Chapter 6

The structure of
accounting theory
 The structure of an accounting theory
The structure of an accounting theory contains the
following elements:
• a statement of the objectives of financial statements
• a statement of the postulates and theoretical concepts
of accounting, concerned with the environmental
assumptions and the nature of the accounting unit.
• a statement of the basic accounting principles
• a body of accounting techniques
 The going-concern postulate
• This postulate holds that the business entity will
continue its operations long enough to recognize
its projects, commitments and ongoing activities.
• The postulate assumes 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.
 The unit of measure postulate
• Accounting is a measurement and communication process
of the activities of the firm that are measurable in
monetary terms
• Limitations apply:
– accounting is limited to the provision/ prediction of
information expressed in terms of the monetary unit.
– accounting does not record or communicate other
relevant information
• Should units of money or units of general purchasing
power be used?
 The accounting-period postulate
•This postulate holds that financial
reports depicting changes in the
wealth of a firm should be disclosed
periodically.
•This postulate imposes accruals and
deferrals.
 The proprietary theory
• According to Coughlan, the entity is the
‘agent, representative or arrangement
through which the individual entrepreneurs
or shareholders operate’
• The proprietor group as the centre of interest
is reflected in the ways in which accounting
records are kept and financial statements are
prepared
 The entity theory
•This theory views the entity as
something separate and distinct from
those who provide capital to the entity
•This view sees the business unit,
rather than the proprietor, as the
centre of accounting interests
 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’
• Fund theory is useful primarily to
government and non-profit
organizations.
 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, costs and equities
• The cost principle is justified both in terms of
its objectivity and the going-concern
postulate:
–acquisition cost is objective, verifiable
information
–the entity will continue indefinitely, therefore
current values or liquidation values for asset
valuation are not necessary
 The revenue principle
The revenue principle specifies:
1.the nature and components of
revenue
2.the measurement of revenue
3.the timing of revenue recognition
 The nature and components of revenue
• An inflow of net assets resulting from the sale
of goods or services
• An outflow of goods or services from the firm
to its customers
• A product of the firm resulting from the mere
creation of goods or services by an enterprise
during a given period of time
 The measurement of revenue
• Measured in terms of the value of the products
and services exchanged in an arms-length
transaction
• Two interpretations:
–cash discounts and any reductions in the fixed
prices should be deducted when computing
revenue
–for non-cash transactions, the exchange value is
set equal to the fair market value of the
consideration given or received
 Timing of revenue recognition
According to the American Accounting
Association Committee on Concepts and
Standards, specific criteria for revenue and
income recognition are:
•it must be earned in one sense or another
•it must be in distributable form
•it must be the result of a conversion brought
about in a transaction between the
enterprise and someone external to it
•it must be the result of a legal sale or
similar process
 Timing of revenue recognition (cont’d)

•it must be severed from capital

•it must be in the form of liquid
assets
•both its gross and net effects on
shareholder equity must be
estimable with a high degree of
reliability
 The matching principle
• Expenses should be recognised in the same
period as the associated revenues
• The association between revenues and
expenses depends on one of four criteria:
1.direct matching of expired costs with a
revenue
2.direct matching of expired costs with the
period
3.allocation of costs over periods benefited
4.expensing all other costs in the period
incurred, unless they have future benefit
 The objectivity principle
• This principle holds that the usefulness of financial
information depends on the reliability of the
measurement procedure used
• There are different interpretations of this objectivity:
– an objective measurement is an impersonal measure
– an objective measurement is a very viable
measurement
– an objective measurement is the result of consensus
among a given group of observers
– the size of the dispersion of the measurement
distribution may be used as an indicator of the degree
of objectivity
 The consistency principle

• This principle holds that similar economic

events should be recorded and reported
in a consistent manner from period to
period
• The consistency principle makes financial
statements more comparable and more
useful
 The full-disclosure principle
•This principle holds that no
information of substance or of
interest to the average investor will
be omitted or concealed
•This principle is enforced by various
disclosure requirements within the
AASB and AAS standards
 The conservatism principle
• This principle holds that when choosing
between two or more acceptable
accounting techniques, some preference
is shown for the option that has the
least favourable impact on shareholders’
equity
• At present, the emphasis on objective
and fair presentation has lessened the
reliance on conservatism
 The materiality principle
• Transactions and events having
insignificant economic effects need
not be disclosed
• According to AAS 5, an item of
information is material ‘if its
omission, non-disclosure or mis-
statement would cause the financial
statements to mislead users when
making evaluations or decisions’
 Two basic criteria for determining
materiality
•The size approach relates the size
of the item to another relevant
variable such as net income
•The change criterion approach
evaluates the impact of an item
on trends or changes between
accounting periods
The uniformity and comparability approach
•This approach refers to the use of
the same procedures by different
firms
•The objective of this approach is
to achieve comparability of
financial statements by reducing
the diversity created by the use of
different accounting procedures
by different firms
 Principle supports for uniformity
Principal supports for uniformity are that it:
• reduces the diverse use of accounting
procedures and the inadequacies of
accounting practices
• allows meaningful comparisons of the
financial statements of different firms
• restores the confidence of users in the
financial statements
• leads to governmental intervention and the
regulation of accounting practices
 Principle supports for flexibility
Principal supports for flexibility are that:
• the use of uniform accounting procedures poses the
risk of concealing important differences among
cases
• comparability is a utopian goal that ‘cannot be
achieved by the adoption of firm rules that do not
take adequate account of different factual
situations’
• ‘differences in circumstances’ or ‘circumstantial
variables’ call for different treatments so that
corporate reporting can respond to circumstances
in which transactions and events occur