THEORY - CONCEPTUAL ISSUES

Definition of Theory
The word ‘Theory’ has originated from the Greek word, ‘Theoria’. It means to behold or view. A
theory is a confirmed hypothesis. A ‘hypothesis’ is an idea or explanation that you then test
through study and experimentation.
Theory is defined as a set of interrelated concepts, definitions and propositions that present a
systematic view of phenomena by specifying relations among variables with the purpose of
explaining and predicting the phenomena.

Simply stated, a theory is a systematic statement of the rules or principles which underline or
govern a set of phenomena.

Accounting Theory
Accounting theory is a set of concepts and ideas that guide the development and application of
financial accounting practices. It helps to explain how financial accounting is used to create
financial statements and how those statements are used to make decisions about the allocation of
resources.

Accounting theory has evolved to encompass a broad range of concepts and ideas, including the
role of accounting in society, the use of accounting information in decision-making, and the
impact of modern technologies on accounting practices.

Accounting theory is crucial because it provides a foundational framework of principles,

concepts, and assumptions that guide accounting practices, ensuring consistency, reliability, and
comparability in financial reporting, allowing users to better understand and interpret a
company's financial health by providing a logical basis for decision-making; essentially, it acts as
a set of rules to ensure accurate recording and analysis of financial transactions across different
businesses

Accounting theory is set of hypothetical, conceptual and pragmatic principles forming a general
frame of reference for enquiring into the nature of accounting.

Accounting theory is that branch of accounting which consists of the systematic statement of
principles and methodology, as distinct from practice. Moreover, it refers to a generally accepted
logical explanation of Accounting Practices. It is that branch of Accountancy which develops
and inculcates a set of logical principles for the evaluation and development of effective
accounting practices.

Objectives of Accounting Theory

The objectives of accounting theory can be classified into four groups:
i. To explain the nature and purpose of accounting
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 ii. To describe the basic accounting concepts and principles
iii. To develop a framework for financial reporting
iv. To guide the application of accounting principles

Need for Accounting Theory

i. Consistency in practice: Accounting Theory provide a common set of guidelines for
accountants to follow, ensuring comparability of financial statements across different
companies. By establishing a common set of principles, it helps to standardize accounting
practices across different companies, making financial statements more comparable.
ii. Conceptual framework: Accounting theory provides a structured approach to analyzing
and solving accounting problems, offering a basis for developing new accounting
practices and addressing emerging issues.
iii. Reliable financial reporting: By defining clear guidelines for recording transactions,
accounting theory helps to ensure the accuracy and reliability of financial statements.
iv. Decision-making support/ User Understanding: Users of financial statements, like
investors and creditors, can make informed decisions based on reliable and comparable
financial data provided through accounting theory. It helps users of financial statements
interpret the information accurately by providing a clear understanding of the underlying
assumptions and principles.
v. Justification for accounting practices: Accounting theory explains the rationale behind
existing accounting rules, policies and procedures chosen by a company, thereby
enhancing transparency, credibility and accountability.
vi. Professional development: Studying accounting theory equips accountants with a
deeper understanding of the underlying concepts behind accounting practices, allowing
them to adapt to changing business environments and complex situations.
vii. Development of New Practices: It enables the evaluation and development of new
accounting methods to adapt to changing business environments.
viii. Identification of problem areas: Accounting Theory help to highlights potential issues
in accounting practices and areas where further research or standard development is
needed

Accounting Frameworks
Several theoretical frameworks provide a foundation for understanding and analysing financial
accounting practices. These frameworks include:
 The income approach views accounting as measuring and reporting economic activity.
 The balance sheet approach focuses on the relationship between assets, liabilities, and
equity.
 The cash flow approach, which emphasises the role of cash flows in decision-making
 The value-added economic approach focuses on creating shareholder value.
Each of these frameworks provides a different lens for understanding financial accounting
practices, and each has its strengths and weaknesses. As such, there is no single "right"
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accounting theory, and different theorists may prefer other approaches depending on their work's
specific context and purpose.

Types of Accounting Theory

 Cost Principle Theory: The cost principal theory is the most basic accounting theory.
This theory states that all transactions should be recorded at their original cost, which is
the cost that was paid when the transaction occurred. This theory is critical because it
provides a consistent and objective way to record transactions.
 Matching Principle Theory: The matching principle theory states that all expenses
should be compared with the revenues they helped generate. This theory is critical
because it helps ensure that all expenses are accounted for and businesses are not
overstating their profits.
 Full Disclosure Theory: The full disclosure theory states that all material information
should be disclosed in financial statements. This theory is important because it helps to
ensure that investors and creditors have all the information they need to make informed
decisions.
 Relevance Theory: The relevance theory states that financial information should be
relevant to the decisions that users need to make. This theory is critical because it helps to
ensure that financial information is used in a way that is helpful to the decision-making
process.
 Reliability Theory: The reliability theory states that financial information should be
reliable. This theory is critical because it helps to ensure that financial information can be
trusted.
These are just a few of the most important accounting theories. Many other theories play a role in
the field of accounting.

