Accounting theory

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Materials for the subject

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Materials for the subject

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 CONTENTS OF THE SUBJECT

Chapter 1: Overview of accounting

Chapter 2: Elements of financial

statements

Chapter 3: Accounting process

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 CHAPTER 1
OVERVIEW OF ACCOUTING

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 CONTENTS OF CHAPTER 1
1.1. The history of development of accounting

1.2. Approaches to accounting

1.3. The users of accounting information

1.4. Types of accounting

1.5. Accounting concepts and accounting principles

1.6. Requirements for accounting information 6

 1.1. The history of development of accounting

Understand A Brief Accounting History from Ancient Times to

Today 

• The Ancient History

• Roman empire

• Medieval Developments

• Modern professional accounting

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 THE ANCIENT HISTORY
• Accounting records dating back more than 7,000 years have been
found in Mesopotamia.
• The early development of accounting was closely related to
developments in writing, counting, and money. May be related to the
taxation and trading activities of temples.
• Other early accounting records were also found in the ruins of
ancient Babylon, Assyria and Sumer, which date back more than
7,000 years
• During the 2nd millennium BC,[12] the expansion of commerce and
business expanded the role of the accountant.
• By about the 4th century BC, the ancient Egyptians and Babylonians
had auditing systems for checking movement in and out of
storehouses, including oral "audit reports", resulting in the term
"auditor" 8
 ROMAN EMPIRE

• The scope of the accounting information at the

emperor's disposal suggests that its purpose
encompassed planning and decision-making
• Records of cash, commodities, and transactions were
kept scrupulously by military personnel of the 
Roman army

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 MEDIEVAL AND RENAISSANCE PERIODS

• Luco Pacioli is the father of accounting who introduced

Double Entry System of account in 1494 at Venice in Italy.
• Pacioli declares that a successful merchant needs three
things: sufficient cash or credit, good keepers and an
accounting system which allows him to view his finances
at a glance.
• Double entry book keeping was developed in the 14th
century in Italy.
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 MODERN PROFESSIONAL ACCOUNTING

• Modern Accounting is a product of centuries of

thought, custom, habit, action and convention.
• Two concepts have formed the current state of the
accountancy profession.
+ The development of the double-entry book-keeping
system.
+ Accountancy professionalization
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 MODERN PROFESSIONAL ACCOUNTING

• Institute of Chartered Accountants in England and

Wales, is established by royal charter in 1880
• In the United States the American Institute of
Certified Public Accountants was established in
1887.

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 1.1. The history of development of accounting

Min

Management

Max

Scarce/limited resources 13
 1.1. The history of development of accounting

• Accounting has formed due to the demand for

information of economic management

• Accounting is associated with specific business entity

• The characteristics of accounting information are:
past and quantitative

• Accounting has formed with arithmetic, writing and

currency
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1.2. Approaches to accounting

 Accounting as a management
tool

 Accountanting as a career

 Accounting as a social science

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 1.2.1. Accounting as a management tool

- Describe the economic management system?

- Identify the position, function of accounting in the economic
management system?
- Analysis of the influence of elements in the economic
management system to accounting?
Impact through economic
Economic management tools and measurements Economic
management management
subject object
Respond back through the information system

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 1.2.2. Accounting as a career

 Why accounting becomes a career?

 What are the factors that make up the accounting career?

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 1.2.2. Accounting as a career

 Accounting process:

Identification Measurement Recording Communication

Accounting
Accounting
Recording
Recording
Transactions Quantification
Quantification reports
reports
Transactions classification
classification
inin$$terms
terms Analysis
Analysis&&
summarisation
summarisation interpretation
interpretation

 The mode of existence of the accounting profession

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 1.2.3. Accounting as a social science

 Why accounting became a science and

when has it become a science?
 What are the elements of financial
Income
statement?
Equity Expense
 What are accounting methods?

Liability

Asset

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 1.2.3. Accounting as a social science

• What are the elements of financial statement?

Asset
Liability
Owner’s equity
Income
Expense

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1.2.4. What is accounting?

