Accounting Theory

What is the 'Accounting Theory'

Accounting theory is a set of assumptions and methodologies used in the study and application of financial reporting 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 changed and added to the regulatory framework that governs financial statements and financial reporting.

BREAKING DOWN 'Accounting Theory'

All theories of accounting are bound by the conceptual framework of accounting. This framework is provided by the Financial Accounting Standards Board and works to outline and establish the key objectives of financial reporting by businesses, both public and private. Further, accounting theory can be thought of as the logical reasoning that helps evaluate and guide accounting practices. Accounting theory, as regulatory standards evolve, also helps develop new accounting practices and procedures.

Key Elements of Accounting Theory

While accounting procedures are formulaic in nature, accounting theory is more qualitative in that it is a guide for effective accounting and financial reporting. The most important aspect of accounting theory is usefulness, which, in the corporate finance world, means that all financial statements should provide important information that can be used to make informed business decisions. This also means that accounting theory is intentionally flexible so that it can provide effective financial information, even when the legal environment changes.

In addition to usefulness, accounting theory states that all accounting information should be relevant, reliable, comparable and consistent. What this essentially means is that all financial statements need to be accurate and adhere to the generally accepted accounting principles (GAAP). Adherence to GAAP allows the preparation of financial statements to be both consistent and comparable to a company's past financials, as well as the financials of other companies.

Finally, accounting theory requires that all accounting and financial professionals operate under four assumptions. The first assumption states that a business is separate from its owners. The second affirms the belief that a company will continue to exist and not go bankrupt. The third assumes that all financial statements are prepared with dollar amounts and not with other numbers like unit production. Finally, all financial statements must be prepared on a monthly or annual basis.

The Origins and Evolution of Accounting Theory

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, and it must adapt to new ways of doing business, new technological standards and gaps that are discovered in reporting mechanisms. For example, organizations such as the International Accounting Standards Board helps create and revise practical applications of accounting theory, and professionals such as CPAs help companies navigate new and established accounting standards.

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