The Impact of Accounting Theory on Financial Reporting Rules and Regulations

Accounting theory significantly impacts financial reporting rules and regulations. It provides the
framework for developing financial reporting rules and regulations, and accounting theory guides
accountants in developing financial reporting rules and regulations consistent with the
underlying economic reality.
The impact of accounting theory on financial reporting rules and regulations is evident in several
ways.
i. The theory guides the recognition and measurement of economic transactions. This
guidance is essential in developing financial reporting rules and regulations designed to
provide helpful information to users of financial statements.
ii. It guides the disclosure of information in financial statements. This guidance is essential
in developing financial reporting rules and regulations designed to ensure that
information is disclosed in a manner that is useful to users of financial statements.
iii. Accounting theory guides the presentation of information in financial statements. This
guidance is essential in developing financial reporting rules and regulations designed to
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 ensure that information is presented in a manner that is useful to users of financial
statements.
iv. It guides the use of financial statements. This guidance is essential in developing
financial reporting rules and regulations designed to ensure that information is used in a
manner that is useful to users of financial statements.
v. The theory guides the interpretation of financial statements. This guidance is essential in
developing financial reporting rules and regulations designed to ensure that information
is interpreted in a manner that is useful to users of financial statements.

Methodology of development of accounting theory

Accounting Theory can be extracted from the practice of accounting (i.e., the practical approach)
or it can result from a logically derived process through the deductive approach. The difference
in not one of purpose, rather the difference is due to adoption of different methodologies. The
divergence of opinions approaches and values between accounting practice and accounting
research have led to the use of two methodologies, one descriptive and the other normative. On
that basis accounting theories are:
 Descriptive theories
 Normative theories

Descriptive Theories
A descriptive theory describes a particular phenomenon as it is, without any value judgment. A
descriptive theory will not inform whether it’s right or wrong; rather the process of ascertaining
results. The practical or conventional approach to accounting theory is essentially descriptive in
character. Such descriptive theories are concerned with the behaviour of the practicing
accountants and what they do. This approach emphasizes accounting practice as the basis from
which to develop theory.

Normative Theories
The essential feature of Normative Theory is the existence of value judgement. Normative
Theories tend to justify what ought to be, rather than what it is. It imposes on the accountant’s
responsibility of determining what should be reported rather than merely reporting what someone
else has requested. Normative Accounting theory prescribes how accounting should be done
based on ideal standards and principles, essentially stating what is considered “best practice”
regardless of current practices. The people, who are developing and using normative accounting
theory, seek to understand the objectives of accounting in practice and compare its ability to
meet those objectives with other systems. Normative accounting theory is subject to considerable
critique from accounting and business professionals. Under this approach, theorists tend to rely
heavily upon circumstantial evidence

Descriptive looks at “what is” while normative looks at “what out to be”
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Key Differences between Descriptive Theory and Normative Theory
Focus
Descriptive theory analyses existing accounting practices to understand how companies currently
report financial information, whereas normative theory proposes ideal accounting methods
proposes ideal accounting methods based on specific goals and values, often without considering
current practice.
Methodology:
Descriptive theory uses empirical research to observe and document current accounting
practices, while normative theory relies on logical reasoning and value judgments to develop
ideal accounting principles.
Application:
Descriptive theory can be used to predict how companies will likely account for a transaction
based on observed pattens, while normative theory can be used to evaluate and improve existing
accounting practices by suggesting better method.
Example:
Descriptive:
Most companies use the FIFO inventory method because it is simple to understand and apply
Normative
Base on the concept of economic value, companies should use the LIFO inventory method
during period of inflation to better reflect the true cost of goods sold.

Approaches to the Formulation of Accounting Theory

New theories are formulated and existing ones are remodeled with the help of accounting theory.
In different time phases for explaining accounting practices different theories have been
formulated. Some of these theories have been put to storehouse in subsequent period while some
others have gained momentum. So, formulation of new theory and rejection of old theories are
well-accepted features of accounting theory.

New theories are always formulated on the basis of new opinions or concepts. Such opinions or
concepts are identified as approaches. So, approaches to the formulation of accounting theory
stand for the different opinions or concepts on the basis of which new accounting theories are
invented. The approaches to the formulation of accounting theory are shown in the following
below:

FORMULATION OF ACCOUNTING THEORY

1. Traditional Approaches
a) Non-theoretical or Pragmatic Approach
b) Theoretical Approaches
i. Deductive Approach
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 ii. Inductive Approach
iii. Ethical Approach
iv. Sociological Approach
v. Economic Approach
vi. Eclectic Approach
2. Modern or New Approaches
a) Events Approach
b) Decision Model Approach
c) Behavioral Approach
d) Predictive Approach
1. Traditional Approaches: The traditional approaches discussed above mainly aim at
construction of theories. These approaches may be divided into two categories:
a. Non-theoretical or Pragmatic Approach; and
b. Theoretical Approach.

