Financial Accounting Standards - Theory Assessment Answer
Accounting theory is a group of methodologies and assumptions, which is applied to the principles of financial reporting. In addition, the study of accounting theory constitutes of a critical appraisal of both chronological fundamentals of the principles of accounting and the methods through which such practices are modified and included in the regulatory framework. This is because the regulatory framework governs the financial reporting and financial statements. The current essay aims to identify three accounting theories and pragmatic principles establishing the general framework. Finally, critical evaluation of these accounting theories has been identified to identify their needs or lack of needs.
Evaluation of the need or lack of need for three identified accounting theories:
The three major accounting theories, which have been identified to suit the purpose of this essay, constitute of “proprietary theory”, “principle of going concern” and “normative theory” of accounting. According to the “proprietary theory” of accounting, an entity acts as an agent, arrangement or representative through which the stockholders or the entrepreneurs operate. Under this theory, the centre of interest is the point of focus of the group of owners, which is depicted in a manner to keep accounting records and develop the financial statements. The ultimate goal of this theory is the ascertainment and dissection of the net worth of the proprietor. Therefore, the proprietary theory views the accounting equation as “Assets – Liabilities = Equity of the proprietor”.
Therefore, the proprietor is the owner of assets and liabilities. Therefore, if the liabilities might be treated as negative assets, the proprietary theory could be considered as asset-centred, which depicts its orientation towards the balance sheet. Under this theory, the valuation of assets is conducted and the statement of financial position is developed for gauging the modifications in the interest of the proprietor or wealth. However, the revenues and expenditure do not increase or decrease due to the investments of the proprietor or withdrawals of capital Hence, net profit is the rise in the wealth of the proprietor, which is to be added with the capital. In addition, the losses, income taxes and interest on loans are expenditures, while dividends are capital withdrawals.
The proprietary theory has direct effects on the techniques of financial accounting and treatment of various accounting items. For instance, net profit of an organisation that is computed after interest treatment and income tax as expenditures, depicts the “net income to equity shareholders” instead of all capital providers. In a similar manner, accounting terms like “dividend per share”, “earnings per share” and “book value per share” reflect a proprietary emphasis.
This theory has two segregations regarding the individuals to be included in the proprietary group. In the first segregation, the common stockholders form a portion of the group, while the exclusion of preferred shareholders is inherent. Henceforth, the preferred dividends are subtracted at the time of computing the proprietor earnings. In the latter segregation, both preferred and common capitals are taken into account in the proprietor equity. This is a broader view, in which the concentration of attention is on the equity section of the shareholders in balance sheet and the amount to be credited to the stakeholders in the statement of profit or loss.
The proprietary theory is applied to sole proprietorship and partnership firms. However, this theory has made certain contributions like the corporate concept of net profit, which depicts the net profit of the shareholders instead of the capital providers. Another instance is the procedure utilised for unconsolidated subsidiary investments, which suggests that the firm takes into account the net income of the subsidiary in the main net profit. However, the major criticism confronting the proprietary theory of accounting is that the relationship in terms of creditors between the firm and the owners has been unrealistic.
According to the second segregation of the proprietary theory, both creditors and the providers of capital need to be treated in identical manner. Therefore, it is an unrealistic foundation to develop a theoretical accounting framework. The organisation is not an individual, instead, it is a device intended to benefit the owners. Therefore, this supports the first segregation that there need not be any association between the entity and owners. However, in the current era, the owners need dividend or rewards for their capital investments in the organisation.
“Going concern principle” is the fundamental theories of accounting based on which the financial statements are formulated. The financial reports are developed by presuming that the organisation would continue to function in the future without any requirement on the part of the management to liquidate its business or reduce its operating activities. Hence, it is assumed that the organisation would recognise its assets and settle its dues in the normal course of the organisation.
It is the responsibility of the higher-level management to ascertain the relevancy of the going concern principle in developing financial statements. In case, the management of the organisation considers the principle as invalid; the financial statements to be prepared based on break-up method. This depicts that the assets need to be recognised at an amount, which is anticipated to be recognised from the sale, instead of its continuing utilisation of inventory in the ordinary business course. In addition, the valuation of assets is conducted based on their individual worth, instead of their values at a collective unit. The liabilities need to be realised at an amount, which could be settled with ease.
The assumption that an organisation is anticipated to continue its operations in the same state in future would influence the nature, timing and amount on which the transactions of accounting are stored. For instance, a criterion for the asset and liability classification into long-term and current is their recognition in the normal business course. In the basis of non-going concern, the incomes, expenditures, liabilities, assets and equity are recorded at values, which depict the winding up of the organisation. This implies that the assets are realised at values, which they could fetch, in case, they are sold in the current conditions.
Therefore, the management needs to evaluate at the date of the annual report about the going concern method. Some of the accounting frameworks need management to disclose their evaluation of going concern. The indicators, which jeopardise the status of going concern of the organisation, include the situation in which liabilities are more than assets, loan default, penalty of taxes, adverse regulations, negative cash inflows and adverse legal claims The auditors of the organisation need to dissect the status of the going concern of the business.
