Key Concepts
For each theory, you must be able to: (a) state the name, (b) explain it, and (c) apply it to a given scenario.
| Theory | Explanation | How it applies |
|---|---|---|
| Accounting entity | The business and its owner(s) are treated as separate and different entities. All transactions are recorded from the point of view of the business. | The owner's personal expenses are not recorded in business books. Capital contributions and drawings — being transactions between owner and business — are recorded in the business books. |
| Accounting period | The life of a business is divided into regular time intervals. | Financial statements are prepared at yearly intervals (e.g. for the year ended 31 Dec 20X5). |
| Accrual basis of accounting | Business activities are recorded when they occur, regardless of whether cash is paid or received. Revenue is recognised when earned; expenses are recognised when incurred. | Revenue earned in the current period is recorded in this period, even if cash is received later. Expenses incurred in the current period are recorded in this period, even if cash is paid later. |
| Consistency | The same accounting method must be applied to the same item across all accounting periods, so that meaningful comparisons can be made. | If the straight-line method is used to depreciate a delivery van, the same method must be used for that van in every later year — the business cannot switch to the reducing-balance method — so that profits can be compared fairly from one year to the next. |
| Going concern | A business is assumed to have an indefinite economic life, unless there is credible evidence it may close down. | Assets are recorded at cost rather than at the low amounts they would fetch if the business had to close down, because the business is expected to continue operating. |
| Historical cost | Transactions are recorded at their original (purchase) cost. | A building bought for $500,000 is recorded at $500,000, even if its market value later rises or falls. |
| Matching | Expenses incurred are matched against the income earned in the same accounting period, so that profit is accurately determined. | Only expenses that helped generate the income of the current period are included in this period's financial statements. |
| Materiality | Whether an item is significant depends on its size relative to the business's income, profit, assets, or equity. An item large enough to affect stakeholders' decisions is material; a very small item is immaterial and may be recorded in a simpler way. | Although a low-cost item that lasts more than a year (e.g. a $15 stapler) would normally be recorded as a non-current asset, it may instead be recorded as an ordinary expense, because the amount is too small to affect any stakeholder's decision. |
| Monetary theory | Only transactions that can be expressed in monetary terms (dollars and cents) are recorded. | The loyalty of employees or the reputation of a business cannot be quantified in dollars, so they are not recorded in the books. |
| Objectivity theory | Accounting information must be supported by reliable and verifiable evidence, so that financial statements are free from personal opinions and biases. | All transactions are verified and supported by source documents (e.g. invoices, receipts, bank statements). |
| Prudence | When there is uncertainty, choose the accounting treatment that least overstates assets and profits, and least understates liabilities and losses. | Prudence applies wherever an asset could be overstated — inventory is shown at the lower of cost and net realisable value (NRV), trade receivables are shown at their net amount (trade receivables − allowance for impairment), and non-current assets are shown at net book value (cost − accumulated depreciation) — so that assets and profit are not overstated. |
| Revenue recognition theory | Revenue is recognised when goods have been delivered or services have been provided, not when cash is received. | If a customer pays in advance, the payment is not recognised as revenue until the goods are delivered or the service is performed. |
The most commonly confused theory pairs:
| Common confusion | How to tell them apart |
|---|---|
| Monetary vs Objectivity |
|
| Accounting entity vs Accounting period |
|
| Accrual basis of accounting vs Revenue recognition |
|
| Historical cost vs Going concern |
|
| Prudence vs Materiality |
|
Name and explain the accounting theory that requires the van to remain recorded at $80,000.
The owner wants to revalue the asset upward from its original purchase price to its current market value.
This is the Historical cost theory.
Under the historical cost theory, transactions are recorded at their original cost. The van was purchased for $80,000, so it must remain recorded at $80,000 in the books, regardless of any subsequent changes in market value.
Final Answer:
Name: Historical cost theory
Explanation: Transactions are recorded at their original cost. The van cost $80,000 when purchased by Firefly Traders, and this is the value that must be used in the accounting records — not the current market value of $95,000.
Applying the wrong theory when something "cannot be measured in $." When the scenario describes something that cannot be quantified in monetary terms (e.g. employee loyalty, business reputation, staff morale), the theory is always Monetary theory — not objectivity or materiality.
Applying the wrong theory when owner's personal items are kept separate from the business. This is always Accounting entity theory. The key signal words are "owner" and "business are treated separately" or "owner's personal [item] is not recorded."
Giving only the definition without applying it to the scenario. Theory questions are typically [2] marks: [1] for the name, [1] for explaining the theory in the context of the specific scenario. Do not just copy the definition — connect it to what is described in the question.