day 2 assumptions, accounting principles

8/19/2019 Day 2 Assumptions, Accounting Principles

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Assumptions, Accounting Principles

I. Accounting Assumptions

A. Entity Assumption -- We assume there is a separate accounting entity for each business

organization.

Example:

The owners and the corporation are separate. The owners own shares in

the corporation; they do not own the assets of the firm. The corporation

owns the assets. The financial statements represent the corporation, not

the owners. A firm cannot own itself. Treasury shares are not assets to the firm -

no one owns treasury shares. A firm can sue and be sued. If a firm is sued, the

owners are not liable.

B. Going Concern Assumption --

1. In the absence of information to the contrary, a business is assumed to have an indefinite

life, that is, it will continue to be a going concern. Therefore, we do not show items at their

liquidation or exit values.

2. This assumption, also called the continuity assumption, supports the historical cost principle

for many assets. Income measurement is based on historical cost of assets because assets

provide value through use, rather than disposal. Thus, net income is the difference between

revenue and the historical cost of assets used in generating that revenue. Without the

going concern principle, historical cost would not be an appropriate valuation basis.

Example:

Prepaid assets, such as prepaid rent, would not be assets without the

assumption of continuity.

C. Unit-of-Measure Assumption -- Assets, liabilities, equities, revenues, expenses, gains, losses,

and cash flows are measured in terms of the monetary unit of the country in which the business is

operated. Price level changes cause the application of this assumption to weaken the relevance of

certain disclosures.

Example:

The amounts of all assets are added together even though

amounts recorded at different times represent different

purchasing power levels.

1. Capital maintenance and departures from the unit of measure assumption --


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a. The concept of capital maintenance is related to the unit of measure assumption.

Capital is said to be maintained when the firm has positive earnings for the year,

assuming no changes in price levels. When a firm has income, it has recognized

revenue sufficient to replace all the resources used in generating that revenue

(return of capital), and has resources left over in addition (income, which is return on

capital). That income could be distributed as dividends without eroding the net assets

(capital) existing at the beginning of the year. GAAP is based on the concept of

"financial" capital maintenance. As long as dividends do not exceed earnings, and

earnings is not negative, financial capital has been maintained.

b. An alternative concept of capital maintenance is "physical" capital maintenance. This

concept holds that earnings cannot be recognized until the firm has provided for the

physical capital used up during the period. To measure the capital used up, changes

in price level must be considered.

Example:

A firm uses up $5,000 worth of supplies in providing its service

during the year, but to replace those supplies for use next year,

$5,500 will have to be paid (10% increase in specific price of

supplies). The "financial" capital maintenance model uses the $5,000 cost

of supplies as the measure of revenue needed to maintain capital. If

revenue for the current period is $5,000 and the firm had no other

expenses, earnings would be zero and capital would just be maintained.

The "physical" capital model would require revenue of $5,500 for capital to

be maintained.

GAAP does not require adjustments for price level changes and thus applies

the "financial" capital maintenance concept in financial reports.

D. Time Period Assumption -- The indefinite life of a business is broken into smaller time frames,typically a year, for evaluation purposes and reporting purposes. For accounting information to be

relevant, it must be timely. The reliability of the information often must be sacrificed to provide

relevant disclosures. The use of estimates is required for timely reporting but also implies a possible

loss of reliability.

II. Accounting Principles

A. Measurement -- At the time of origination, assets and liabilities are recorded at the market

value of the item on the date of acquisition, usually the cash equivalent . This origination value is

referred to as historical cost. For many assets and liabilities, this value is not changed even though

market value changes. Other assets, such as plant assets and intangibles, are disclosed athistorical cost less accumulated depreciation or amortization. Given the going concern assumption,

revaluation to market value is inappropriate for plant assets, because the value of these assets is

derived through use, rather than from disposal.

B. There are measurement attributes other than h istorical cost that are used to represent items

reported on the financials statements. Below is a brief summary and example of each

measurement attribute.

