DEPARTMENT OF COMMERCE

UNIVERSITY OF JAFFNA- SRI LANKA

Programme Title : Third in Bachelor of Commerce -2016/2017
Course Unit : COM ACF E 32072: Accounting Theory and Application
Handout : 1.1 – An Introduction to Accounting Theory
Prepared by : Mr. A. Ajanthan
Issued on : 04th of December, 2018
Intended Learning Outcomes (ILOs):
After studying this section, the students should be able to:
 define the terms ‘theory’ and ‘accounting theory’
 explain the need and nature of accounting theory
 describe the relationship between accounting theory and practice.

Introduction
Why do rockets need so much power to lift off? Why do humans walk on two legs? To
answer these questions, we are likely to call upon the theories of gravity and evolution. The
students of accounting when enter in their career after passing graduation or post graduation
in commerce, they believe that there is a solution to every accounting problem. No, it is for
away from the truth because there are many issues remain unresolved after having the
knowledge of mere accounting. To become of student of accounting in real sense of the
business world, one should also concentrate on understanding the problems of accounting
practice and profession. For this matter and reason, the accounting theory is recommended.
The accounting theory provides the knowledge of Generally Accepted Accounting Principles
(GAAPs), Contemporary issues and other developments in the field.

Accounting is usually viewed as a subject that engages in a discussion of techniques

and tools that accounting professionals employ in the practice. However, what is not really
appreciated is that these techniques and tools employed in the practice have been devised in a
systematic and orderly manner to ensure that the practice results in an output, which is useful
to those who require the services of accounting professionals. A famous Classical Greek
scholar, Aristotle, claimed that practice emerges from theory. Thus, generally speaking,
theories provide the reasoned basis for practice. The process of theorizing is designed to
obtain an understanding and then provide an explanation of phenomena to serve as the basis
for practice.

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Theory
The word theory is derived from the classical Greek word meaning ‘viewing, speculation and
contemplation.’ The term 'theory' can be used in different ways. As such, it can take on
several meanings. There is no precise definition for theory. A theory is usually defined as a
logical combination of interrelated concepts, definitions and propositions that describe a
systematic view of phenomena by establishing relations among variables, with the purpose of
explaining and predicting the phenomena. However, there are various
perspectives/definitions as to what is meant by a theory;

Definitions of Theory
 A statement on belief expressed in a language.
 A deductive system of statements of decreasing generality that arise from an agreed
or hypothesised premise.
 A set of ideas used to explain real-world observations.
 A deductive system in which observable consequences logically follow from the
conjunction of observed facts with the set of the fundamental hypotheses …
(Braithwaite, 1968)
 A coherent set of hypothetical, conceptual and pragmatic principles forming the
general framework of reference for a field of inquiry…..(Hendriksen,1970)
 A set of premises which is logically related.

However, a close examination of these different definitions shows that theories involve in
things such as reasoning, propositions, concepts, logical analysis, hypotheses, explanations,
phenomena, reality and abstraction. Thus, theories are not ad hoc in nature and are based on
logical reasoning. There are many different types of theories that have been proposed over
the years. This is true in accounting as it is in all other disciplines. A theory depends on how
would be the theorist views the world and the phenomena under consideration, the
assumption they make about the behavior of people and the phenomena, and their aims in
developing the theory.

Accounting
Accounting has frequently been described as a body of practices which have been developed
in response to practical needs rather than by deliberate and systematic thinking. Accounting
is the process of identifying, measuring, recording and communicating economic information
to others so that they may make decisions on the basis of that information. This is generally

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termed as the language of business throughout the world. It serves as a means to
communicate matters relating to various aspects of business operations. As the individual
business enterprises keep their accounting records separately, the offer to communicate is
essentially from a business enterprise to various individuals, groups and institutions that are
having interest in the operations and results of that enterprise. Now, although accounting is
generally recognised with the business, trade and profession, the business enterprise is not the
only kind of organisation that makes use of accounting. Legal entities ranging from
individual to governments use and prepare accounting to obtain information on the financial
condition and performance of the entity in question. Just as the business enterprises like
firms, companies, societies and institutions keep their accounts, so can the nations and even
the individual owners of the business and profession entities. It is necessary to have a good
knowledge of accounting-grammar (in the shape of construction of accounts, conventions,
concepts, postulates, principles, standards etc.) to interpret accounting information for
purposes of communication, reporting, decision making or appraisal.

Accounting Theory
Accounting theory is a modern concept when compared with, say, theories emanating from
mathematics or physics. Accounting first developed as a set of tools to record activities or
transactions. Even Pacioli's treatise on double entry accounting was focused on documenting
the processes involved and not about explaining the underlying basis for this method of
recording. According to Hendriksen (1970), accounting theory may be defined as logical
reasoning in the form of a set of broad principles that provide a general framework of
reference by which accounting practice can be evaluated and guide the development of new
practices and procedures.” Further, an accounting theory refers to having a body of
knowledge which sets out the rules and regulations to be followed in accounting for
transactions. Accounting theories should provide guidance to accounting practice and a basis
for the future development of accounting standards.

