The Financial Accounting Standards Board (FASB) attempts to base U.S. GAAP on a number of key theoretical assumptions, principles, and constraints which are commonly known as “conceptual framework of the financial reporting”.
Through this post, I outlined each of the above accounting assumptions, principles and constraints in simple way. Though this post is useful for any accounting students and starter, even accountants who need some refreshers.
A. Accounting Assumptions
Assumption#1. Accounting Entity
A company is considered a separate “living” enterprise, apart from its owners. In other words, a corporation is a “fictional” being:
- It has a name.
- It has a birthdate and birthplace (referred to as incorporation date and place, respectively).
- It is engaged in clearly defined activities.
- It regularly reports its financial health (through financial reports) to the general public.
- It pays taxes.
- It can file lawsuits.
Why Assume “Accounting Entity”?
- It Provides Context. The accounting entity assumption enables users of financial reports to tell whose financials they are reviewing and therefore places those financials into context.
- It Promotes Ownership. The assumption of a company as a separate economic entity promotes ownership in the business, since its current and future owners know that their financial liability is limited to the value of their investment while they are legally shielded from any potential lawsuits brought against the company.
Assumption#2. Going Concern
A company is considered viable and a “going concern” for the foreseeable future. In other words, a corporation is assumed to remain in existence for an indefinitely long time. Exxon Mobil, for example, has existed since 1882, and General Electric has been around since 1892; both of these companies are expected to continue to operate in the future. To assume that an entity will continue to remain in business is fundamental to accounting for publicly held companies.
Why Assume “Going Concern”?
The going concern assumption essentially says that a company expects to continue operating indefinitely; that is, it expects to realize its assets at the recorded amounts and to extinguish its liabilities in the normal course of business.
If this assumption is incorrect or untenable for a particular company (think of a liquidation or a fire sale), then the methods prescribed by Generally Accepted Accounting Principles (GAAP) for accounting for various transactions would need to be adjusted, with consequences to revenues, expenses, and equity.
Assumption#3. Measurement and Units of Measure
Financial statements have limitations; they show only measurable activities of a corporation such as its quantifiable resources, its liabilities (money owed by it), amount of taxes facing it, and so forth. For example, financial statements exclude:
- Internally developed trademarks and patents (think of Coke, Microsoft, General Electric)—the value of these brands cannot be quantified or recorded.
- Employee and customer loyalty—their value is undeterminable. Since financial statements show only measurable activities of a company, they must be reported in the national monetary unit: U.S. financial statements are reported in U.S. dollars (Exhibit 2.2); European financial statements now use the euro as a standard monetary unit.
A continuous life of an entity can be divided into measured periods of time, for which financial statements are prepared. U.S. companies are required to file quarterly (10-Q) and annual (10-K) financial reports. Typically one calendar year represents one accounting year (usually referred to as a fiscal year) for a company. Be aware that while many corporations align their fiscal years with calendar years, others do not.
Summing Up the Accounting Assumption
We have just covered four assumptions in accounting:
- Accounting Entity – A corporation is considered a “living, fictional” being.
- Going Concern – A corporation is assumed to remain in existence indefinitely.
- Units of Measure of a company – Measurement and Financial statements show only measurable activities. Financial statements must be reported in the national monetary unit (i.e., U.S. dollars for U.S. companies).
- Periodicity – A company’s continuous life can be divided into measured periods of time for which financial statements are prepared. U.S. companies are required to file quarterly and annual reports.
B. Accounting Principles
Principle 1: Historical Cost
Financial statements report companies’ resources at an initial historical or acquisition cost. Let’s assume a company purchased a piece of land for $1 million 10 years ago. Under GAAP, it will continue to record this original purchase price (typically called book value) even though the market value (referred to as fair value) of this land has risen to $10 million.
Why is such undervaluation of a company’s resources required? There are two reasons:
- It represents the easiest measurement method without the need for constant appraisal and revaluation. Just imagine the considerable amount of effort and subjectivity required to determine the fair value of all of General Electric’s resources (plants, facilities, land) every year.
- Additionally, marking resources up to fair value allows for management discretion and subjectivity, which GAAP attempts to minimize by using historical cost.
Principles# 2 and 3. Accrual Basis
Accrual basis of accounting is one of the most important concepts in accounting, and governs the company’s timing in recording its revenues (i.e., sales) and associated expenses.
Principle 2: Revenue Recognition. Accrual basis of accounting dictates that revenues must be recorded when earned and measurable.
Principle 3: Matching Principle. Under the matching principle, costs associated with making a product must be recorded (“matched” to) the revenue generated from that product during the same period.
A Case Example
The following transactions occurred on the specified dates:
- Amazon.com purchases a book from a publisher for $10 on May 5, 2008.
- Amazon.com receives a $20 credit card order for that book on December 29, 2009.
- The book is shipped to the customer on January 4, 2010.
- Amazon.com receives cash on February 1, 2010.
From the options above, when should Amazon.com record revenue and Expenses?
In line with the accrual principles of accounting, Amazon.com will record $20 in revenues and $10 in expenses on January 4, 2008.
Why can’t companies immediately record these revenues and expenses?
According to the revenue recognition principle, a company cannot record revenue until that order is shipped to a customer (only then is the revenue actually earned) and collection from that customer, who used a credit card, is reasonably assured.
Why shouldn’t Amazon.com record the expense when it actually bought the book?
According to the matching principle, costs associated with the production of the book should be recorded in (matched to) the same period as the revenue from the book’s sale.
Principle#4. Full Disclosure
Under the full disclosure principle, companies must reveal all relevant economic information that they determine to make a difference to their users. Such disclosure should be accomplished in the following sections of companies’ reports:
- Financial statements
- Notes to financial statements
- Supplementary information
Summing up The Accounting Principles
We just covered four underlying principles in accounting:
- Historical Cost – Financial statements report companies’ resources and obligations at an initial historical cost. This conservative measure precludes constant appraisal and revaluation.
- Revenue Recognition – Revenues must be recorded when earned and measurable.
- Matching Principle – Costs of a product must be recorded during the same period as revenue from selling it.
- Disclosure – Companies must reveal all relevant economic information determined to make a difference to their users.
C. Accounting Constraints
Constraint#1. Estimates and Judgments
Certain measurements cannot be performed completely accurately, and must therefore utilize conservative estimates and judgments.
For example, a company cannot fully predict the amount of money it will not collect from its customers, who having purchased goods from it on credit, ultimately decide not to pay. Instead, a company must make a conservative estimate based on its past experience with bad customers.
Inclusion and disclosure of financial transactions in financial statements hinge on their size and effect on the company performing them.
Note that materiality varies across different entities; a material transaction (taking out a $1,000 loan) for a local lemonade stand is likely immaterial for General Electric, whose financial information is reported in billions of dollars.
For each company, the preparation of financial statements must utilize measurement techniques and assumptions that are consistent from one period to another.
Keep in mind that, companies can choose among several different accounting methods to measure the monetary value of their inventories. What matters is that a company consistently applies the same inventory method across different fiscal years.
Financial statements should be prepared with a downward measurement bias. Assets and revenues should not be overstated, while liabilities and expenses should not be understated.