1. Net realizable value -- This value is used to approximate liquidation value or selling

price. It is the net value to be received after the costs of sale are deducted from the current

market value


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a. Example: Lower cost or market for inventory valuation uses NRV.

2. Current replacement cost -- This value represents how much you would have to pay to

replace an asset. Current replacement cost would represent current market value from the

buyer's perspective.

a. Example: Replacement cost is also used in inventory valuation.

3. Fair value -- This value is also referred to as current market value. It is the price that

would be received to sell an asset (or the price to settle a liability) in an orderly transaction

from the perspective of a market participant at the measurement date (see the fair value

lessons for further discussion of fair value).

a. Example: Current market value (or fair value) is used to value trading and available-

for-sale securities.

4. Amortized cost -- This value is historical cost less the accumu lated amortization or

depreciation of the asset.

a. Example: Buildings and equipment are reported at historical cost less accumulated

depreciation.

5. Net present value -- This is the value determined from discounting the expected future

cash flows.

a. Example: The discounted future cash flows are used in many capital budgeting

decisions.

C. Revenue Recognition Principle -- This principle addresses three important issues related to

revenues. Below is a general view of revenue—see the revenue recognition lessons for moredetails.

1. Revenue Defined -- What revenue is: Revenue refers to increases in assets or the

extinguishment of liabilities stemming from the delivery of goods or the provision of services

- the main activities of the firm.

2. When to Recognize Revenue -- Revenues are recognized when the entity completes its

performance obligation to a customer and the revenue is earned and realized (or realizable)

. The performance obligation is completed when the goods or services are delivered

(revenue is earned) and cash or promise of cash is received (realized). In general, there are

five steps to allocate the components of revenue.

a. Identify the contract with the customer ( promise to deliver a good or service);

b. Identify if there is more than one performance obligation;

c. Determine the transaction price;

d. Allocate the transaction price to the separate performance obligations (if there is

more than one performance obligation);

e. Recognize revenue when each performance obligation is satisfied.


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3. Measure Revenue -- How to measure revenue: Revenues are measured at the cash

equivalent amount of the good or service provided.

Example:

A contract is entered into with the customer to deliver an

automobile and provide a warranty on the parts associated with

the automobile.

There are two separate performance obligations: deliver the automobile

and provide parts if needed.

Determine the price of the automobile without the warranty or the price

that the warranty is sold for separate from the automobile.

Allocate the transaction price to the separate performance obligations.

Recognize revenue when each performance obligation is satisfied. With

respect to the automobile, revenue would be recognized upon delivery,

with respect to the warranty, the revenue would be recognized over the

warranty period.

D. Expense Recognition Principle -- This principle addresses when to recognize expenses and is

sometimes referred to as the matching principle.

1. The matching principle says: recognize expenses only when expenditures help to produce

revenues. Revenues are recognized when earned and realized or realizable; the related

expenses are recognized, and the revenues and expenses are "matched" to determine net

income or loss.

2. Expenses that are directly related to revenues can be readily matched with revenues theyhelp produce.

3. Cost of goods sold and sales commissions are expenses that are directly associated and

therefore matched with revenue. Other expenses are allocated based on the time period of

benefit provided. Depreciation and amortization are examples. Such expenses are not

directly matched with revenues. Still other expenses are recognized in the period incurred

when there is no determinable relationship between expenditures and revenues.

Advertising costs are an example.

E. Full Disclosure Principle -- Financial statements should present all information needed by an

informed reader to make an economic decision. This principle is sometimes referred to as the

adequate disclosure principle.

Example:

An aircraft manufacturer enters into a contract to build 200 airplanes for

an airline company. As of the balance sheet date, production has not

begun. Thus, there is no recognition of this contract in the accounts.

However, a footnote should explain the financial aspects of the contract. This

information is potentially of greater interest than many items recognized in the

accounts.


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Flashcards

Flashcard #1 (FC5757)

What is the entity assumption? We assume there is a separate accounting entity for

each business organization.


What is the going concern assumption? In the absence of information to the contrary, a

business is assumed to have an indefinite life, that is,it will continue to be a going concern.