Process of identifying,
measuring, recording
& communicating
economic information
to permit informed
judgements and economic
decisions by users of the
information
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 Identification

 Identification involves observing economics events and

determining which of those events represent economic
activities related to a particular business
Economic events of an entity = Transactions
Two kinds of transactions:
 External transactions: involve transactions between one
entity and others
 Internal transactions: involve transactions within one entity

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 Measurement

 Measurement
 Definition: process of expressing assets of one
entity in terms of money
 Reasons:
 Assets with differently physical forms
 Needs of useful information; inventories, fixed
assets
 Unit of money: $ U.S, VND…

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 Recording

 Recording is the process of systematically maintaining a file of all

transactions which have affected the business entity after being identified
and measured

Recorded data must be classified and summarized

 Classification permits reduction of the effects of thousands of transactions

into more meaningful groups or categories

 Summarization of financial data is presented in financial statements

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 Communication

Communication is the process of preparing

and distributing accounting reports to potential
users of accounting information
Prepare accounting reports
Distribute these reports to potential users

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 1.3. The users of accounting information

Internal users External users

Managers Lenders
Officers Investors
Internal Auditors Governments
Sales Staff Consumer groups
Employees External auditors
Owners… Customers…
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 1.3. The users of accounting information

 Internal decision makers (managers): need

accounting information for planning, controlling
the operations of business
 Internal users
 What resources are available?
 How much is owing to outsiders?
 How much profit is being earned?
 What products should be produced?
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 1.3. The users of accounting information

 External decision makers need accounting information

to make decisions related to investing, grating of credit,
complying with law as well as other regulatory
organizations
• Should I invest money in this business?
• Will the business be able to repay money lent to it?
• How much income tax should be collected?
• …
=> Role of accounting (in economic management system)
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1.4. Types of accounting

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 1.4. Types of accounting

Types of accounting - Comparison of Managerial and

Financial Accounting
Similarities

Both deal with economic events of a

business – Thus, interests overlap

Both require that economic events be

quantified and communicated to interested
parties

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1.4. Types of accounting

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 1.4. Types of accounting

•Accounting for public sector: is An information system

designed to measure financial information (transactions) of public
sector organizations for purposes of the planning, appraisal,
reporting, evaluation and management of the organizations.
•Business accounting:  is the process of gathering and analyzing
financial information on business activity, recording transactions,
and producing financial statement.

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1.5. Accounting concepts and accounting principles

1.5.1. Accounting concepts

1.5.2. Accounting principles

1.5.3. Accounting assumption

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 1.5.1. Accounting concepts

Moneytary
unit concept
Accounting
unit
(business Concepts
entity)
Concept

Time period concept

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 1.5.1.1. “Business entity” concept

Definition

The business entity concept states that the

transactions associated with a business must be

separately recorded from those of its owners or

other businesses.
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 1.5.1.1. “Business entity” concept

Notes:
+ The business and its owner(s) are two separate existence
entity
+ Any private and personal incomes and expenses of the
related parties should not be treated as the incomes and
expenses of the business
+ A reporting entity is an entity that chooses, or is
required, to present general purpose financial statements.
+ It does not have to be a legal entity and can comprise
only a portion of an entity or two or more entities
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 1.5.1.1. “Business entity” concept

• Are the following transactions are recorded by the

business entity?
Insurance premiums for the owner’s house
The owner’s property
The owner of a company personally acquires an office
building, and rents space in it to his company at $5,000
per month
The owner of a business loans $100,000 to his company
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 1.5.1.1. “Business entity” concept

Example:

Mr. John has acquired a floor of a building having

3 halls for $1,500 per month. He uses two halls for
his business and one for personal purpose.

According to business entity concept, How much

money is a valid expense of the business?
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 1.5.1.1. “Business entity” concept

Example:
Mr. Sam owns a company. He uses two different credit
cards – one for the payment of business expenses and
one for the payment of personal expenses. He pays
$200 as the electricity bill of his company using his
personal credit card.
According to business entity concept, the electricity bill
of the business should have been paid using company’s
credit card.
What does the company treat with the payment of 39

200$?
 1.5.1.2. “Money measurement” concept

Definition
The money measurement concept states that a
business should only record an accounting
transaction if it can be expressed in terms of money.

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 1.5.1.2. “Money measurement” concept

- Notes:

+ All transactions of the business are recorded in terms

of money
+ The currency used to provide information is called the
accounting currency.