It can cover a broad range of issues from purely technical and measurement issues to
political and social issues. Accounting theory is not separate from reality. Its main purpose is
to explain current accounting practice and to provide a basis for developments in accounting
practice. Llewelyn (2003) points out that term ‘accounting theory’ is not only applied to
‘grand theories’, which seeks to tell us about broad generalisable issues but also applies to
any framework which helps us to make a sense of aspects of the (social) world in which we

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live, and which helps to provide a structure to understand our (social) experiences. Thus, a
broad range of theories exists in accounting dealing with various perspectives.

There is no universally accepted theory of accounting. Instead, many theories exist in

financial accounting. Some theories prescribe what should be done in particular
circumstances while other theories explain and predict particular accounting related
phenomenon. These theories provide different perspectives about the central objective, role
and scope of financial accounting. There is also no universally accepted perspective about
the role of accounting theory. Different researchers have different perspectives on the role of
accounting theory. Some researchers believe that the principal role of accounting theory
should be to explain and predict particular accounting-related phenomena where as others
believe that the role of accounting theory is to prescribe particular approaches to accounting.
A researcher’s own values will influence which theory he or she elects to embrace.

Nature and Need for Accounting Theory

No discipline can develop in a systematic and result oriented manner unless it is supported by
sound and strong theoretical base. Hence, accounting practices also should be supported by
sound realistic theory. So, actual growth and development of accounting practices depend
upon the development of accounting theory. Here lies the importance of accounting theory.
The basic character of accounting theory is its flexibility because it is not a particular or a
single theory but is actually an accumulation of a series of theories from times to time
depending upon the practical applicability and the problems faced by accounting practices.
The framework of accounting theory is based on the present conventions, concepts and the
objectives of accounting. It also includes double entry system of bookkeeping and forms of
different financial statements for presenting accounting information at the end of the financial
year. Proper knowledge of accounting theories helps the accountant not to see accounting as
a mechanical process. A sound knowledge of theories helps them choose a suitable method
and procedures, and also helps them detect deficiencies in the existing accounting systems or
practices. It helps them explain why they use a particular method and its applicability and
utility within the organisation.

Nature of Accounting Theory

a. Accounting as a language
 Perceived as a language of business.
 Business activities are reported in accounting statements using accounting language.

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  Translate economic event and transactions into something that can be understood by
users.
b. Accounting as a historical record
 Concern with providing a faithful record of the transactions of an entity and manager
stewardship of the owner’s resources.
c. Accounting as an economic good
 Accounting info is not costless to produce and impose compliance costs.
 Manager chooses accounting rules that minimize info costs and shareholders impose
accounting rules that improve the ability to control and monitor the actions of
managers.
d. Accounting as current economic reality
 Balance sheet and income statement should be based on a valuation basis that is more
reflective of economic reality rather than historical costs. Focus on current and future
prices.
e. Accounting as communication-decision information
 Accounting is action oriented. Accounting is prepared to suit the needs of users and
will have impact on the decision-making behaviour of managers and investors.

Relationship between Accounting Theory and Practice

Simply it can be said that what is to be done and why that should be done are explained by
accounting theory. On the other hand, what accountants do in their profession is called
accounting practice. Accounting theories explain or justify accounting actions or practices.
At the first instance, we may say that accounting actions or practices consist of collecting and
recording of some business transactions. The next phase consists of processing the recorded
data for the purpose of classifying and condensing them. The last phase involves preparation
of accounting statements, such as profit and loss accounts and balance sheet, out of the
process data. Hendriksen, for instance, arrives at the following definition “accounting theory
may be defined as logical reasoning in the form of a set of broad principles that provide a
general framework of reference by which accounting practice can be evaluated and guide the
development of new practices and procedures.” The function of an accounting theory is not
to explain or justify practices outright, but to examine how far they are logical or justifiable.

Accounting theory and practice are inseparable. In practice, deprecation is charged to profit
and loss account, but accounting theory explains why it should be charged and why. Hence,
accounting theory is the abstraction of what accountants do in practice. Both accounting

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theory and practice are concerned with measure and communication of economic event of an
entity. Both are interested in presenting financial data or information in a systematic manner
to protect the interest of the owners and other users. It is better to say that they are mutually
dependant and complementary to each other.

Differences: accounting theory is based on logic, but not all practice is logically conceived.
There are some cases where it is not possible for accounting practice to follow the accounting
theory strictly due to practical problem or according to the desire of the users. That is why it
is frequently said that, “theoretically it is perfect but practically it is not feasible”. It is the
objective of accounting theories to satisfy the needs of accounting practices for the users of
financial statements by developing accounting principles and guidelines for maintaining
uniformity and consistency in accounting. Whereas accounting practices follow the said
developed principles and guidelines while preparing their accounting work. Accounting
practices raise the practical problems faced by them while preparing their financial statements
for the best interest of the owners and users. These practical problems work as a fuel for
developing new accounting standards and principles for the present and future accountants.
However, accounting practices are more dynamic and flexible than that of accounting theory.

As a conclusion, you can say that accounting theory and practice are two sides of a coin.
They are neither separate, nor competing-rather they are complementary to each other.
Without accounting theory, accounting practice cannot develop in the right direction and, on
the other hand, accounting theory is developing day by day on the basis of data and
information provided by the accounting practice. They both help the management in decision
making.

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