A. Non-theoretical or Pragmatic Approach: The approach that speaks in favour of

formulation of theory in conformity with the real-world needs and problems and aims at
finding out their solutions may be identified as pragmatic or non-theoretical approach to
accounting theory. This is also called need based or practical approach. Here those
concepts and principles are emphasised upon which are effective to meet the practical
problems and useful to the users of accounting information in taking relevant decisions.
According to this approach, accounting techniques and principles should be chosen because
of their usefulness to users of accounting information and their relevance to decision making
processes. This approach takes into consideration not only the interest of the owners but the
need of all the users of accounting information as well. Besides, it is difficult to determine
the yardstick of measuring the utility of the accepted principles under pragmatic approach
due to its non-dependence on normative theories.
B. Theoretical Approach: The theory-based approaches to the formulation of accounting
principles may be divided into six categories as under.

i. Deductive Approach: This approach is used to construct normative theories. So, deductive
approach helps formulation of those principles of accounting that explain the standard or
ideal happenings with logic. A deductive approach is that outlook which follows logically
and ideally correct concepts, opinions, bases and principles for formulation of accounting
theory. The steps required for development of theories under deductive approach are:
 Objectives: to determine the general and specific objectives of financial statements.
 Postulates: to select the basic accounting concepts or postulates relating to economic,
political and sociological environment.
 Constraints: to set out the constraints or regulations this will guide the theory.
 Structure: to build up the framework of theoretical ideas.

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  Definitions: to develop the definitions to explain the related ideas.
 Principles: to fix up the accounting principles on the basis of logic.
 Application: to develop the process of application or the techniques and methods of
accounting based on the principles framed.
As deductive approach follows ideally right principles, from the viewpoint of justification it
is identified as the best approach. But if there exists any defect in the postulates or concepts
selected, the theory formulated on the basis of deductive approach may mislead the
accounting activities.

ii. Inductive Approach: The main theme of inductive theory is to arrive at a generalised
decision as to the logic, reasons and assumptions acting behind the occurrence of events
through observation and analysis. Inductive approach to the formulation of accounting theory
may be defined as that outlook which emphasises upon developing generalised decisions and
principles through observation, measurement and analysis of the events occurred. The
process of induction consists of drawing generalised conclusions from detailed observations
and measurements. It starts with observation of financial information of business enterprises
and leads to draw, on the basis of repeated relationships, generalisations and principles of
accounting. The steps required for development of theories under deductive approach are:
 To observe and to keep records of all observations.
 To find out recurring relationships, similarities and differences among these observations
by analysis and classification.
 To formulate generalised principles of accounting on the basis of recorded observations.
 To test and apply these generalised principles.
The main advantage of this approach lies in its independence. It is not influenced by any
predetermined norm or standard model. This helps the researchers to work independently and
to arrive at decisions which they think as the best outcome of their observations and analysis.
The main drawback of the inductive approach is that the researchers in studying
relationship among the data collected from observations may be influenced by pre-conceived
or subconscious notions. Another problem of inductive approach is that the financial data
collected through observations may vary from firm to firm. This creates difficulty in arriving
at meaningful and generalised principles.

iii. Ethical Approach: The approach to the formulation of accounting theory that puts emphasis
on fairness, justice and truth and considers these attributes as centres of focus for framing the
theories is known as ethical approach. The concept of ethics is also used more or less in all
other approaches to accounting theory. For this reason, the ethical approach is not treated as a
separate and independent approach.
The object of this approach is to prepare the accounting statements accurately and in an
unbiased manner not giving any favour to any of the interested parties. At present the
financial statements must exhibit the true and fair view of the state of affairs of the concern.
This is nothing but the acceptance of ethical approach. The main drawback of ethical
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 approach is that it does not provide a sound and independent basis for the development of
accounting principles. It also fails to form the basis for the evaluation of existing accounting
principles.

iv. Sociological Approach: This approach emphasis the social aspect of accounting. It is the
outcome of ethical approach that takes into consideration fairness and justice for the
construction of accounting theory. This approach state that accounting principles or
techniques are to be evaluated on the basis of their reporting effects on the people of the
society. Here it is assumed that the information supplied by accounting will be useful for
social welfare.
The object of sociological approach is to provide information to make possible an evaluation
of the effect of a firm's activities on society.
For achieving its objective, the sociological approach assumes the existence of certain
accepted social values. These social values are used to regulate the formulation of accounting
theory.
However, it is difficult to ascertain those social values which may be accepted by all
concerned. The sociological approach to accounting theory has helped formulation of a new
branch of accounting known as social or socio-economic accounting.

