Accounting: The Language of Business - Vol. 2 (Intermediate: Part 15)

The first year, I didn't have much capital so I did everything myself. I had to keep my overhead low by learning everything about running a business, from accounting to fixing the gears of my equipment. I really started from scratch.

Li Ka-shing

Financial Reporting Theory (Part I)

by

Charles Lamson

Assumptions in Financial Reporting

We will now examine a number of underlying assumptions that are integral to the financial reporting process. The assumptions we discuss are:

• Going concern concept

• Business or economic entity concept

• The monetary unit assumption

• Periodicity assumption

U.S. GAAP does not directly state these four items as assumptions in the conceptual framework. [Another assumption, the full disclosure principle, states that accountants must report and disclose all information that can significantly affect the judgment of a reasonably informed financial statement user. The revisions to the conceptual framework (The Conceptual Framework is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that help achieve those objectives.) added that financial information must be complete to be a faithful representation. Completeness, then, makes explicit the prior assumption of full disclosure.] Yet, they are implicit in determining financial reporting standards.

Going Concern Concept

Many assumptions in the financial statements are based on long-term periods. How can a manager assert with certainty that a business will be valuable in, say, twenty-five years? The going concern concept indicates that accountants will record transactions and prepare financial statements as if the entity will continue to operate for an indefinite period of time unless there is evidence to the contrary. That is, the entity will exist for a period of time long enough to carry out contemplated operations, utilize existing productive capacity, and liquidate outstanding obligations. This concept justifies accounting practices such as the long-term/short-term classifications on the balance sheet and the depreciation of buildings for as long as 40 years.

The going concern concept is also tied to the use of historical cost. A business planning to operate for an indefinite period of time will now sell productive assets. Consequently, market values are less relevant. If a business is in jeopardy of failing (e.g., bankruptcy), then the going concern assumption would not be valid. If the assumption is not applicable, accountants would measure assets and liabilities at the amount at which they expect to dispose of them, their liquidation values.

Business or Economic Entity Concept

The business or economic entity concept states that all transactions and events relate to the reporting entity and must be kept separate from the personal affairs of the owner, related businesses, and the owners outside business interests. For example, Kyle Perry owns and operates several sporting goods shops called Perry's Sports. Perry's Sports is an economic entity separate from Kyle Perry. Perry's Sports owns its store buildings and reports them in the company's financial statements. Kyle Perry owns his house. The house is an asset of Kyle Perry and is not reported in the financial statements of Perry's Sports. Financial reporting for different entities must be separate and include disclosures describing transactions among related entities.

Monetary Unit Assumption

The monetary unit assumption stipulates that an entity measure and report its economic activities in dollars (or some other monetary unit).These dollars are assumed to remain relatively stable over time in terms of purchasing power. This assumption ignores any inflation or deflation experienced in the economy in which the entity operates. This assumption justifies adding dollars of different purchasing power on the balance sheet. For example, a company would add land purchased in the current period to the balance of land acquired in 1969.

Periodicity Assumption

The periodicity assumption specifies that an economic entity can divide its life into artificial time periods for the purpose of providing periodic reports on its economic activities. The periodicity assumption results in the need for accrual accounting because revenue and expenses must be reported in a given period under this assumption. In addition, the time period used will vary depending on the demands of financial statement users. For example, the SEC currently requires quarterly financial statements for publicly traded firms. These statements use significant estimates and may be less representationally faithful than the annual report. However, quarterly statements are more timely (an enhancing characteristic) than reporting on an annual basis because timely information is more useful (relevant) in decision making.

Assumptions in Financial Reporting: International Financial Reportng Standards (IFRS)

IFRS explicitly addresses the going concern assumption. The other assumptions are implicit in the standard-setting process. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 42-43*

end