What is the unit of measurement assumption? Assets, liabilities, equities, revenues, expenses, gains,

losses, and cash flows are measured in terms of the

monetary unit of the country in which the business is

operated.


What is the concept of capital maintenance? Capital is said to be maintained when the firm has

positive earnings for the year, assuming no changes in

price levels.


What is the time period assumption? The indefinite life of a business is broken into smaller

time frames, typically a year, for evaluation purposes

and reporting purposes.


What does the historical cost accounting principle

state?

Assets and liabilities are recorded at historical cost,

that is, their cash equivalent amount at time of

origination. This value is the market value of the item

on the date of acquisition.


What are revenues? Revenues are increases in assets or extinguishment of

liabilities stemming from delivery of goods or from

providing services -- the main activities of the firm.


When should a company recognize revenues? Revenues are recognized when they are earned and

collectability is reasonably assured.


When does realization occur in the accounting period? (1) Goods or services have been provided, (2)

Collectability of cash is assured, (3) Expenses of

providing goods and services can be determined.


How do we measu re a reven ue? Reven ues are measu red as th e cash equ ivalen t

amount of the good or service provided.


What is the matching principle? Recognize expenses only when expenditures help to

produce revenues.


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What is the full disclosure principle? Financial statements should present all information

needed by an informed reader to make an economic

decision. This principle is sometimes referred to as the

adequate disclosure principle.


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Matching is not an accounting assumption.

True

False

Question #8 (PQ8497)

A firm has income of exactly zero for a year during which both specific and general prices

(inflation) have increased. The firm maintained its capital under the financial concept of capitalmaintenance.

True

False

Question #9 (PQ8498)

The accounting assumption of separate entity supports the inclusion of prepaid insurance in total

assets.

True

False


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Past Exam Questions

Question #1 (AICPA.940503FAR-FA)

Reporting inventory at the lower of cost or market is a departure from the accounting principle of:

A. Historical cost.

B. Consistency.

C. Conservatism.

D. Full disclosure.


According to the conceptual framework, the process of reporting an item in the financial

statements of an entity is:

A. Allocation.

B. Matching.

C. Realization.

D. Recognition.

Question #3 (AICPA.930505FAR-TH-FA)

When a parent-subsidiary relationship exists, consolidated financial statements are prepared in

recognition of the accounting concept of:

A. Reliability.

B. Materiality.

C. Legal entity.

D. Economic entity.


On December 31, 2002, Brooks Co. decided to end operations and dispose of its assets within

three months. At December 31, 2002, the net realizable value of the equipment was below

historical cost. What is the appropriate measurement basis for equipment included in Brooks'

December 31, 2002, Balance Sheet?

A. Historical cost.

B. Current reproduction cost.

C. Net realizable value.

D. Current replacement cost.

Question #5 (AICPA.101043FAR)

Ande Co. estimates uncollectible accounts expense using the ratio of past actual losses from

uncollectible accounts to past net credit sales, adjusted for anticipated conditions. The practice

follows the accounting concept of:


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A. Consistency.

B. Going concern.

C. Matching.

D. Substance over form.

Question #6 (AICPA.082114FAR-I.A.II)

According to the FASB conceptual framework, certain assets are reported in financial statements

at the amount of cash or its equivalent that would have to be paid if the same or equivalentassets were acquired currently. What is the name of the reporting concept?

A. Replacement cost.

B. Current market value.

C. Historical cost.

D. Net realizable value.


Which of the following assumptions means that money is the common denominator of economicactivity and provides an appropriate basis for accounting measurement and analysis?

A. Going concern.

B. Periodicity.

C. Monetary unit.

D. Economic entity.


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Proficiency Question Answers

Question #1 : : False

Question #2 : False

Question #3 : False


Question #5 : : True


Question #7 : True

Question #8 : True

Question #9 : False


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Past Exam Question Answers


A. (Correct!) LCM departs from historical cost because it provides an ending valuation below cost when market

value is below cost. The inventory is actually written down to a value below what was originally paid. This is one

of the few such departures.