v. Economic Approach: Two conditions are to be satisfied for formulating accounting theory
under this approach are:
 The principles and methods of accounting should reflect the present economic situation
or 'economic reality'.
 Selection of the accounting techniques should depend on the economic consequences.
The approach that focuses on the concept of 'national economic welfare' for formulating
accounting principles is termed as economic approach. Under this approach the impact of
national economic welfare is the main determining factor for formulation of accounting
principles and techniques.
The economic approach to the formulation of an accounting theory puts emphasis on
controlling the attitude of macro-economic indicators that result from the adoption of
different accounting techniques. Under this approach the selection of a particular accounting
technique depends on a particular economic situation.
For example, under the condition of continuous increase in price level it is more reasonable
to adopt LIFO method of pricing of materials. So, this method of pricing of materials is to be
adopted in times of inflation.
The main drawback of this approach is that while framing theory it relies more on economic
conditions rather than on operational problems of accounting.

vi. Eclectic Approach: The word 'eclectic' refers to the inference of opinion from different
methods. All the above approaches to the formulation of accounting theory have some
special advantages with limitations as well. In comparative analysis none of these approaches
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 is identified as the best fit to construct theories which can match up all the practical needs of
the users of accounting information. For this reason, there lies the need to develop an
approach by combining all the accepted approaches. This combined approach will assist in
framing such an accounting theory that can consider all the practical problems of different
users of accounting information. This combined approach is known as eclectic approach.
So eclectic approach is that approach which is built up by combining the advantages of all
other approaches for formulating that theory which will assist in solving the problems of all
the users. It is not a new approach but a mixture of the old ones.

2. Modern or New Approaches

The traditional approaches discussed above mainly aim at construction of theories but not
evaluation of the theories already established. Due to this defect, efforts were made by the
scholars of accounting to develop such approaches which would not only help in formulating
new accounting theories but in verifying the same as well. These new approaches are identified
as modern approaches. The important modern approaches are as under:
 Events Approach
 Decision Model Approach
 Behavioural Approach
 Predictive Approach

i. Events Approach: The events approach for the formulation of accounting theory was first
proposed by George Sorter and it was endorsed by the majority of the members of the AAA
committee that issued “A statement of Basic Accounting Theory” in 1966. Events approach
formulate accounting theory on the basis of relevant economic events affecting the
users' decisions. The principal argument used in favour of the events approach is that, due to
wide ranging use and heterogeneous users of financial statements, accountants should not
direct the published financial statements to specified ‘assumed’ group.
Events are of two types: Monetary event and Non-Monetary event. Under this approach
the main objective of accounting is to supply information of those monetary events which
have relevance in decision making of the users.
The main advantage of this approach is that it helps maximisation of forecasting accuracy
of the accounting statements because it takes into consideration all probable information of
an economic event which may be useful to the users. Given this argument, the events
approach suggests expansion of accounting data in the financial statements.
The limitations of the events approach, however, are the following:
 It presupposes that the users are knowledgeable enough to be able to classify and
aggregate accounting data for their own use.
 It does not explicitly mention which data are to be selected for the financial
statements.

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  There is definite limit to the amount of data a person can handle at a time. The expansion
of data may cause information overload to the users.

ii. Decision Model Approach: The accounting approach, where an ideally adequate decision
model is pre-determined on the basis of anticipated needs of the users of the financial
statements, is identified as decision model approach. In this approach, the information
need of different users for making decisions is emphasised upon. Keeping an eye to this
need all probable information which may be helpful to the users is presumed with care.

iii. Behavioural Approach: The behavioural approach is concerned with direct evidence of
user’s reaction to accounting reports as a basis for descriptive generalisation about the
behavioural aspects of particular accounting techniques and problems such as:
 The adequacy of disclosure;
 The usefulness of financial statement data;
 Attitudes about corporate reporting practices;
 Materiality Judgement; and
 The decision effects of alternative accounting valuation bases.
In behavioural approach, the need and behaviour of the users of accounting information are
taken as the primary consideration for the formulation of accounting theory.
Accounting is practice-oriented work which directly and indirectly affects human behaviour.

This behaviour orientation of accounting paves the way of introducing the concept of
behavioural science in developing its principles and techniques. Under this approach it is
accepted that accounting should be done keeping an eye to the objectives and behaviour of
the users of accounting information. For this purpose, the choice of accounting principles
should be based on what information the users need and what would be their behaviour in
relation to that information. As accounting is identified as a behavioural process the
behavioural approach makes accounting ideas nearer to behavioural science.

