Many associate accounting with math in terms of absolute precision. However, accounting is actually more like art and social science and depends on certain fundamental assumptions.
Accounting information should be presented for specific and distinct reporting units. In other words, the entity assumption requires that separate transactions of owners and others not be commingled with the reporting of economic activity for a particular business.
On one hand, an individual may prepare separate financial statements for a business he or she owns even if it is not a separate legal entity. On the other hand, consolidated financial statements may be prepared for a group of entities that are economically commingled but are technically separate legal units.
In the absence of contrary evidence, accountants base measurement and reporting on the going-concern assumption. This means that accountants are not constantly assessing the liquidation value of a company in determining what to report, unless of course liquidation looks like a possibility. This allows for allocation of long-term costs and revenues based on a presumption that the business will continue to operate into the future. Accountants are typically conservative (when in doubt, select the lower asset/revenue measurement choice and the higher liability/expense measurement choice) but not to the point of introducing bias based on an unfounded fear for the future.
If conditions or events raise substantial doubt about the ability to continue to operate as a going concern, and management does not have a viable plan to alleviate those concerns, disclosure is required. This disclosure must accompany the financial statements and include details about the conditions and events giving rise to the doubts, the potential impact on entity obligations, and plans to attempt to mitigate the problem.
Accountants assume they can divide time into specific measurement intervals (i.e., months, quarters, years). This periodicity assumption is necessitated by the regular and continuing information needs of financial statement users. More precision could be achieved if accountants had the luxury of waiting many years to report final results, but users need timely information. For instance, a health club may sell lifetime memberships for a flat fee, not really knowing how long its customers will utilize the club. But, the club cannot wait years and years for their customers to die before reporting any financial results. Instead, methods are employed to attribute portions of revenue to each reporting period. This is justified by the periodicity assumption.
The monetary unit assumption means that accounting measures transactions and events in units of money. This assumption overcomes the problems that would arise by mixing measures in the financial statements (e.g., imagine the confusion of combining acres of land with cash). The monetary unit assumption is core and essential to the double-entry, self-balancing accounting model.
Inflation can wreak havoc on the usefulness of financial data. For example, suppose a power plant that was constructed in 1970 is still in operation. Accounting reports may show a profit by matching currently generated revenues with depreciation of old (“cheap”) construction costs.
A different picture might appear if one reconsidered the “value” of the power plant that is being “used up” in generating the current revenue stream. Inflation can distort performance measurement. Inflation also has the potential to limit the usefulness of the balance sheet by reporting amounts at costs that differ greatly from current value.
Accountants have struggled with this issue for many years, and even experimented with supplemental reporting requirements. However, accounting generally operates under the stable currency assumption, going along as though costs and revenues incurred in different time periods need not be adjusted for changes in the value of the monetary unit over time.
|Did you learn?|
|Be able to define the following assumptions: entity, going-concern, periodicity, monetary unit, and stable currency.|