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 1.5.1.2. “Money measurement” concept

• Accounting currency:
• A specific unit of currency used in recording
transactions within the financial books of a company
or business.
• Accounting currency and home currency might be
different.
•  If transactions are in other currencies, they must be
translated into the accounting currency (foreign
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exchange translation).
 1.5.1.2. “Money measurement” concept

• Example:
The CEO of Fine Enterprise delivers a lecture to the
employees in a special meeting that can be helpful in
raising the employees’ morale and completing the current
projects on time.

Can the value of the lecture be recorded in the books of

account of Fine Enterprise?
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 1.5.1.2. “Money measurement” concept

Example:

• The Metro company purchased a tract of land for

$25,000 in 2005.

• Because of inflation, the worth of the tract of land is

now $40,000. Can the Metro company adjust its
balance sheet?
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 1.5.1.2. “Money measurement” concept

Example:
The Fast transport company has five trucks. One of its truck
is seriously damaged in a road accident and is being
repaired.
The company can only account for the amount of insurance
or any expenses that it actually has to pay to get the truck in
working condition but cannot record the loss of revenue
caused by the time the truck takes to be overhauled.
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 1.5.1.3. “Time period” concept

Definition

The time period concept (also known as periodicity concept,

accounting time period concept, time period assumption)
states that the life of an entity can be divided into equal time
periods. These time periods are known as accounting periods
for which companies prepare their financial statements to be
used by various internal and external parties.
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 1.5.1.3. “Time period” concept

• The length of accounting period to be used for the 

preparation of financial statements depends on the nature
and requirement of each entities as well as the need of the
users of financial statements. Normally, an accounting
period consists of a month, a quarter, six months or a
year.

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 1.5.1.3. “Accounting period” concept

Accountants divide the economic life of a business into artificial

time periods (Time Period Concept).

.....
Jan. Feb. Mar. Apr. Dec.

Generally a
Alternative Terminology
 month, The time period assumption
is also called the
 quarter, or periodicity assumption.
 year. 48

LO 1
 1.5.1.3. “Time period” concept
Fiscal and Calendar Years
 Monthly and quarterly time periods are called interim
periods.
 Most large companies must prepare both quarterly and
annual financial statements.
 Fiscal Year = Accounting time period that is one year
in length.
 Calendar Year = January 1 to December 31.

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 1.5.1.3. “Time period” concept
Question
The time period assumption states that:
a. revenue should be recognized in the
accounting period in which it is earned.
b. expenses should be matched with revenues.
c. the economic life of a business can be divided
into artificial time periods.
d. the fiscal year should correspond with the
calendar year.
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LO 1
 1.5.1.3. “Time period” concept
Example:

The Meta company provides services valuing $2,500 to

Beta company during the first quarter of the year. The Beta
company will pay the cash for these services next quarter.
According to time period assumption, if Meta company
prepares its financial statements at the end of the first
quarter of the year, it must include this service revenue of
$2,500 in its income statement for the first quarter.
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 1.5.1.3. “Time period” concept

Example:

The Meta company incurs expenses of $1,200 during

the first quarter of the year. The cash for these
expenses will be paid next quarter. The time period
assumption requires Meta company to disclose these
expenses on the income statement for the first quarter
of the year. 52
1.5.2. Accounting principles

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 1.5.2.1. Principles are bases for the measurement of accounting
objects

• Historical cost principle

• Market value principle

• Lower of cost and market principle

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 Historical cost principle
 The historical cost principle states that businesses
must record and account for elements of financial
statements (most assets and liabilities) at their
purchase or acquisition price
 Transactions are recorded at their cost when they
occurred instead of current value.
Historical cost is a term used instead of the
term cost. Cost and historical cost usually mean the
original cost at the time of a transaction. 55
 Historical cost principle

Examples:
Pam's Restaurant, LLC was formed in 1985. It purchased
a building soon after in 1986 for $20,000. Total, some 30
plus years later, Pam's is still in business. The original
building is still on the balance sheet for $20,000 even
though the current fair market value of the building is
well over $200,000. Pam's will keep the building on its
balance sheet for $20,000 until it is either retired or sold.