This approach is on the process of continuous research. It has not yet been finalised and no
theory has yet been formulated following this approach. But no doubt, it has created great
enthusiasm among the thinkers of accounting and in near future, something positive and
constructive can be expected of it.

iv. Predictive Approach: Like other modern approaches this approach is also decision oriented;
but here decision is not the primary goal, primary goal is prediction for decision. Under the
traditional approach accounting measures are generally used for non-predictive purposes e.g.,
accountability and reporting on stewardship. In the predictive approach however, accounting
measures are not just considered as post-mortem exercise. This approach is based on
predictive forecasting to take future decisions on the basis of data supplied by accounting.

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 Under predictive approach the principles are formulated taking into consideration the
predictive capacity of accounting information.
The predictive approach is directly related to the predictive ability of financial data and is
purported to provide a purposive criterion to relate the function of collecting financial data to
the task of decision-making.

Generally Accepted Accounting Principles (GAAP)

GAAP are the common set of accounting principles, standards and procedures that are used by
accountants to prepare the financial statements. They are derived from practice, and on being
useful get accepted into the accounting system. These principles are developed by the
professional accounting bodies of different countries of the world, with the aim of attaining
uniformity in accounting practiced by the entities of the respective countries. As such different
GAAP have developed in different countries of the world. The GAAP must aim to satisfy the
following three basic criteria:
a. Usefulness i.e. making the information relevant and meaningful to the users of financial
statements.
b. Objectivity i.e. ensuring that the information is reliable, verifiable, trustworthy and unbiased.
c. Feasibility i.e. making it applicable without much complexity and cost.

Accounting Principles
Accounting principles refer to those rules of action which are universally adopted by the
accountants for recording accounting transactions. They act as the guidelines for recording and
reporting transactions.
Features
 They have evolved out of assumptions made and conventions followed in accounting.
 They provide explanations to the current accounting practices.
 They act as the ‘grammar’ of accounting language.

Classification
Accounting Principles can be classified into two categories:
 Accounting Concepts; and
 Accounting Conventions.
Accounting Concepts
Accounting Concepts refers to the assumptions on the basis of which the transactions are
recorded in the books of accounts and financial statements are drafted. They are perceived,
presumed and accepted in accounting to provide a unifying structure and internal logic to the
accounting process.
They are also referred to as Accounting Postulates.

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 Features
 Accounting Concepts are the necessary assumptions and ideas which are fundamental to
accounting practice.
 Accounting Concepts are the ideas which have been accepted universally.
 They are the foundation on which the superstructure of accounting are developed.
 The concepts provide the support to the basic structure of accountancy.

Classification of Accounting Concepts

i. Business Entity Concept: The concept implies that every business should always be
regarded and treated as an entity that is distinctly different from its proprietor or owner. In
the strict legal sense, only limited liability companies are regarded as legal entities separate
from their owners. They can acquire assets and incur liabilities. They can enter into contracts
on their own and can owe debts. They can sue and be sued. However, all forms of entities are
regarded as being separate from their owners. The resources contributed by the owner to the
business is regarded as the liability of the business to the owner, which is called capital or
owners’ equity.

The essence of the entity concept is to distinguish the income and costs of the business from
the private income and costs of the proprietor or his drawings from the business. For
instance, if the owner of a business draws cash from the business bank account to repair
delivery vans for business use, it would be regarded as business expenses. But if he pays his
child’s school fees with the business cash, the amount will be treated as drawings of the
owner rather than expenses. The entity concept is key to the proper understanding of the
double entry principle and so must be properly grasped at this stage.

ii. Dual Aspect Concept (Double Entry Principle): This is the oldest and arguably the most
important of all the concepts. Its application to accounting dates backs to 1340 or earlier, but
was first published in the year 1494 by an Italian Monk named Luca Pacioli who also
happened to be a mathematician and a university teacher. The concept stipulates that since
there are two parties to every business transaction, the recording of any business truncation
should be done in such a ways that the Giving Party (The Giver) can be readily distinguished
from the Receiving Party (The Receiver).The phrase “The Giver” denotes a person or
business that gives away an item, while the phrase “The Receiver” denotes a person or a
business that receives an item as a result of a business transaction.

iii. Going Concern Concept: Unless otherwise stated, it is always assumed that a business
entity will continue in operation for the foreseeable future. It is assumed that the entity has
neither the intention nor the necessity of liquidation or curtailing significantly the scale of its
operation. The going concern concept will help investors, payables, employees, customers
and other stakeholders to determine the extent to which they want to continue to patronize
the business.

