Accounting Theory

ACCT 202 – Theory and Concepts of

Accounting – Islamic Perspective
 Introduction
• Various accounting theory exist and non of them is
overall generally accepted.
• Various valuation alternatives available, historical cost
one of them.
Why not taught earlier?
Measurement
• Accounting theories might have confused and made it Accounting
Valuation
Capitalfor
Maintenance
alternative
change in prices

more difficult to assimilate/understand basic rules of

accounting.
• Theory taught in a vacuum is counter productive for
students.
 General accounting theory
• Accounting theories exist, their purpose is to broaden accountants’ thinking and not
to confuse.
• Reason for discussion is to explore the ideas and identify weaknesses in the current
accounting. Some will agree, others may not.
• Accounting theory provides a general frame of reference to judge accounting
practices.
• It guides the way to development of new practices and procedure.
• There have been multiple attempts for development of generally accepted accounting
theory.
1. Inductive Approach
2. Normative Approach
 Approaches to accounting theory
Inductive Approach:
• This practice of accountants were observed and analysed to detect a consistent behaviour
• The theory was developed with a hope that a general principle and everyone can apply it.
• The approach failed.
Normative Approach:
• This approach is aimed at what accountant should do rather than what they are doing.
• It also included elements of inductive approach to derive rules based on logical
reasoning
The combination of these approaches has been promising but again, there has been a lack of
general agreement as to the objective of the accounting.
 Measurement of Income
There are some important questions that needs to be addressed:
• How can we measure wealth at the beginning and end of a period?
• How do we measure the change in wealth over a period?
• Having measured wealth over a period, how much can be available for
consumption and how much should not be consumed?
Sir John Hicks (The Nobel prize winner) expressed the view that profit was the maximum
value which a person could consume during a period and still be as well off at the end of
the period as at the beginning. What you have left after you subtract all your expenses
from your receipts is your ‘income’ (here income means “Net Profit”).
In terms of a limited company, the Sandilands Committee, which will be mentioned in
greater detail later, said that a company’s profit for the year is the maximum value which
the company can distribute as dividends during the year, and still be as well off at the end
of the year as it was at the beginning.
 Measurement of Income
There are two ways for measurement of wealth:
• by finding the values of the individual assets of a business and then subtracting
from them the value of the individual liabilities of the business;
• by measuring the expectation of future benefits.
However, the term ‘value’ is specifically important here.
• It is rather more than just the amount paid or the amount something is sold for.
Consider that, a water glass has more value in a desert than in city.
• Value of an item in accounting might be different from what you paid for.
• Various methods for valuation of assets are available.
 Assets Valuation Alternatives

There are various assets valuation alternatives

• Historical Cost
• Adjusted Historical Cost
• Replacement Cost
• Net Realizable Value
• Economic Value
• Deprival Value
 Capital Maintenance
• Capital maintenance is the method for measure of change in wealth from the start of a
period till the end of a period
• Money Capital Maintenance is one of a capital maintenance technique used frequently
and is acceptable to everyone when there is no price changes.
Example: If a business started with a value according to its financial statements of
£100,000 on 1st January 20X0 and finished with a value in its financial statements of
£170,000 on 31 December 20X0, it must have made a profit of £70,000.

Maintenance of specific
Money capital maintenance Real capital maintenance purchasing power of the capital of
the equity
 Capital Maintenance – Worked Example
A company has only equity share capital. Its net assets on 1 January 20X5 are £1,000, and
on 31 December 20X5 £1,400. There have been no issues or withdrawal of share capital
during the year. The general rate of inflation, as measured by the retail price index, is 10
per cent, whereas the specific rate of price increase for the type of goods in which the
company deals is 15 per cent. The profits for the three measures are as follows:
 Capital Maintenance – Worked Example
A company has net assets on 1 January 20X7 of £100,000 financed purely by equity share capital.
During 20X7 there has been no injection or withdrawal of capital. At 31 December 20X7 net assets
have risen to £115,000. Both the retail price index and the specific price index for the goods dealt
in have risen by 25 per cent. Taxation, based on traditional historical cost calculations
(maintenance of money capital), is at the rate of 40 per cent. The profit may be calculated as
follows.
 Operating capital maintenance concept
• It looks at the output which could be generated by the initial holding of assets
• A profit will only be made if the assets held at the end of the period are able to maintain
the same level of output.
A simple example of this is that of a newspaper seller who sells newspapers on a street
corner. The only costs the newspaper seller incurs are those of buying the newspapers. No
other products are sold and the newspaper seller has no assets apart from the newspapers.
In this case the operating capital consists solely of newspapers.
Under historical cost, a newspaper seller will recognise a profit if the revenue from the
sale of newspapers is greater than the historical cost of the newspapers. Using the
operating capital maintenance concept, the newspaper seller will recognise a profit only if
the revenue from the sale is greater than the cost of buying the newspapers to replace the
newspapers sold.
 Accounting for changing price levels

• Changes in price levels can lead to both profit and asset valuation figures being far from
reality if simple historical cost figures are used
• The greater the rate of change in price levels, the greater the distortion. The clamour for
changes to simple historical cost accounting is noticeably greater when the inflation rate
is high
Methods to adjust financial statements for changing price levels.
• Current purchasing power
• Current cost accounting
Current Cost Accounting

ACCT 202 – Theory and Concepts of

Accounting – Islamic Perspective
 Introduction
• Financial statements have traditionally been prepared for two main purposes,
stewardship and decision making.
• There are circumstances when financial statements prepared under historical cost
approach can present financial information in a misleading way (inflation not
accounted for)
Criticism on historical cost accounting:
• Inability to reflect the effects of changing prices.
• Degree of subjectivity involved.
Criticism on current cost accounting:
• One of the major difficulties with current cost accounting is the level of subjectivity
which can be involved in converting historical costs to current costs.
 Valuation under historical cost accounting
Assets can be evaluated by following:
• Economic value
• Deprival value
• Replacement cost
• Net realisable value
• Recoverable amount
There is important question how replacement cost determined by business?
Replacement cost of assets can be determined by:
• Using relevant indices
• Prepare its own index based on experience
Adjustments of current cost financial statements

