Accounting Assumptions, Accounting Principles and Constraints

The lectures cover CPA questions covering accounting Assumptions, accounting Principles and constraints that are covered in the conceptual framework.

Accounting Assumptions, Accounting Principles and Constraints

Basic Assumptions

Four basic assumptions underlie the financial accounting structure: (1) economic entity, (2) going concern, (3) monetary unit, and (4) periodicity. We’ll look at each in turn.

Economic Entity Assumption

The economic entity assumption means that economic activity can be identified with a particular unit of accountability. In other words, a company keeps its activity separate and distinct from its owners and any other business unit.

Going Concern Assumption

Most accounting methods rely on the going concern assumption.  Accounting assumption that a company will continue in operation for the foreseeable future. Only in situations in which liquidation appears imminent is the assumption inapplicable.—that the company will have a long life. Despite numerous business failures, most companies have a fairly high continuance rate. As a rule, we expect companies to last long enough to fulfill their objectives and commitments.

This assumption has significant implications. The historical cost principle would be of limited usefulness if we assume eventual liquidation. Under a liquidation approach, for example, a company would better state asset values at net realizable value (sales price less costs of disposal) than at acquisition cost. Depreciation and amortization policies are justifiable and appropriate only if we assume some permanence to the company. If a company adopts the liquidation approach, the current/noncurrent classification of assets and liabilities loses much of its significance. Labeling anything a fixed or long-term asset would be difficult to justify. Indeed, listing liabilities on the basis of priority in liquidation would be more reasonable.

The going concern assumption applies in most business situations. Only where liquidation appears imminent is the assumption inapplicable. In these cases, a total revaluation of assets and liabilities can provide information that closely approximates the company’s net realizable value. You will learn more about accounting problems related to a company in liquidation in advanced accounting courses.

Monetary Unit Assumption

The monetary unit assumption means that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. That is, the monetary unit is the most effective means of expressing to interested parties changes in capital and exchanges of goods and services. The monetary unit is relevant, simple, universally available, understandable, and useful. Application of this assumption depends on the even more basic assumption that quantitative data are useful in communicating economic information and in making rational economic decisions.

In the United States, accounting ignores price-level changes (inflation and deflation) and assumes that the unit of measure—the dollar—remains reasonably stable. We therefore use the monetary unit assumption to justify adding 1990 dollars to 2017 dollars without any adjustment. The FASB in SFAC No. 5 indicated that it expects the dollar, unadjusted for inflation or deflation, to continue to be used to measure items recognized in financial statements. Only if circumstances change dramatically (such as if the United States experiences high inflation similar to that in some South American countries) will the FASB again consider “inflation accounting.”

Periodicity Assumption

To measure the results of a company’s activity accurately, we would need to wait until it liquidates. Decision-makers, however, cannot wait that long for such information. Users need to know a company’s performance and economic status on a timely basis so that they can evaluate and compare firms, and take appropriate actions. Therefore, companies must report information periodically.

The periodicity (or time period) assumption implies that a company can divide its economic activities into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly.

The shorter the time period, the more difficult it is to determine the proper net income for the period. A month’s results usually prove less verifiable than a quarter’s results, and a quarter’s results are likely to be less verifiable than a year’s results. Investors desire and demand that a company quickly process and disseminate information. Yet the quicker a company releases the information, the more likely the information will include errors. This phenomenon provides an interesting example of the trade-off between timeliness and accuracy (free from error) in preparing financial data.

The problem of defining the time period becomes more serious as product cycles shorten and products become obsolete more quickly. Many believe that, given technology advances, companies need to provide more online, real-time financial information to ensure the availability of relevant information.

Basic Principles of Accounting

Basic Assumptions

Four basic assumptions underlie the financial accounting structure: (1) economic entity, (2) going concern, (3) monetary unit, and (4) periodicity. We’ll look at each in turn.

Economic Entity Assumption

The economic entity assumption means that economic activity can be identified with a particular unit of accountability. In other words, a company keeps its activity separate and distinct from its owners and any other business unit. At the most basic level, the economic entity assumption dictates that Panera Bread Company record the company’s financial activities separate from those of its owners and managers. Equally important, financial statement users need to be able to distinguish the activities and elements of different companies, such as General MotorsFord, and Chrysler. If users could not distinguish the activities of different companies, how would they know which company financially outperformed the other?