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 Historical cost principle
Examples:
Jeff's Construction, LLC bought a piece of
equipment in 2010 for $10,000. Today this piece
of equipment is only worth $2,000. Jeff would
still report the equipment at its purchase price of
$10,000, less depreciation, even though its
current fair market value is only $2,000.
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 Historical cost principle
Examples:
A herbal medicine company purchases a piece of land
for growing herbs on it, paying $25,000 in cash. The
company will enter $25,000 as the cost of the land in its
accounting records. In a booming real estate market,
the fair market value of the land five years later might be
$35,000. Although the market price of the land has
significantly increased, the amount entered in the 
balance sheet and other accounting records would
continue unchanged at the cost of $25,000. 58
 Historical cost principle
Examples:
The New York Company purchased a tract of land for
$50,000 on January 1, 2010. Today the fair market
value of the land is $65,000. Although the economic
value or market price of the land has increased, the
company would continue reporting it at its historical
cost of $50,000

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 Market value principle

 The market value principle states that the financial

elements cost or price that owners report at the end of

an accounting period must be adjusted for changes in
the market or economy and changes due to inflation.

 Market value is the highest estimated price that a

buyer would pay and a seller would accept for an item

in an open and competitive market.
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 Market value principle

• Examples:
Jeff's Construction, LLC bought a piece of equipment
in 2010 for $10,000. Today this piece of equipment is
only worth $2,000. Jeff would report the equipment
at the price of $2,000.

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 “Lower of cost and market” principle

Lower of cost or market (LCM) states that businesses

must record and account some financial elements
(inventory, securities holdings) under certain
conditions that owners report at the end of an
accounting period at the lower of either (a) historical
cost or (b) value in the market..

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 “Lower of cost and market” principle
Mulligan Imports resells five major brands of golf clubs, which are
noted in the following table. At the end of its reporting year,
Mulligan calculates the lower of its cost or net realizable value in the
following table:
Lower of
Quantity Inventory Market
Product Cost
Unit Cost
Line
on Hand at Cost per Unit or Market
Free Swing 1,000 $190 $190,000 $230 $190,000

Golf Elite 750 140 105,000 170 105,000

Hi-Flight 200 135 27,000 120 24,000

Iridescent 1,200 280 336,000 160 192,000

Titanium 800 200 160,000 215 160,000

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 Question 5
Situation 1: On 1/1/N, enterprise A purchased company B’s shares of 100 million
VND, purchase cost: 2 million VND. On 31/12/N, the stocks’ market value was
110 million VND
Required: How did A record the above stock investment on Financial Statements
at the year ended 31/12/N if:
A. A applied the historical cost principle
B. A applied the market value principle
C. A applied the Lower of cost and market principle
Situation 2: On 15/3/N+1, enterprise A, in Situation 1, sold all company B’s stocks
to the Chairman of Board of Directors of company B for 120 million VND, paid
by cash on hand, selling expense: 2.5 million VND.
Required: Should company B record the above transaction? State the reason for
your answer. 64
1.5.2.2. Principles are bases of recording and measuring
income, expense, net earnings

a. Cash basis accounting principle

b. Accrual basis accounting principle

c. Matching principle

d. Materiality principle
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 Cash basis accounting principle

•Cash basis:  A company records customer receipts in

the period that they are received, and expenses in the
period in which they are paid.

 Revenues recognized when cash is received.

 Expenses recognized when cash is paid.

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 Accrual basis accounting principle

• Accrual basis: Revenues are recognized when they are earned and
expenses are matched to revenues or the accounting period when
they are incurred (rather than paid)

 Transactions recorded in the periods in which the events occur.

 Companies recognize revenues when they perform services

(rather than when they receive cash).

