The basic accounting theories are the basis and fundamental ideas, or assumptions, underlying the practice of financial accounting. These theories are a set of broad rules for all accounting activities and were developed over time by accounting professionals. The accounting profession has evolved and developed these basic concepts (theories) to standardize the way in which companies perform financial accounting in the United States.
The Accounting Formula
The basic accounting formula is: assets = liabilities + owner’s equity. This basic equation is the formula and theory behind the double-entry accounting system. Every entry will have an offsetting entry to a corresponding asset, liability or owner’s equity account. This is the basis for all financial accounting.
This concept states that all revenue transactions are recorded when they occur and not when the cash changes hands. This applies to revenue transactions that do and do not generate liabilities. The liabilities are also recorded when they occur and not when they are actually paid. Cash accounting, accounting for transactions only when the cash is paid or received, is not a theory and is used for small businesses without inventory.
This concept states that once a company chooses an accounting method, this method should be applied consistently over all future accounting periods. The accounting method can be changed if there is a valid business reason. Once the new method is adopted, the consistency concept is in place again. This new method will be followed for all future accounting cycles. Accounting method changes should never take effect in the middle of an accounting cycle.
The going concern states that when a business’s accounting is being managed, it is understood by the lead accountant (controller) that the business is financially viable and will continue to be in business into the foreseeable future. The assumption is that the business is healthy enough to stay in operation. If for any reason the accountant determines that the business is not viable, and failure is imminent, then it should be stated in the financial statements. The reason should be outlined and well defined. If this is the opinion of the accountant and no evidence can be provided, then the accountant is free to include a disclaimer. However, lacking any credible evidence an accountant should be very cautious when issuing such a disclaimer.
This concept states that all liabilities are accounted for even if there is a chance that they will not occur. This same principle applies to liabilities and not revenues. The only revenues that can be accounted for are the ones that have already occurred. Any liability that might occur should be recorded and at the higher possible amount. For example, a company has been sued for a faulty product. The legal department has determined that the potential liability to pay claims will fall between $100,000 and $225,000. The higher amount should be accounted for in the financial statements. A note to the financial statements should disclose the liability range.
This concept requires that accounting focuses on material facts and not on facts that are immaterial to determining revenues. Only transactions that have monetary information are recorded. If a transaction that has no bearing on income occurs, it should not be included in the accounts. Non-monetary information can be included in the notes of the financial statements if the information may affect the way in which investors evaluate the company. If the transaction or activity does not affect income today but may in the future, then these facts must be disclosed in the financial statements.