Accounting Theory

Accounting Theory refers to a framework of concepts and ideations that facilitate the applications and development of financial accounting practices. It guides the manner in which accounting data can be used to make business decisions, and transactions can be reported and recorded in financial statements.

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Financial accounting theory contains methodologies, assumptions, and frameworks to guide the execution and examination of financial principles. Financial accounting theory and analysis have been used to develop consistent standards of financial reporting. Moreover, it also ensures that financial data remains reliable, comparable, and relevant across entities.

Accounting theory in the business world refers to complete knowledge that describes the logic behind the procedures and practices used by accountants. One can use it to explain the way in which financial accounting could be used to construct financial statements and the manner in which they may be used in decision-making regarding resource allocation. It encompasses multiple accounting frameworks that lay the foundation for evaluating and analyzing practices of financial accounting. The frameworks that it includes have been listed below:

• As per the approach of income, accounting is viewed as reporting and measuring economic activity.
• The approach of a balance sheet centers on the relation between equity, assets, and liabilities.
• Next, the approach of cash flow stresses the vitality of cash flows toward decision-making.
• Finally, the approach of value-added economics revolves around the creation of shareholder value.

All these frameworks offer a district perspective on comprehending practices of financial accounting laced with weaknesses and strengths. Therefore, any single theory of accounting cannot be taken as correct, so it takes many approaches to fulfill its given objectives:

• Explaining the purpose and nature of accounting
• Describing the basic principles and concepts of accounting
• Developing a suitable framework regarding financial reporting
• Guiding the implementation of principles of accounting

As a result of these objectives, it offers the benefits:

• Provide a guideline regarding comprehending financial statements and related financial reports.
• Helping accountants communicate with each other and understand each other's job.
• Helping accountants to develop tailored accounting practices per their needs.
• Lastly, it aids accountants in maintaining professional ethics and keeping up with modifications in their accounting careers.

Hence, the theory of accounting has the following impact:

• Shaping of financial reporting regulations and rules
• Provides frameworks to recognize, measure, disclose, present, deploy, and interpret financial information
• Making accounting practices align with economic realities
• Making financial statements useful to users

It has the following main types vital to the field of accounting:

1. Cost Principal Theory – It makes it mandatory to record transactions at only their original cost.
2. Matching Principal Theory: It is necessary to align expenses with revenue generation.
3. Full Disclosure Theory: It stresses the open disclosure of all material data to be reflected in the financial statements.
4. Relevance Theory: It ensures that all financial information is relevant in decision-making.
5. Reliability Theory: It insists that all financial information has to be trustworthy.
6. Positive Accounting Theory: It relates to a relatively young accounting discipline supported by empirical evidence.
7. Mental Accounting Theory: It concerns one’s cognitive bias, the ability to treat money distinctly according to its source or intended use.

Let us use a few examples to understand the topic.

Example #1

A green energy company called Greena, located in Old York City and led by Mindy, recently acquired hi-tech innovative equipment. The total cost of this purchase was $600,000. Hence, as per the theory of cost principle, its transaction is recorded at its real cost price of $600000 in Greena's financial records. Therefore, to align with the theory of the matching principle, Greena compares the expense of depreciation of $60000 every year with the profit generated by the hi-tech equipment.

Therefore, in the financial statements, Greena implements the theory of full disclosure by reporting an imminent lawsuit impacting its financial health and growth. Moreover, the relevance theory makes it possible that Greena's financial reports focus on revenue growth. It does so with the help of its latest eco-friendly products vital to the decision of the investor. Finally, Greena complies with the theory of reliability by offering verifiable and accurate data, such as sales data of $3 million from its new product line. Hence, in this manner, it ascertains and creates trust in stakeholders to believe its financial data.

Example #2

An online article published on February 14, 2022, discusses a comment letter penned by students of public accountancy admitted into ACCT 440: Accounting Theory and Research. The letter addresses the 9 proposed edits to the Financial Accounting Standards Board (or FASB)'s interim report standard as published on its website. The assistant professor led groups of students in researching relevant problems and recommended that the suggested guidelines be used by financial statement users. They also provided additional suggestions based on their findings.

Christopher Shepp, acting as primary editor, co-authored the letter with 15 students. Furthermore, FASB would analyze all comment letters, organize public meetings for discussion, and conduct polls on the proposed new standard. As such, the project gave students valuable hands-on experience in developing accounting standards.

There are many reasons why this theory becomes important, as shown below:

• It aids in adding logic to accountants' decision-making
• It facilitates the development of efficient accounting methodology within accountants
• Accounts can increase their efficiency by using it
• Ambiguity in practices of accounting can be reduced with its help
• It can logically justify the accounting practices
• It fosters planning and compliance related to economic laws and income tax
• It helps make the audit of accounts easier
• It plays a vital role in framing procedures and policies of accounting
• Interested parties can satisfactorily fulfill their informational needs in a better manner
• Accountants can come out of their dilemmas of choosing from various alternatives
• One can interpret and understand the accounting information from accounting documents in the best possible way.