 Expenses are recognized when incurred (rather than when

paid). 67
 Accrual basis accounting principle
• Under the accrual basis accounting, revenues and expenses are
recognized as follows:
Revenue recognition: Revenue is recognized when both of the
following conditions are met:
a. Revenue is earned.
b. Revenue is realized or realizable.
In which:
• Revenue is earned when products are delivered or services are
provided.
• Realized means cash is received or it is reasonable to expect that cash
will be received in the future.
 Expense recognition: Expense is recognized in the period in which
related revenue is recognized (Matching Principle). 68
 Matching Principle

• Matching principle: The matching principle

requires that income earned is matched with the
expenses incurred in earning it
• Revenues are recognized when they are earned, but
not when cash is received
• Expenses are recognized as they are incurred, but
not when cash is paid
• The net income for the period is determined by
subtracting expenses incurred from revenues earned
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 EXAMPLES: Cash and Accrual

Example 1:
Revenue recognition. A company sells $10,000 of
green widgets to a customer in March, which pays the
invoice in April.
- Under the cash basis, the seller recognizes the sale
in April, when the cash is received.
- Under the accrual basis, the seller recognizes the
sale in March, when it issues the invoice.
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 EXAMPLES: Cash and Accrual

Example 2:
Expense recognition. A company buys $500 of office
supplies in May, which it pays for in June.
- Under the cash basis, the buyer recognizes the
purchase in June, when it pays the bill.
- Under the accrual basis, the buyer recognizes the
purchase in May, when it receives the supplier's
invoice.
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 EXAMPLES: Cash and Accrual
Example 3:
Suppose John rents a house from Sam at $100,000 per year.
Now consider the following three cases in which John pays
cash to Sam and records rent expense.

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 EXAMPLES: Accrual

Example 4:
Commission. A salesman earns a 5% commission on
sales shipped and recorded in January. The
commission of $5,000 is paid in February. You
should record the commission expense in
January.

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 EXAMPLES: Accrual

Example 5
Depreciation (Amortization). A company acquires
production equipment for $100,000 that has a
projected useful life of 10 years. It should charge
the cost of the equipment to depreciation expense
at the rate of $10,000 per year for ten years.

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 EXAMPLES: Matching principle

Example 6:
Employee bonuses. Under a bonus plan, an employee
earns a $50,000 bonus based on measurable
aspects of her performance within a year. The
bonus is paid in the following year. You should
record the bonus expense within the year when
the employee earned it.
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 Accrual basis accounting principle

Exercises 1:

Suppose company Y rents a house at $120,000 per year.

How much money will Y record as the expense of each
month in each following cases:

1. Y makes a monthly payment of 10.000$

2. Y makes a whole payment at the first month of rent
3. Y makes a whole payment at the last month of rent
76
 Accrual basis accounting principle

Exercises 2
On 20/12/N, company X sold goods to company Y for 150
million VND. 50% of the amount was paid immediately by cash
in bank. Company Y agreed to pay the remaining amount on
10/1/N+1.
Required: Determine revenue of X for the year N and N + 1, if:
A. Company X applied cash accounting principle
B. Company X applied accrual accounting principle

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 Materiality Principle

•Materiality principle: The materiality principle states

that an accounting standard can be ignored if the net
impact of doing so has such a small impact on the
financial statements that a reader of the financial
statements would not be misled.
•Immaterial amounts may be aggregated with the amounts
of a similar nature or function and need not be presented
separately
•Materiality depends on the size and nature of the item
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 Materiality Principle

Examples:
A classic example of the materiality concept or the materiality
principle is the immediate expensing of a $10 wastebasket that has
a useful life of 10 years. The matching principle directs you to
record the wastebasket as an asset and then depreciate its cost over
its useful life of 10 years. The materiality principle allows you to 
expense the entire $10 in the year it is acquired instead of
recording depreciation expense of $1 per year for 10 years. The
reason is that no investor, creditor, or other interested party would
be misled by not depreciating the wastebasket over a 10-year
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period.
 Materiality principle

 Examples

You may have prepaid $100 of rent on a post office box that
covers the next six months; under the matching principle, you
should charge the rent to expense over six months. However,
the amount of the expense is so small that no reader of the
financial statements will be misled if you charge the entire
$100 to expense in the current period, rather than spreading it
over the usage period. In fact, if the financial statements are
rounded to the nearest thousand or million dollars, this
transaction would not alter the financial statements at all.
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1.5.2.3. Principles are bases for qualitative accounting
information

a. Objectivity

b. Consistency

c. Prudence

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 Objectivity Principle

• Objectivity: The objectivity principle states that

accounting information and financial reporting should be
independent and supported with unbiased evidence.
•Meaning:

+ The accounting information should be free from bias

and capable of independent verification
+ The information should be based upon verifiable
evidence such as invoices or contracts
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 Objectivity principle
Examples
A company is trying to get financing for an extra plant
expansion, but the company's bank wants to see a copy of
its financial statements before it will loan the company
any money. The company's bookkeeper prints out an
income statement from its accounting system and mails it
to the bank. Most likely the bank will reject this financial
statement because an independent party did not prepare it.
In other words, this income statement violates the
objectivity principle.
83
 Consistency Principle
•Consistency The consistency principle states that, once you
adopt an accounting principle or method, continue to follow it
consistently in future accounting periods.
Companies should choose the most suitable accounting
methods and treatments, and consistently apply them in every
period
Changes are permitted only when the new method is considered
better and can reflect the true and fair view of the financial
position of the company
The change and its effect on profits should be disclosed in the
financial statements 84
 Consistency Principle

Examples

If a company adopts straight line method and should not be

changed to adopt reducing balance method in other period.

If a company adopts weight-average method as stock

valuation and should not be changed to other method e.g.

first-in-first-out method 85
 Prudence Principle (Conservatism)

• Prudence: Under the prudence concept, do not

overestimate the amount of revenues recognized or
underestimate the amount of expenses
Revenues and profits are not anticipated. Only realized
profits with reasonable certainty are recognized in the
profit and loss account
However, provision is made for all known expenses and
losses whether the amount is known for certain or just an
estimation
This treatment minimizes the reported profits and the
valuation of assets 86
 Prudence Principle (Conservatism)

• The conservatism principle does not say that

accountants are to be super conservative.
Accountants should be fair and objective. The
conservatism principle says if there is doubt between
two alternatives, the accountant should opt for the
one that reports a lesser asset amount or a greater
liability amount, and a lesser amount of net income.
87
 Prudence Principle (Conservatism)

• A company has an inventory with a cost of $15,000. However,

the marketplace has changed dramatically and now the inventory
can be sold for only $14,000 if the company spends an
additional $2,000 to package and ship the goods.
• For the next balance sheet the accountant is faced with 1)
continuing to report the inventory at its cost of $15,000 or 2) to
report the inventory at its net realizable value of $12,000.
Expressed another way, on the next income statement the
accountant is faced with 1) ignoring the loss in inventory value
until the goods are actually sold, or 2) reporting the loss
immediately.
• The principle of conservatism directs the accountant to report
the inventory at the value of $12,000. 88
 1.5.3. Assumption of accounting

• GOING CONCERN
The business will continue in operational existence
for the foreseeable future

Financial statements should be prepared on a going

concern basis unless management either intends to
liquidate the enterprise or to cease trading, or has no
realistic alternative but to do so
89
 1.5.3. Assumption of accounting

Example:
o Possible losses form the closure of business will not
be anticipated in the accounts
o Prepayments, depreciation provisions may be carried
forward in the expectation of proper matching against
the revenues of future periods
o Fixed assets are recorded at historical cost 

90
 1.6. Requirements for accounting information

1.6.1 The fundamental qualitative characteristics

1.6.2 Enhancing qualitative characteristics

91
 1.6.1. The fundamental qualitative characteristics

Predictive
value
Relevance Confirmatory
value

Completeness

Faithful
representation Neutral

Free from
error
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 1.6.1. The fundamental qualitative characteristics

• Predictive value: Helps users in predicting future

outcomes
• Confirmatory value: Enables users to check and
confirm earlier predictions or evaluations
• Completeness: Adequate or full disclosure of all
necessary information
• Neutrality: Fairness and freedom from bias
• Free from errors: No inaccuracies and omissions
93
1.6.2. Enhancing qualitative characteristics

Comparability

Verifiability

Timeliness

Understandability
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 1.6.2. Enhancing qualitative characteristics

• Comparability: Comparable information enables

comparisons within the entity and across entities
• Verifiability: Helps to assure users that information
represents faithfully what it purports to represent
• Timeliness: Means providing information to decision-
makers in time to be capable of influencing their
decisions.
• Understandability: Requires financial information to
be understandable or comprehensible 95
96