistency principle discussed above, which refers to
the use of the same accounting principles for related item by a given firm. The desired objective
of the uniformity principle is to achieve comparability of financial statements by reducing the
differences created by the use of different accounting principles by different firms. It can further
be explained as the system of adopting the same accounting system, principles and techniques in
the operations of the business transactions of a holding company and subsidiaries. The
performances through the profit and loss account and balance sheet should give opportunities for
comparison with companies in competition.

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ACCOUNTING THEORY AND POLICY MAKING

Bodies such as International Accounting Standard Board (IASB) and Nigerian Accounting
Standard Board (NASB), which are charged with making financial accounting rules, perform a
policy function. The policy function is also called standards setting or rule making and
specifically refers to the process of arriving at the pronouncements issued by the IASB, or the
NASB. The inputs to the policy-making function come from three main sources:

i. Economic factors,
ii. Political factors and
iii. Accounting theory.

The relationship between accounting theory and policy making must be understood within its
wider context as shown in the diagram below. Economic conditions have an impact on both
political factors and accounting theory. Political factors in turn, also have an impact on
accounting theory.

Economic Factors: The best example of economic factor is inflation, which is the reason for the
standard setting bodies to force the disclosure of information concerning price changes, and it is
a classic example of an economic condition that impinge on policy making. Another example of
an economic factor is the high rate of mergers and acquisitions.

Political Factors: The term “political factors” refers to the effect on policy making of those who
are subject to the resulting rules or regulations. In this category are auditors, who are responsible
for assessing whether the rules have been followed and the preparers of financial statements. In
addition the management of major firms and industry trade unions are important political
components of the policy-making process. Although it has been important to give voice to those
who are affected by accounting rule making, it should be remembered that political factors can
subvert the standard-setting process.

Once policy is made, accounting practice implements the policy, while users observe effects of
implementation.

Accounting Theory: Accounting theory is developed and refined by the process of accounting
research. Accounting professors are the primary producers of accounting research but many
individuals from policy-making organizations, public accounting firms, and private industry also
play an important role in the research process.

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 FINANCIAL ACCOUNTING ENVIRONMENT

ACCOUNTING POLITICAL ECONOMIC

THEORY FACTORS CONDITIONS

ACCOUNTING
POLICY MAKING

ACCOUNTING AUDIT
PRACTICE FUNCTION

USERS
OF ACCOUNTING
DATA AND REPORTS

HISTORY OF ACCOUNTING THEORY

Elements of the theory of accounting can be found as far back as the ancient civilizations of
Mesopotamia and Egypt. By the time of the Roman Empire, financial data was widely used, and
the government kept detailed financial records. Although elements of accounting can be found
much earlier, in 1494, Luca Pacioli created a system of accounting much like the one we know
and use today. This Italian mathematician, who is said to have taught math to Leonardo DaVinci,
started what's called the double-entry accounting system. He also introduced the use of ledgers,
journals and bookkeeping, key elements of modern accounting. Pacioli is known as the first
person to have used a balance sheet and income statement. Two chapters he wrote about
bookkeeping, known as "De Computis et Scripturis" ("Of Reckonings and Writings") and now
known as ‘The Method of Venice," changed the entire way accounting was seen and used.
Although, businesses and governments had been recording business information long before the
Venetians, Pacioli was the first to describe the system of debits and credits in journals and
ledgers that is still the basis of today's accounting systems.

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With the advent of the Industrial Revolution in the 1700s, more advanced cost accounting
systems became necessary. Corporations created large groups who were not part of a firm’s
management but had a vested interest in the company’s results. They were the first shareholders
and bondholders who provided external financing. For the first time, accounting became a
profession, first in the United Kingdom and then in the United States. And in 1887, 31
accountants created the American Association of Public Accountants. Ten years later, the first
standardized test for accountants was given. In 1896, the first CPAs were licensed. The history
and development of accounting theory took a new turn after the Great Depression, which led, in
1934, to the creation of the Securities and Exchange Commission. The SEC was created to help
the American public regain trust in the United States capital markets after the stock market crash
of 1929. After the SEC was established, all publicly traded companies were required to file
reports that were certified by accountants. This increased the necessity for and prestige of
accountants.

ACCOUNTING THEORY AND PRACTICE

There can be a difference between accounting theory and practice. While accounting procedures
are formulaic, accounting theory is more qualitative. It is used as a guide for effective accounting
and financial reporting, and that guide needs to be more flexible than mere formulas allow.

HOW ACCOUNTING EVOLVED

The Stock Market Crash of 1929 and the subsequent Great Depression were caused, in part, by
shady financial reporting practices by some publicly traded companies. To help set America on
the right path, the federal government began working with professional accounting groups to
establish standards and practices for consistent and accurate financial reporting. These came to
be known as Generally Accepted Accounting Principles or GAAP. The Securities Act of 1933
and the Securities Exchange Act of 1934 were two key pieces of legislation that led to the
formation of GAAP. These standards have evolved based on changing economic climates and
established best practices. Two key organizations in the accounting profession are The American
Institute of Certified Public Accountants, which was founded in 1887. It set accounting standards
until 1973 when the Financial Accounting Standard Board was established.

