College Accounting 16th Edition
Chapter 14
Section II
Incomplete
Underlying Assumptions
The FASB’s conceptual framework lists four assumptions financial statement users should
be able to assume that preparers of the statements have made in preparing the statements.
*insert table
Separate Economic Entity Assumption
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Accounting records are kept for a specific business or activity. The separate economic
entity assumption assumes that the business is separate from its owners. Transactions
on the records of a business and the resulting financial statements reflect the affairs of
the business- not the affairs of the owner
About Accounting
The Business and Its owners as Separate entities
If the business entity is a sole proprietorship, it may be difficult to think on terms of the
owner and the business as separate entities
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It is easy to understand the separate assumption for a corporation such as Microsoft
because Microsoft is legally separate from its owners. However, the separate entity
concept applies equally to sole proprietorship and partnerships, even though the owners
may be legally liable for all debts of the business and for actions carries out on behalf of
the business.
Going Concern Assumption
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When transactions are recorded and financial statements are prepared, it is assumed
that the business is a going concern- that is, it will continue to operate indefinitely. This
assumption permits businesses to record property and equipment as assets at their
cost without having to be concerned about what they are worth in case of liquidation in
the near future.
Monetary Unit Assumption
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There are two aspects to the monetary unit assumption. First is the idea that expressing
financial facts and events is meaningful only when they can be expressed in monetary
terms. ' The entity may possess many assets, usually intangible--such as goodwill it has
created among customers-that cannot be specifically identified and their values
determined. If these assets cannot be expressed in meaningful monetary amounts, an
attempt to include them in the financial statements would result in the violation of one
or more of the qualitative characteristics or basic assumptions. Similarly, there may be
College Accounting 16th Edition
Chapter 14
Section II
potential liabilities, such as a lawsuit that has been filed against the entity but appears
to have little validity. However, it may be appropriate or even necessary to discuss such
potential assets or liabilities in disclosures accompanying the statements in order to
give a full presentation, even though they do not possess the characteristics necessary
to assign a monetary value to them.
The second aspect of the monetary unit assumption is that the value of money is
stable. The assumption that the value of the monetary unit is stable allows the cost of
assets purchased many years ago to be added to the costs of recently purchased
assets of the same kind and the total dollar amount reported on the financial
statements. This means that it is deemed to the total dollar amount reported on the
financial statements. This means that it is deemed to be unnecessary for
accountants to convert dollars spent in different years, when the purchasing power
might be quite different, to a common unit of purchasing power. This assumption has
been criticized because the value of money does not, in fact, remain stable. Its
purchasing power changes substantially over the years. Proposals have been made for
abandoning the stable monetary concept, but the practical problems involved and the
objectivity and reliability of historical cost figures have prevailed to this time.
Periodicity of Income Assumption
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The income statement covers a certain time period and the balance sheet is prepared as
of the end of that time period. It is assumed that the activities of the business can be
separated into time periods with revenues and expenses being assigned on a logical
basis to those periods.
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This assumption is called the periodicity of income assumption. In reality, the final
results of a business are known only when the business ceases to exist. When all assets
are sold and all liabilities paid, the owners can determine the amount of the overall
profit or loss. However, owners, creditors, and other interested parties cannot wait until a
business is. dissolved to make decisions. Operating and financing decisions must be
made constantly throughout the life of the business.
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Many of these decisions are based on profit or loss for a specified period of time. Others
are based on assets and liabilities as of the end of the period. Accountants have
developed techniques, including the accrual basis of accounting, to prepare financial
statements at regular intervals to meet the goals implied by this assumption. Many, if
not most, of the concepts you learn in accounting result from the periodicity
assumption.
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Although the fiscal year is generally perceived as the standard accounting period, the
SEC and FASB require that the same accounting rules be applied in measuring income
for each quarter. Many businesses assume that the periodicity assumption can be
extended even 4 further to monthly financial statements. Obviously the assumption of
periodicity has more validity for some types of business. For example, a merchandising
business can measure assets, liabilities, revenues, and expenses easily each quarter, or
College Accounting 16th Edition
Chapter 14
Section II
even each month. However, an enterprise growing timber may find it much more
difficult to get an accurate measure of financial results each quarter.
General Principles
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Four basic principles to serve as guides to preparing financial statements are presented
in the FASB’s basic concepts: *insert table
Recall
Recording Assets and Depreciation
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Property, plant, and equipment assets are recorded at historical, or original, cost.
Depreciation is recorded in a separate accumulated depreciation account.
Historical Cost Basis Principle
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Business transactions are, with few exceptions, recorded on a historical cost basis,
which is the amount of consideration, expressed in monetary terms, involved in a
transaction through dealings in the market between the business and outsiders. Assets
are generally carried at historical cost, adjusted for depreciation, until they are removed
from use and disposed of.
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Historical cost is the cost when an asset is acquired. Historical cost is preferred to some
possible alternatives to cost because cost, when determined in an “arm’s length”
transaction with independent outsiders, is an objective, verifiable measure of initial
economic value. The alternatives to using cost involve some measure or estimate of
value, which is generally neither an objective nor verifiable quantity. As a result of this
principle, generally an asset is recorded and remains in the account at its original cost
even though its value may increase to an amount materially in excess of cost.
Important!
When is Revenue Earned?
Revenue is earned when the entity has done all that it has to do to be entitled to all benefits
to be received from the sale or service
Revenue Recognition Principle
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One of the greatest challenges an accountant faces is determining the period in which
to record revenue and report it on the income statement. Revenue represents the inflow
of new assets resulting from the sale of goods or services to an outsider. Under the
revenue recognition principle, revenue is recognized when it is both earned and realized.
The earning process is completed when the product or service has been delivered and