The Nature of Accounting Theory, Principles, Policy and Procedures

Accounting is a language — one used to communicate the financial story of an entity to the people who need to understand it. Before you can speak it fluently, you need to know where it comes from, how it is structured, and why it works the way it does.

1. What is accounting?

Accounting is a specialised language used to convey financial information about an entity to the people who need it. Like any language, it has its own vocabulary, grammar and rules. If the reader cannot understand it, the message has no value.

More formally, accounting is a process made up of three core activities:

A practical example

Imagine you own a small shop. On Monday you buy R5 000 worth of stock on credit from a supplier. On Tuesday a customer buys R800 worth of goods, paying cash. Both of these are economic events that affect your business. Accounting asks: Did it happen? Can it be expressed in rand? If yes — identify it, record it, and eventually report it in your financial statements.

2. The universal accounting denominator

For accounting to work as a system of communication, all transactions must be expressed in a common unit. That unit is money. In South Africa, that means the rand (R). Every single transaction — no matter how different — gets converted into a rand value before it is recorded.

This seems obvious, but it creates two important limitations you must know:

3. Forms of ownership

The way a business is owned determines how it is managed, how profits and losses are shared, and how it is taxed. In South Africa, four main forms of ownership exist for profit-seeking entities, plus a separate category for non-profit entities.

4. Users of financial information

Financial statements are not prepared for the preparer — they are prepared for users. Different users need the same information for very different reasons. Understanding who uses financial information, and why, is a core concept in this study unit.

5. Fields of accounting

Because internal and external users need different kinds of information, two distinct fields of accounting have developed to serve them.

6. Accounting principles, policy and IFRS

6.1 Accounting principles

The practical techniques of accounting are not arbitrary — they are built on conceptual and theoretical foundations. These foundational ideas are called accounting principles. Think of them as the “rules of grammar” in the accounting language.

6.2 Accounting policy

Many transactions can be handled in more than one acceptable way. For example, an entity can choose between two methods to calculate depreciation on equipment. Accounting policy is the entity’s documented decision about which method it will use — consistently — for similar transactions over time.

Example: Accounting policy in practice

Zara’s Clothing CC owns delivery vehicles. It must choose how to depreciate them. It could use the straight-line method (equal amount each year) or the diminishing balance method (higher amount in early years). Whichever it chooses, that becomes its accounting policy — and it must apply the same method every year, and disclose which method it uses in its financial statements.

6.3 Disclosure of accounting policy

Because different entities can make different policy choices, every entity must disclose its accounting policies in the notes to its financial statements. This allows users reading the statements to understand the basis on which figures have been calculated — and to compare entities on a fair footing.

6.4 International Financial Reporting Standards (IFRS)

If every entity could report however it liked, using its own rules and interpretations, financial statements from different entities would be incomparable — chaos would result in the business and investment world.

To solve this, an internationally agreed body of standards has been developed: IFRS. It encompasses the accounting concepts, principles, methods and procedures that financial accounting must follow worldwide. In South Africa, listed companies and public entities are required to apply IFRS.

7. The Conceptual Framework for Financial Reporting (2010)

The Conceptual Framework is not a standard — it is the theoretical foundation behind the standards. It sets out the objectives, assumptions and qualitative characteristics that all financial statements should meet.

7.1 Objective of financial statements

The primary objective is to provide useful financial information to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.

7.2 Underlying assumption: Going concern

Financial statements are prepared on the assumption that the entity will continue to operate for the foreseeable future — it is not about to be liquidated or significantly scaled back. This assumption affects how assets and liabilities are valued.

7.3 Qualitative characteristics

For financial information to be useful, it must possess certain qualities. The framework distinguishes between fundamental characteristics (the most important) and enhancing characteristics (which improve usefulness).

7.4 The elements of financial statements

Financial statements are built from five fundamental building blocks called elements. Three elements describe the entity’s financial position; two describe its financial performance.

The accounting equation

The three financial position elements combine into the most fundamental equation in all of accounting:

8. Worked exercise

These are the types of scenario-based questions that appear in FAC1502 assignments and exams. Work through each one before revealing the answer.

9. Quick quiz

Ten questions drawn from the full study unit. Answer without referring to your notes first — that’s how you find the gaps.