Financial Accounting Theory

What is Financial Accounting Theory?

Financial accounting theory is the approach of understanding the reasoning of why accounting theories are implemented in a certain way. Financial accounting theory allows users to gain a new perspective on the “why” factor in accounting procedures rather than “What” or “How.”

“Why do transactions have to be reported in a certain way?” is what financial reporting theory addresses to those involved in the accounting process and those who absorb the information accounted for.

“But what is an accounting theory?” you say. An accounting theory is a set of frameworks, assumptions, and methodologies to implement financial reporting standards in an organization’s accounting practices.

In other words, accounting theory sets a level of understanding on how a business communicates, i.e., through understanding a company's financial reporting and how companies channel their financial statement using strategies implemented by the management.

Financial accounting theory just enhances the base accounting theory as the accounting theory focuses on “what” and “how” to implement the theories, leaving out the framework for understanding “why” it is being implemented. Financial accounting theory fixes precisely that!

Understanding how business communicates is one of the essential skills business-related professionals need to possess. So, what financial accounting theory has in store for us? Let us find out.

Understanding Financial Accounting Theory

To understand the importance of accounting theories for real-world businesses, we must understand the entity that sets standards for businesses whose foundations are based on accounting theory.

As mentioned before, accounting is the language of the business, and such language should be understandable by all users. Therefore, certain entities are responsible for setting standards the companies must follow.

Two standard setters on the global stage prepare accounting frameworks whose influence is based on the adaptation of regional legislation.

The US and its territories' legislation accepts the Financial Accounting Standards Board (FASB) as the standard setter that prepares Generally Accepted Accounting Principles (GAAP) standards.

Meanwhile, legislation outside of the US generally accepts the International Accounting Standards Board (IASB) as they set the International Financial Reporting Standards (IFRS).

Think of these two standards as dialects of a language; they have minor variations, but people can still understand them. Similarly, there isn’t much difference between the two standards; the baseline difference is:

• US GAAP takes a rule-based approach
• IFRS takes a principle-based approach 

All the accounting theories are bound by the conceptual frameworks of the standard-setting regulatory bodies such as IASB and FASB to bring a common ground among the users in understanding the accounting practices adopted by the reporting entities.

Hence, it signifies the importance of accounting theory. To be more specific, the theory of accounting provides

1. Guidance on financial reporting and accounting practices 
2. Explanation of the nature, purpose, and significance of the accounting 
3. Description of the accounting concepts and principles 
4. Framework development about financial reporting and upkeeping professional ethics
5. Guidance on the application/implementation and effective communication of the accounting principles 

Accounting Principles

Now, the creation of the accounting theory is not whipped up out of thin air but instead based on several accounting principles. Accounting principles are guidelines and rules that bring consistency while recording. Some of the principles are as follows:

1. Cost Principle: Any transactions that occur should be recorded at their incurred price at the time of the event.
2. Accrual Principle: Any transactions that occur should be recorded at the time of the event, regardless of whether the amount is received or not. 
3. Conservatism Principle: Any future-based transaction whose nature is of liabilities or expenses should be recorded instantly, but if the transaction is an asset or income, then register when they are sure to be received.
4. Consistency Principle: Any implemented standards should be followed throughout the business’s lifespan, unless required by law, to avoid unwanted discrepancies. 
5. Full Disclosure Principle: Every piece of vital information should be disclosed in the financial statements to bring awareness to the shareholders and other users of financial statements. 
6. Economic Entity Principle: The business should be considered as a separate legal entity from its owner. Therefore, a business can sue others and get sued by others. 
7. Matching Principle: For every revenue earned, there is an expense to bear. Therefore, record every revenue alongside the expenses incurred from it. 
8. Monetary Unit Principle: All economic transactions should be recorded in terms of monetary value. Thus, taking money as a measure of the unit so that its value can be assessed easily. 
9. Going Concern Principle: The business should operate and grow for the foreseeable future. Thus, allowing businesses to plan for future growth.
10. Reliability Principle: Each entry that is recorded into the system should be backed by a verifiable, reliable, and objective evidence source supporting the entry. 

The theory of accounting is an ongoing process. It is not a one-stop shopping but continues to grow, adapt, and evolve when faced with real business scenario-based challenges. Either new accounting standards are implemented, or the old standards get revised to address the issue.

What Is The Purpose Of Financial Reporting?  

The International Financial Reporting Standards (IFRS) precisely explain the main motive of financial reporting for registered companies. The IFRS clearly states that: 

These are achieved based on the user’s expectation of the amount, the risk involved, and the timing of the future net cash inflows. Financial reporting, in general, is uniform, but one can notice slight differences that vary between different accounting standards.