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 The going concern concept may be more justified in a limited liability company where the
death or withdrawal of any member (shareholder) may not affect its scale of operation. This
does not imply that a business cannot come or be brought to an end.
The point is that accounting information should disclose the ability or otherwise, of a
business to remain in existence. Assets and liabilities of a going concern entity are generally
valued on historical cost basis, or fair value basis.

iv. Historical Cost Concept: Historical cost is the amount of cash or cash equivalent paid or the
fair value of the considerations given to acquire assets. In this vein, liabilities are recorded at
the amount of proceeds received in exchange for the obligation. The justification for the
historical cost principle is its objectivity; that is, the cost can be traced to the source
documents whereas other measures of value would be based on the subjective judgement of
management. The main criticism against the historical cost concept is that, with the passage
of time, cost would no longer represent the fair value of an asset.

For instance, the value of a building constructed ten years ago might have appreciated
considerably over the period. In periods of inflation, the use of historical cost instead of fair
values, normally leads to the recognition of “holding gain” because cost would significantly
understate the value of the resources being consumed. Recognizing holding gain may lead to
the distribution of the profits that would have been retained in the business for further
expansion. Hence, the IASB has prescribed the use of fair value as an alternative.

v. Realisation Concept: The realisation concept is concerned with determining when revenue
is earned. This concept implies that income should not be considered earned on a transaction
until when it is irreversibly sealed or concluded. The concept holds that revenue should be
recognised at the time goods are sold and services are rendered; that is the point at which the
customer has incurred liability.
In other words, it implies that the preparation of financial statements should not include
receipts or expenses that are expected to accrue from ongoing business transactions. Before
revenue can be realised and recorded, it must have met the following two conditions
a. The revenue is capable of objective measurement
b. The value of asset received or receivable is reasonably certain.
The realisation concept may however be difficult to apply in hire purchase transactions, lease
transactions, contract jobs, advertisement agencies etc.

vi. Periodicity Concept: The essence of this principle is that the financial statements of an
organisation should be prepared to cover a specific period of financial activities which is
technically known as Accounting Period. The assumed life span of a business is usually
subdivided into smaller periods of twelve months (one year). This enables an entity’s
operations to be subjected to periodic review to determine the financial performance and
position of the entity. It also empowers the management to make periodic distributions to the
owners. The periodic review would also help to assess management efficiency and the
planning and control of future operations.

vii. Consistency Concept: Usually there is more than one way of treating an item in the
accounts without going against any accounting principle. Consistency concept requires that

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 when a method has been adopted in treating an item in the financial statements, the method
should not be changed but used consistently from period to period. For instance, there are
many methods of depreciating non-current asset such as straight line, reducing balance, sum
of the digit methods. If straight line method is chosen to depreciate buildings in year one, the
company should continue to depreciate buildings on straight line basis from year to year.
This method should not be changed unless there are compelling reasons.

The essence of this principle is to make it easy for users of financial statements to compare
the results of one period to another. Constant change in method will distort profits and make
comparison difficult. Occasionally there may be justification to change from one method to
another. If the change is made, adequate disclosure must be made about the nature of the
change and the effect of the change on profits.

viii. Accrual Concept: The accrual concept states that income should be recognized when they
are earned and not when they are received in cash. Expenses should also be recorded when
they are incurred and not when paid. The application of this concept gives rise to
prepayments and accrued expenses (accrual). An accrued expense occurs when it has been
incurred but has not been paid. Prepaid expenses occur when payment has been made for
services but benefits have not been derived from them. They give rise to liabilities and assets
respectively. Prepaid expenses and outstanding receivables are assets while income received
in advance and outstanding payables are liabilities of the business.

ix. Matching Concept: This concept simply implies that Profit or Loss for a particular
accounting period, should be deducted, using only Earned Receipts (Income) and Consumed
Expenditures (Expenses) for the same accounting period. Hence, it is wrong to match
incomes from a particular accounting period against Expenses for a different period. All
expenses due but not yet paid should be added to the expenses paid in order to determine the
total expenses for the period.
All expenses prepaid should be excluded from the amount to be deducted in the statement of
profit or loss. All income due and receivable should form part of the income for the period.
While all income received in advance should be excluded. The concept also holds that for
any accounting period, the earned revenue should be matched with the cost that earned them.
If revenue is deferred from one period to another, all elements of cost relating to them should
also be carried forward accordingly.

The concept is important in measuring the cost of goods sold or services rendered in a period.
It is also useful in determining when the cost of an item becomes expenses (that is expired
cost). This concept is applied to products where the costs can be related directly to them. It is
applied in relation to time period where the cost incurred cannot be related to the product.

For instance, if a trader bought 50 pairs of shoes for ₦50,000 and sold 35 pairs for ₦70,000
at the end of a period. The cost of goods sold would be measured on the 35 pairs sold. That is
35
X ₦50,000 = ₦35,000. ₦15,000 would be deferred to the next period. Some costs that
50

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 cannot be related to specific transactions are depreciation, electricity bill, insurance cost etc.
When this concept is not properly applied profits are either overstated or understated.

x. Money Measurement Concept: Money serves as the common denominator for measuring
the various assets and liabilities of an entity, therefore, accounting transactions are expressed
in monetary values. The Naira and Kobo represents a unit of value which has the ability to
command goods and services in Nigeria. Apart from the fact that money serves as a common
unit, accountants also believe that it is stable in value.