In order to prepare current cost financial statements, a number of adjustments to the

historical cost figures must be made, specifically:
• Fixed assets
• Depreciation (It can be restated)
• Stock
• Cost of sales
• Monetary working capital and gearing
(Monetary assets and liabilities are not restated as these items have a fixed monetary
value which does not change)
Social Accounting

ACCT 202 – Theory and Concepts of

Accounting – Islamic Perspective
 Introduction
• Social accounting is concerned about the application of
social policies adopted by the organizations
• Policies adopted by an organizations impact the
environment and the organization itself.
Why business requires social accounting?
Social Actions
• To determine the social effects of company’s business Impact
Reporting
of Social
to Public
Actions
on environment
• Impact of activities taken by the business
 Costs and measurement
Problems to identifying Costs:
There are some important questions that need to be addressed;
• How employee loyalty and commitment to quality performance increase be
measured using objective and verifiable techniques?
• How can the benefits of controlling pollution from a factory be evaluated?
• Would they be better reported in qualitative or non-financial quantitative terms?
 Pressure for social action and accounting
Social Action:
• The existence of many environmental laws social action implementation pressure comes from the
pressure groups. These groups have an enormous impact on organizations profitability
• Organization need to be aware of their social responsibility particularly for the environmental issues
inherent to their activities and must be in a position to assess it
• They can only do so if they identify all variables both “Quantitative and Qualitative” and determine the
actions to take.
Social Accounting:
• It is concerned how to report upon applications social policies adopted by an organization
• An organization that does social accounting affectively will provide rich information to users
• It will be enhancing its ability to take decision appropriate for long term survival.
 Corporate social responsibility
• The reporting of non-financial information usually takes the form of narrative
disclosure, sometimes supported by a statistical summary
• It is non-mandatory, however, the comparison with other companies is difficult
• This environmental information usually includes details about the company’s waste
disposal practices, attitudes towards pollution and natural resource depletion, as well
as the overall corporate environmental policy
Difficulties in reporting:
• Most companies tend to report only good news
• Lack of standards governing what to include and how to report
Issue:
• On political agenda since the early 1980s and large corporations responded to public
demands for more information about ‘green issues’
 Types of social accounting
Social accounting can be divided into five general areas:
• National social income accounting.
• Social auditing
• Financial social accounting in profit-oriented organizations;
• Managerial social accounting in profit-oriented organizations;
• Financial and/or managerial social accounting for non-profit organizations.
 National social income accounting
• National social income accounts is in existence for many years.
• Measure of nation’s productivity recorded in accounts (in sales term) is called GNP
(Gross national product)
• Increase in GNP will indicate the betterment or progress in state of affairs existing in
the country and increase results because of the profit elements
• It includes profits generated from:
• Construction of plants by Constructors
• Paint, Woodwork by House paint dealers and carpenters
• Car Paintwork by Garages and Car paint manufacturer
 National social income accounting
As national income accounts do not record the ‘social’ well-being of a country, other
national measures have been proposed. The one most often mentioned is a system of
‘social indicators’. These measure social progress in such ways as:
• National life expectancies
• Living conditions
• Levels of disease
• Nutritional levels
• Amount of crime
• Road deaths
 Social auditing
• National social accounting measures national social progress. Many individuals and
organizations are interested in their own progress this form is called ‘Social Responsibility’.
• To identify activities to be measured, a ‘social audit’ is required, investigating:
(a) which of their activities contribute to, or detract from, being socially responsible;
(b) measurement of those activities;
(c) a report on the results disclosed by the investigation.

• Social audits can be carried out by organization staff or external auditor.

Examples of social activities are as follows:
• employment of women / disabled people
• occupational safety / health
• benefits at pensionable age
• air / water pollution
Financial social accounting in profit-oriented organizations

The objective is to either show how the social action have affected financial performance or
otherwise to put a social value on the financial statements
There are two types of social accounting:
1. Human resource accounting
The value may be determined by:
• Capitalizing recruitment and training costs of employees and apportioning value over
employees’ period of employment; or
• Calculating the ‘replacement cost’ of the workforce and taking this as the value of human
resources; or
• Extending either of the above to include the organization’s suppliers and customers
2. Compliance costs of statutory/professional requirements:
• The effects of organizations upon societies widely recognized, There will be more and more
regulation with which to comply the cost of compliance will obviously become a basic and
essential part of financial statement
 Managerial social accounting in profit-
oriented organizations
• The items described earlier have an effect upon the information systems of an
organization.
• They will have to be established on an ongoing basis, rather than be based purely on
adjustments
• The information will be used to affect the day-to-day decisions needed to run the
organization.
Financial and/or managerial social accounting for non-profit organizations

It is difficult for an organization to measure how well they are performing. Two approaches of
measurement is used:
Planning, programming, budgeting systems (PPBS)
• PPBS enables management of non-profit organisations to make decisions on a better informed
basis about the allocation of resources to achieve their overall objectives
• PPBS works in four stages:
 Review organizational objectives.
 Identify programmes to achieve objectives.
 Identify and evaluate alternative ways of achieving each specific programme.
 On the basis of cost/benefit principles, select appropriate programme.
Social programme measurement
• Government auditor would determine whether the agency had complied with the relevant laws
and exercised adequate cost control. Auditor would determine whether results expected were
being achieved