In addition, the principle of going concern is associated closely with the concept of business entity, concept of materiality and the concept of historical cost. In the principle of going concern, the business is viewed at the owner isolation, which is in line with the entity concept and the material reasons influence the occurrence of continuing operations, which are in line with the concept of materiality.
The going concern concept provides an effective basis for measuring the profit or income. This implies that the items that provide future economic advantage are recorded at long-term assets, instead of expenditures only because of the assumptions of going concern. In addition, the assumption of going concern facilitates the segregation of both short-term and long-term assets and liabilities. Therefore, it is due to the going concern concept that the liabilities and assets appear in book value. However, the assets are not measured at the market price because these assets are not aimed for sale.
With the help of going concern concept, the investors could expect the operations of the business in the same manner to perform all the business operations to comply with the pre-set goals. The current assets are measured at a value, which is lower between the market value and cost of the business. The information about the liquidation consequences is not provided under the concept of going concern. However, if an organisation prepares its financial reports based on the going concern concept, it could raise concerns about the transparency and fairness of the financial reports. This is because many organisations have shut down during inflationary periods after publishing their accounts based on the principle of going concern.
Moreover, in case of liquidation, the liabilities, which would arise, are not taken into account. As a result, it deprives the unsecured creditors of significant information. Furthermore, the alternate courses of action could not be analysed under the principle of going concern.
Normative accounting theory aims to provide guidance to the policy makers about the steps to be taken developed on a theoretical underpinning. In other words, normative theory of accounting follows the deductive approach, which is just reverse in case of positive accounting theory. This is because normative accounting theory begins with the theory and deduces to particular policies, while positive theory of accounting begins with the particular policies and generalises the same to greater-level principles. For instance, many incomprehensible financial securities of the banks have been accounted in a manner, which is identical to that of real estate and common asset. These assets were not needed to be re-valued and as a result, they have been accounted at their existing market values.
However, such scenario has changed after the crisis at the time the market for the assets have been saturated. Therefore, the policies of accounting have been modified to require the assets to be re-valued on each financial report. This has resulted in unrecognised gains and losses for banks. This has proved to be a main driver of profit and loss. Henceforth, the normative theory of accounting has come into existence through a major change in the accounting policy. This has been driven by a principle, which was not prevalent in the accounting treatment in place at the owners of these assets.
Under normative theory of accounting, the evaluation of different elements and carrying out studies in diverse ways are conducted. As a result, it helps in framing and development of various theories of accounting, which form the construct and basis of accounting theories. In addition, the normative theory postulates that the policy makers need to discuss their viewpoints and judgements on the different accounting practices and the inclusions on the theory. The theorists make effective utilisation of their previous experiences and evaluations, which depend on the things that they have explained and define other things to be added in the theory. Therefore, the major things included in the normative theory of accounting comprise of personal viewpoint, utilisation of inductive processes and deductive reasoning.
For instance, one of the most common instances of the normative theory of accounting is the conceptual framework. The accounting conceptual framework is the definition of various rules and regulations, which are framed on the part of various accounting boards and institutions for explaining the various rules and methodologies. These are needed to be followed for the accounting purpose. The “Financial Accounting Standards Board (FASB)” explains a group of rules based on the problem approach to frame a conceptual framework. With the help of conceptual framework, the organisations could measure the constituents of the financial reports like incomes and expenditures.
The major advantage of normative accounting theory is that it could be used to frame future economic policies based on the existing theory. For instance, the vision strategy of an organisation enlisted in its business plan might be treated as normative statements. This is because they depict the ideals of business, which the organisation aims to accomplish. As a result, it helps in effective financial planning of future through factual-based practices.
However, the major disadvantage associated with the normative accounting theory is the framing of accounting principal to be applied to different situations. For instance, after the signing of a contract, the major issue is the recognition of costs and income regarding whether they are realised immediately, incremental over time or lump sum in the future. Based on the contract, the organisation and the products provided, the answer might be any of three alternatives or a combination of all.
Based on the above discussion, the three major accounting theories include “proprietary theory” of accounting, “principle of going concern” and “normative theory” of accounting. Under the accounting theory of proprietary accounting, the focus of the owners’ group is the centre of interest, which is depicted in a manner to keep accounting records and develop the financial statements. Hence, the ultimate aim of this theory is to determine and evaluate the net worth of the proprietor. In addition, the proprietary theory could be applied in case of sole proprietorship and partnership firms.
However, the contributions of this theory are immense like the corporate concept of net profit, which depicts the net profit of the shareholders, rather than the capital providers. Another example is the method used for unconsolidated subsidiary investments, which depicts that the firm takes into account the net income of the subsidiary in the main net profit. Under the principle of going concern, the financial reports are prepared by assuming that the organisation would continue to perform in the future without any requirement on the part of the management to liquidate its business or reduce its operating activities.
In case of normative accounting theory, it aims to provide guidance to the policy makers about the steps to be taken in future developed on a theoretical underpinning. In addition, it helps in framing and development of various theories of accounting, which form the construct and basis of accounting theories. However, the recognition of incomes and expenses in terms of timeframe has been the major obstacle in the normative theory of accounting,
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