There are some limitations in the use of money as measure of value in accounting.
i. The value of money does not always remain stable particularly in an inflationary
economy.
ii. Apart from inflation, the time value of money today is greater than the time value of
money in any future time. This affects the cost of funds.
iii. There are some activities of an entity that are not recorded because monetary value
cannot be attached to them. Examples are good management, employees’ morale, an
entity’s comparative advantages, etc.
However, accounting does not provide all the information about a firm, it provides only
economic information that can be expressed in monetary terms. We may then understand
why limited liability companies are now being required to disclose a lot of non-accounting
information in their annual reports and accounts.

xi. Prudence Concept: The prudence concept requires that an accountant should not recognize
income until the income has been earned and adequate allowances made for all known losses.
The essence of the principle is that profits are not overstated in any accounting period. The
prudence concept is most useful when matters of judgement or estimates are involved. For
instance, if the credit policy of a business requires a customer to pay for the goods sold to
him within 60 days and he has not paid after 120 days, it may be reasonable to make
allowance for the entire amount as irrecoverable and doubtful debt. Another example is when
inventories become obsolete and its net realizable value falls below cost, the difference
between the cost and the net realizable value should be written off to the statement of profit
or loss.

Failure to write foreseeable losses off or the recognition of unrealized income will produce a
misleading result which may lead to payment of taxes or distributions that should not have
been made.

Accounting Conventions
These are the traditions or customs that are observed by the accountants for preparation of
financial statements. They have evolved out the different accounting practices followed by
different entities over a period of time.

Features

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  They have been developed by the accountants by usage and practice.
 Conventions need not have universal application.
 The accounting conventions have developed over a period of time.

Classification of Accounting Conventions

The different accounting conventions are:
i. Materiality Principle: Any accounting information that affects users’ decision about a
reporting entity’s performance when such information is omitted or misstated is regarded as
material. Therefore, an item is said to be material if its omission or misstatement will affect
the decision of users of the financial statement or information. The principle of materiality
holds that financial statements should separately disclose items which are significant enough
to affect evaluation or decisions. It refers to the relative importance of an item; therefore,
some level of judgement may be required in determining what is material to an entity. What
is material to a sole trader may be immaterial to a large company.

The nature, amount (value) and size of a business (in terms of capital employed) will
generally be considered in determining the materiality of an item of cost. For instance,
stapler, perforator, waste basket are expected to be used for more than one period, so that
their costs should be measured over the period of use. However, because of the insignificant
amounts involved, the concept of materiality permits the immediate write off of these costs
as expenses.
ii. Substance over Form: Although business transactions are usually governed by legal
principles; nevertheless, they are accounted for and presented in accordance with their
financial substance and reality and not merely by their legal form. In preparing accounting
records, with regards to the acquisition of assets, preference should be given to the financial
effects of the assets over the legal terms and conditions underlying the acquisition. In order to
be useful, information contained in financial statements must be relevant and reliable. This
can only be achieved if the substances of transactions are recorded. If this did not happen the
financial statements would not represent faithfully the transactions and other events that had
occurred. Examples are found in sales and re-purchase agreements, lease contracts and
consignment of goods.

iii. Objectivity / Fairness Principle: Objectivity concept holds that financial statements should
not be influenced by personal bias of management in favour or against any class of users of
the information. The use of historical cost for asset valuation is an attempt to be objective,
because it can be backed up by vouchers, invoices, cheques, bills etc.

A change in the value of an asset should therefore be recognized when it can be measured in
objective terms. Objectivity is useful in accounting in the following ways:
a. Auditing is made possible
b. Accounting data are standardized.
c. Fraud and falsification of accounts are minimized.

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 d. Data is available for an independent party to cross-check.

In spite of the goals of objectivity concept some personal opinions and judgement are
brought into accounting information in a few instances. For instance, estimates are required
to determine the useful life of a non-current asset and the net realizable value of inventories
or the allowance to be made for irrecoverable and doubtful debts. However, figures used in
financial statements should rely as little as possible on estimates or subjectivity.

Distinguish between Accounting Concept and Accounting Convention

It should be noted that the terms ‘Concepts’ and ‘Conventions’ are usually used interchangeably,
but they are different from each other:
i. Assumption
ii. Purpose: ‘Concepts’ are primarily concerned with maintenance of books of accounts,
while ‘Conventions’ are applied for preparation of financial statements.

Accounting Standards
Accounting standards are the written statements issued by the statutory accounting bodies on
specific accounting policies for the preparation and presentation of uniform and consistent
financial statements. It is a common set of principles, standards, and procedures that define the
basis of financial accounting policies and practices. These standards provide the terms and
conditions of accounting policies and practices by way of codes, guidelines and adjustments. In a
nut-shell, accounting standards provide the rules in relation to recognition, measurement and
disclosure of financial information for preparation of financial statements.

