Page 200 - Accounting Principles (A Business Perspective)

5. Accounting theory

be recorded in that one time period and would not have to be assigned to artificially short periods of one year or
less.
Approximation and judgment because of periodicity To provide periodic financial information,

accountants must often estimate expected uncollectible accounts (see Chapter 9) and the useful lives of depreciable
assets. Uncertainty about future events prevents precise measurement and makes estimates necessary in
accounting. Fortunately, these estimates are often reasonably accurate.
Other basic concepts

Other basic accounting concepts that affect accounting for entities are (1) general-purpose financial statements,
(2) substance over form, (3) consistency, (4) double entry, and (5) articulation. We discuss these basic accounting
concepts next.
Accountants prepare general-purpose financial statements at regular intervals to meet many of the
information needs of external parties and top-level internal managers. In contrast, accountants can gather special-
purpose financial information for a specific decision, usually on a one-time basis. For example, management may

need specific information to decide whether to purchase a new computer system. Since special-purpose financial
information must be specific, this information is best obtained from the detailed accounting records rather than
from the financial statements.
In some business transactions, the economic substance of the transaction conflicts with its legal form. For
example, a contract that is legally a lease may, in fact, be equivalent to a purchase. A company may have a three-
year contract to lease (rent) an automobile at a stated monthly rental fee. At the end of the lease period, the
company receives title to the auto after paying a nominal sum (say, USD 1). The economic substance of this

transaction is a purchase rather than a lease of the auto. Thus, under the substance-over-form concept, the auto is
an asset on the balance sheet and is depreciated instead of showing rent expense on the income statement.
Accountants record a transaction's economic substance rather than its legal form.
Consistency generally requires that a company use the same accounting principles and reporting practices
through time. This concept prohibits indiscriminate switching of accounting principles or methods, such as
changing inventory methods every year. However, consistency does not prohibit a change in accounting principles
if the information needs of financial statement users are better served by the change. When a company makes a
change in accounting principles, it must make the following disclosures in the financial statements: (1) nature of the
change; (2) reasons for the change; (3) effect of the change on current net income, if significant; and (4) cumulative

effect of the change on past income.
Chapter 2 introduced the basic accounting concept of the double-entry method of recording transactions. Under
the double-entry approach, every transaction has a two-sided effect on each party engaging in the transaction.
Thus, to record a transaction, each party debits at least one account and credits at least one account. The total
debits equal the total credits in each journal entry.
When learning how to prepare work sheets in Chapter 4, you learned that financial statements are
fundamentally related and articulate (interact) with each other. For example, we carry the amount of net income

from the income statement to the statement of retained earnings. Then we carry the ending balance on the
statement of retained earnings to the balance sheet to bring total assets and total equities into balance.

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