In the late 20th century, the accounting industry grew and thrived. Large accounting firms
expanded their services beyond the traditional auditing function and added on many forms of
consulting. However, this expansion sometimes led to unsavory places. As the responsibilities of
accountants expanded beyond that of financial watchdog, some accounting firms got embroiled
in corporate scandals. Arguably, the biggest scandal was the Enron scandal in 2001. This had
broad repercussions for the accounting industry. Arthur Andersen, one of the top U.S. accounting
firms, went out of business as a result of Enron. And the Sarbanes-Oxley Act tightened
restrictions on consulting opportunities for accountants. However, accounting scandals generate

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more work for accountants, which is a paradox of the profession. Demand for accounting
services continued to boom throughout the early part of the 21st century.

KEY ELEMENTS OF ACCOUNTING THEORY

An important aspect of accounting theory is usefulness. All financial statements should provide
important information that can be used to make informed business decisions. This also means
that accounting theory should be able to produce effective financial information, even when the
legal environment changes.

Accounting theory also states that all accounting information should be relevant, reliable,
comparable and consistent. This means that all financial statements need to be accurate. They

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should also adhere to the GAAP because this ensures the preparation of financial statements will

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 BABCOCK UNIVERSITY,
DEPARTMENT OF ACCOUNTING,
SCHOOL OF MANAGEMENT SCIENCES,
ILISHAN REMO, OGUN STATE

COURSE: ACCOUNTING THEORY

COURSE CODE: ACCT 313

LECTURER: Dr. Akinwunmi Abiodun

TOPIC: INTRODUCTION TO ACCOUNTING THEORY

DEFINITION OF ACCOUNTING THEORY

[1] Accounting theory can be defined as assumptions, methodologies, and framework used in
the study and application of financial 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 verified and added to the regulatory frameworks that
govern financial statements and financial reporting.

Accounting as a discipline has existed since the 15th Century. Since then both businesses
and economies have greatly evolved. Accounting theory is a continuously-evolving
subject, as it must adapt to new ways of doing business, new technological standards and
gaps that are discovered in reporting mechanisms. Organizations such as the International
Accounting Standards Board, Nigerian Accounting Standard Board help create practical
applications of accounting theory, and professionals such as CPAs, ACAs, ACCAs help
companies navigate accounting standards.

[2] Accounting theory can also be defined as a set of basic concepts and assumptions and
related principles that explain and guide the accountants actions in identifying,
measuring, and communicating economic information. Accounting theory provides a
logical framework for accounting practice.

Accounting theory includes:

a. Conceptual framework
b. Accounting legislation
c. Concepts.
d. Valuation models.
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be both consistent and comparable to a company's past financials, as well as the financials of
other companies.

Four main assumptions guide all accounting and financial professionals.

1. First, is that a business is separate from its owners.

2. The second affirms the belief that a company will not go bankrupt but will continue to
exist.
3. Third, all financial statements should be prepared with dollar amounts and not with other
numbers like unit production.
4. Lastly, all financial statements must be prepared on a monthly or annual basis.

THE FUTURE OF ACCOUNTING

As with almost all professions, technology is having a huge impact on accounting. A recent
survey by Accountancy Age asked 250 accountants and bookkeepers what the future might be
for the profession. Three things were predicted by those surveyed:

 First, that automation will take over tasks such as entering data, creating electronic
documents and producing receipts;

 Second, the cloud will change the way professionals store data, collaborate, and gather
information;

 Third, new developments in accounting software will have an impact.

While it may sound like these dire predictions will do away with the profession, 89 percent of
accountants surveyed said advances in technology are a real positive for the accountancy
profession and will create new opportunities for them. Seventy-five percent said the technology
they have started using already has either made their job easier or freed up time for them to
concentrate on adding further value for clients. For example, they can now spend more time
analyzing accounts and giving business advice.

Consequently, this means the skills used by accountants will never become useless or obsolete.
Those in the profession should continue to maintain their skills as well as keeping abreast of the
new skills that could be required by new tools. As an accountant, it is important to keep up with
developments in accounting technology and make sure you can adapt. The human brain and its
powers of analysis as seen in the field of accounting are now, and in the foreseeable future,
considered a necessity by business owners worldwide.

REVIEW QUESTIONS

1 Accounting theory provides a logical framework for accounting practice resting on

postulates, theoretical concepts, principles and techniques. Discuss

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2 Discuss the financial accounting environment with relevant diagram explaining the
interconnection of the various aspects of the environment.

3. State the purposes of accounting theory.

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