The primary objective of issuing accounting standard is to standardize the prevalent diverse
accounting policies and practices. This is done for the dual purpose of:
 eliminating the non-comparability of financial statements to the extent possible; and
 adding reliability to the financial statements.

Major Difficulties in Setting up Accounting Standard

The following points highlight the four major difficulties faced in setting up accounting standard.
i. Difficulties in Definition
ii. Political Bargaining in Standard Setting
iii. Conflict in Accounting Theories
iv. Pluralism.

1. Difficulties in Definition
 Scope of Accounting not properly defined: To agree on the scope of accounting and of
principles or standards, is admittedly most difficult. Some, for example, equate
accounting with public accounting that is mainly with auditing and the problems of the

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 auditor. Another opinion is that it (accounting) is frequently assumed to have a basis in a
private enterprise economy.
 Principles vs. Rules: Some use “principles” as a synonym for “rules or procedure”. The
result is that the number of principles becomes large and most uneven in coverage and in
quality. Another group seems to equate “Accounting concept” with “Accounting
convention,” that is, with consensus or agreement. If this is the case, then a principle can
be changed if all agree it should be or alternatively, the only propositions that can qualify
as principles are those that command consensus or agreement. Such disagreement leads
to difficulty in-standard setting and further does not make the standards totally acceptable
to society.

2. Political Bargaining in Standard Setting

Some years ago, accounting could be thought of as an essentially non-political subject, but today,
as the standard setting process reveals, accounting can no longer be thought of as non-political.
The numbers that accountants report, have a significant impact on economic behaviour.
Accounting rules therefore affect human behaviour. The stories conveyed by annual reports
confirm or disappoint investor expectations and have the power to move millions (whether of
money or persons). For the entire bloodless image that accounting may have, people really care
about the way the financial score is kept. Hence, the process by which they are made is said to be
political.
The setting of accounting standards is as much a product of political action as of flawless logic
or empirical findings. The setting of standards is a social decision. Standards place restrictions on
behaviour; therefore, they must be accepted by the affected parties. Acceptance may be forced or
voluntary or some of both. In a democratic society, getting acceptance is an exceedingly
complicated process that requires skillful marketing in a political arena.
Accounting standard setting is certainly a political process, responding to pressures from the
economic environment and compromising between the conflicting interests of different parties. It
is important that standard setters be aware of the specific pressure and interests involved. It
would be unrealistic to expect to determine standards without such difficulties, and the best way
to deal with them is to admit their existence rather than pretending to ignore them.

3. Conflict in Accounting Theories

There has been remarkable growth in accounting theories especially relating to income
measurement, asset valuation, and capital maintenance. Though much of the developments has
taken place abroad, (USA, UK, Canada, Australia, etc.), accounting in other countries has also
been influenced. While the theorists battled on, the various sectional interests found that the
theories could be used to support their own causes and arguments. At present, there is not a
single theory in accounting which commands universal acceptance and recognition. There is no
best answer to the different terms like profit, wealth, distributable income, value, capital
maintenance, and so forth.

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We cannot say what the best way to measure profit is. If the profession truly wishes to be helpful
it needs to discover from users, or to suggest to them, what would support their decision-making,
and then do develop the measures which best reflect those ideas. The search for an agreed
conceptual framework could be regarded as essential to orderly standard setting and a
responsible way for the standard-setter to act. Also, it could be helpful in distracting critics while
getting on with the real issues in accounting problems. Absence of a conceptual framework, i.e.,
a set of interlocking ideas on accountability and measurement is not conducive to standard
setting and improved financial accounting and reporting.

4. Pluralism
The existence of multiple accounting agencies (such as ICAN. FRCN. ANNA, CAMA 2020 etc.
in Nigeria) has made the task of standard setting more difficult. No one agency has jurisdiction
over the entire area of accounting standards.
Similarly in other countries also, there is plurality of accounting bodies. For example, in USA
there are organisations like Securities and Exchange Commission, Financial Accounting
Standards Board, American Institute of Certified Public Accountants. In U.K., there are
Accounting Standards Board of ICAEW and Companies Acts to deal with accounting matters
and financial reporting.
If pluralism were reduced or eliminated, the path toward the goal would be smoother. However,
the absence of pluralism is not a necessary condition for agreement on standards developed by a
single accounting body. No one would claim that the mere absence of an obstacle constitutes a
sufficient condition for success. A standard setter has to face many difficulties in standard setting
process.
In a rational way, a standard setting body should first define the objectives of financial
accounting and reporting, identify user groups to be served, and the information which were
useful to them before starting the process of standard setting

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