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What is Financial Accounting Theory?

By Marisa O'Connor
Updated May 17, 2024
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Financial accounting theory is a fairly broad term. The very basics of accounting theory date back to 1494 and were founded in Italy. Financial accounting has changed over time to adapt to different sources of profit and losses, but its core remains the same. It is a methodology for individual or business budgeting. It provides a way to determine what the value of individual products and services are as well as the financial value of the overall business or person.

The basics of financial accounting theory date as far back as 1494. These first concepts were published in Italy in a book on applied mathematics by Luca Pacioli called Summa de Arithmetica, Geometria, Proportion et Proportionalita. Over time, theories have developed to adapt to the growing complexities of larger businesses and corporations. The theories address new types of assets and liabilities that have come about since 1494, but the core of accounting has remained the same.

Financial accounting theory states that accounting is required for businesses to understand their profits or losses. Accounting involves recording the financial value of all assets and liabilities of a business or individual. Keeping track of all financial transactions is also important to understand the changing value over time. This information is used to build and maintain a budget, which is necessary for financial planning and growth.

Financial accounting theory is critical to business growth, as it is the best methodology for deciding what a business should charge for its services. Without a proper understanding of accounting theory, businesses are at risk of under- or over-charging, and either case is bad for business. The cost of a product or service should be based on material and labor cost, which can include any special training required. If a business charges less than it spent to acquire the product or service, it is losing money with every sale. Alternatively, if a business is charging a much higher amount than the product or service cost to acquire, customers will likely go to another business that is accounting for a lower profit margin, effectively selling the same thing for less.

One of the most commonly used financial accounting theories for business is called the normative theory. This is a very prescriptive type of theory and does not address actual spending. In its simplest form, this theory is a budget, recording all income and predicting where the losses will occur in terms of bills and other expenses. The success of normative theory depends on how well the theory is implemented into actions. This method of accounting only provides the business or individual with potential profits or losses; the actual results depend on how accurate the predicted expenses were.

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