The entity concept does not apply solely to the segregation of activities among competing companies, such as Home Depot and Lowe’s. An individual, department, division, or an entire industry could be considered a separate entity if we choose to define it in this manner. Thus, the entity concept does not necessarily refer to a legal entity. A parent and its subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes does not violate the economic entity assumption

Going Concern Assumption

Most accounting methods rely on the going concern assumption—that the company will have a long life. Despite numerous business failures, most companies have a fairly high continuance rate. As a rule, we expect companies to last long enough to fulfill their objectives and commitments.

This assumption has significant implications. The historical cost principle would be of limited usefulness if we assume eventual liquidation. Under a liquidation approach, for example, a company would better state asset values at net realizable value (sales price less costs of disposal) than at acquisition cost. Depreciation and amortization policies are justifiable and appropriate only if we assume some permanence to the company. If a company adopts the liquidation approach, the current/noncurrent classification of assets and liabilities loses much of its significance. Labeling anything a fixed or long-term asset would be difficult to justify. Indeed, listing liabilities on the basis of priority in liquidation would be more reasonable.

The going concern assumption applies in most business situations. Only where liquidation appears imminent is the assumption inapplicable. In these cases, a total revaluation of assets and liabilities can provide information that closely approximates the company’s net realizable value. You will learn more about accounting problems related to a company in liquidation in advanced accounting courses.

Monetary Unit Assumption

The monetary unit assumption means that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. That is, the monetary unit is the most effective means of expressing to interested parties changes in capital and exchanges of goods and services. The monetary unit is relevant, simple, universally available, understandable, and useful. Application of this assumption depends on the even more basic assumption that quantitative data are useful in communicating economic information and in making rational economic decisions.

In the United States, accounting ignores price-level changes (inflation and deflation) and assumes that the unit of measure—the dollar—remains reasonably stable. We therefore use the monetary unit assumption to justify adding 1990 dollars to 2017 dollars without any adjustment. The FASB in SFAC No. 5indicated that it expects the dollar, unadjusted for inflation or deflation, to continue to be used to measure items recognized in financial statements. Only if circumstances change dramatically (such as if the United States experiences high inflation similar to that in some South American countries) will the FASB again consider “inflation accounting.”

Periodicity Assumption

To measure the results of a company’s activity accurately, we would need to wait until it liquidates. Decision-makers, however, cannot wait that long for such information. Users need to know a company’s performance and economic status on a timely basis so that they can evaluate and compare firms, and take appropriate actions. Therefore, companies must report information periodically.

The periodicity (or time period) assumption implies that a company can divide its economic activities into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly.

The shorter the time period, the more difficult it is to determine the proper net income for the period. A month’s results usually prove less verifiable than a quarter’s results, and a quarter’s results are likely to be less verifiable than a year’s results. Investors desire and demand that a company quickly process and disseminate information. Yet the quicker a company releases the information, the more likely the information will include errors. This phenomenon provides an interesting example of the trade-off between timeliness and accuracy (free from error) in preparing financial data.

The problem of defining the time period becomes more serious as product cycles shorten and products become obsolete more quickly. Many believe that, given technology advances, companies need to provide more online, real-time financial information to ensure the availability of relevant information.

Cost Constraints

In providing information with the qualitative characteristics that make it useful, companies must consider an overriding factor that limits (constrains) the reporting. This is referred to as the cost constraint (the cost-benefit relationship). That is, companies must weigh the costs of providing the information against the benefits that can be derived from using it. Rule-making bodies and governmental agencies use cost-benefit analysis before making final their informational requirements. In order to justify requiring a particular measurement or disclosure, the benefits perceived to be derived from it must exceed the costs perceived to be associated with it.

A corporate executive made the following remark to the FASB about a proposed rule: “In all my years in the financial arena, I have never seen such an absolutely ridiculous proposal…. To dignify these ‘actuarial’ estimates by recording them as assets and liabilities would be virtually unthinkable except for the fact that the FASB has done equally stupid things in the past…. For God’s sake, use common sense just this once.” Although extreme, this remark indicates the frustration expressed by members of the business community about rule-making and whether the benefits of a given pronouncement exceed the costs.

The difficulty in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable. The costs are of several kinds: costs of collecting and processing, of disseminating, of auditing, of potential litigation, of disclosure to competitors, and of analysis and interpretation. Benefits to preparers may include greater management control and access to capital at a lower cost. Users may receive better information for allocation of resources, tax assessment, and rate regulation. As noted earlier, benefits are generally more difficult to quantify than are costs.