The differences are minimal yet substantial; US GAAP is a rule-based standard, whereas IFRS is a principle-based standard. The advantage IFRS has over GAAP is its flexibility when faced with new challenges, whereas GAAP is easy to implement due to its textbook structure. 

Key Elements of the Financial Accounting Theory

Accounting theories have crucial characteristics/elements that contribute to preparing indispensable accounting frameworks. Below are the elements that accounting theory possesses:

1. Relevance: The provided information should stay relevant to the recorded transaction or event. Due to relevancy, any additional and related information can be verified. 
2. Reliability: The provided information stays reliable to procure the users' trust by following accounting standards such as GAAP (US) or IFRS (International). 
3. Useful: The information provided in the financial statements should be helpful to the management and other users who make informal decisions regarding the company. 
4. Consistency: The provided information stays consistent in the approaches taken by the management to avoid any unwanted future misunderstandings. 

Financial Accounting Theory Assumptions

Embarking upon uncertain discoveries and inventions, experts and scholars from different backgrounds offer their hypotheses and theories to anchor baseline understanding, often based upon assumptions due to limited data.  

The accounting theory is no different as it runs on four borderline assumptions. They are as follows:

1. A business is a separate legal entity from its owners and creditors (Business Entity Concept). Therefore, a business can sue as well as get sued.  
2. A business is expected to continue for the foreseeable future and not run into bankruptcy (Going Concern Concept)
3. A business is expected to use monetary value as a measurement of value and refrain from using any non-monetary units of measurement, such as production units (Monetary Unit Concept). 
4. A business is expected to prepare the required financial statements consistently on a monthly or quarterly basis (Consistency Concept). 

Uncertainty and Information Asymmetry

The purpose of the reporting in the financial statements is to transfer the information to the interested users who use such provided information to make business and investment decisions.

Such sensitive information should be reported in a relevant and reliable manner. It should be void of any material misstatements, i.e., misstatements or errors in financial statements, which can influence the judgment of a user who relies on such financial statements.

In financial reporting, there is a common phenomenon every financial accountant encounters called Information asymmetry. This phenomenon poses a situation where one party possesses more or less information than another.

With this information in mind, two information asymmetries are relevant to financial reporting:

In an ideal world, we would have a perfect market where the financial statements issued by the companies are 100% reliable and relevant, voiding biases and errors due to a lack of information asymmetry.

Snapping back to reality, no such perfect market exists. No sets of financial statements are 100% relevant and reliable to its core.

There is a reason why companies are required to audit their financial statements to procure the trust of the interested parties. There always will be a trade-off between reliability and relevance. 

Supply and Demand of Accounting Information

As mentioned, financial statements are the statements the reporting entity prepares through financial reporting (supply) to transfer the reported information to those interested in it (demand).

Supply and demand will always exist, as in this imperfect market, the reporting entity may not always be in the best interest of the interested users. The very existence of information asymmetry in financial statements creates demand and supply.

Accountants and the regulatory bodies guiding the production of financial statements are seen as suppliers.

On the other hand, users of internal and external sources seeking such financial statements for decision-making are seen as a demand. 

Positive Financial Accounting Theory

In reality, fair and objective reporting is important, but that doesn't stop the fraudulent temptations, especially when managers are often concerned with maximizing their compensation and perks. This self-fulfillment is a term known as Earnings management.

Earnings management is an act of deliberate manipulation or influence on the financial statement by the management for the records to be in their favor for a short-term self-benefit rather than the long-term benefit of the company or maximizing shareholders’ wealth.

Therefore, to combat the management’s short-term self-fulfillment for the long-term company benefit, Positive Accounting Theory tries to consider and understand the manager’s motivations, choices of accounting policies, and reactions to different accounting standards.

Some reasons for the manager’s engagement in earnings management are as follows:

Securities Law and Financial Accounting Theory

The information asymmetry's sensitivity has caught the eyes of securities regulators worldwide. Therefore, tackling it has become an utmost priority for securities regulators. Due to this, preventive measures are implemented to protect investors from investing in fraudulent investments. 

Security regulations such as Canada’s Canadian Securities Administrators (CSA) and the United States’s Securities and Exchange Commission (SEC), to name a few, have implemented Securities Laws to which all public companies are mandated to adhere. 

One unique example of a prevention-specific measure of the Securities law is “Black-out periods.”

The black-out period targets individuals who possess high-value insider information, which no ordinary user would have access to other than the published financial statements. Then, it restricts such individuals from trading (buying and selling) the company shares.

Benefiting from such insider information, which is yet to be revealed, is illegal and offensive by law (depending on the country’s laws and regulations).

Researched and Authored by Muhammed Ishfaque Ishaque | LinkedIn

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