B. LCM does not imply a departure from consistency. It is an accounting principle applied consistently whenever

market is less than cost, indicating a decline in the utility of the inventory.

C. Just the opposite, LCM is an example of conservatism. The market value of inventory, even if it is known to be

below cost, is never a definite number. Under uncertainty, conservatism demands that the less optimistic value

be reported.

D. LCM does not violate full disclosure. It can be argued that, given a decline in market value below cost, LCM

actually provides more relevant information than maintaining the historical cost valuation.


A. Allocation may affect the amounts of items reported, but allocation does not necessarily imply reporting in the

financial statements. Recognition is the correct term.

B. Matching is only one accounting principle that requires reporting. In this case, expenses are recognized(reported) when they contribute to the generation of revenue. But matching is not the only reason items are

recognized in the accounts.

C. Realization implies the completion of a transaction and the receipt of liquid assets (or other resources if

acceptable to the transferee). Most realizations require reporting in the accounts (recognition), but there are

many other events that cause recognition. In other words, most realizations are recognitions, but not all

recognitions are realizations.

D. (Correct!) Recognition is the strongest reporting action that can be taken. When an item is recognized, that

means it will appear in the financial statements, perhaps not as an individual line item, but definitely part of one.

Many other items find their way into the footnotes, but are not recognized.


A. Consolidated financial statements are an example of trying to account for the economic entity that comprises

more than one legal entity. All financial statements need to be reliable, but that is not related to the issue at

hand and is, therefore, not the correct response.

B. Consolidated financial statements are an example of trying to account for the economic entity that comprises

more than one legal entity. Materiality is a modifying criteria for all financial statements, but it is not related to

the issue at hand and is, therefore, not the correct response.

C. Consolidated financial statements are an example of trying to account for the economic entity that comprises

more than one legal entity. Actually, consolidation is, inherently, a violation of the legal entity concept since it is

the combination of more than one legal entity into one report. Therefore, this is incorrect.

D. (Correct!) Consolidated financial statements are an example of trying to account for the economic entity thacomprises more than one legal entity, making this the correct response.


A. This historical cost of the asset is no longer relevant. The firm is no longer a going concern-the assumption

that supports the historical cost principle. All that matters now is what Brooks can receive for the equipment.

B. After the decision is made to liquidate the business, the only relevant values are exit values-the net amounts

that can be received from sale of the assets.

C. (Correct!) When a firm is in liquidation, historical cost and entry values (replacement cost) are no longer

relevant. The going concern assumption supports the historical cost principle. The firm is no longer a going


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concern. The only amounts relevant are the amounts to be received on sale of the assets. Net realizable value is

the net value to be received, after the costs of getting the asset ready for sale are deducted.

D. Current replacement cost is the amount Brooks would have to pay to replace its assets. Brooks has no interest

in replacing its assets, but rather wishes to sell its assets. Thus, the relevant values are the net amounts that

can be realized on sale.


A. Consistency is the desired characteristics of the application of accounting principles in the same manner from

year to year. Consistency permits comparison within one company over a period of time. Comparability permitscomparison between companies.

B. Going concern is the assumption that the entity will continue into the future.

C. (Correct!) The matching principle requires that we recognize and match expenses with the revenues

generated. For all sales in a given period, some will be uncollectible. The cost of those uncollectible accounts is

matched in the period that the revenue is recognized.

D. Substance over form is an economic concept that refers to the economic substance of a transaction or event

rather than the way that the transaction or event is presented.

Question #6 (AICPA.082114FAR-I.A.II)

A. (Correct!) Replacement cost is the amount to be paid for an item at the current time. This concept is used i

the lower-of-cost-or-market inventory valuation procedure. Replacement cost is an example of an entry price-the

amount required to be paid currently to obtain an asset already held.

B. Current market value is also called fair value, which is the price that would be received to sell an asset in an

orderly transaction between market participants at the measurement date. Market value is an example of an exit

price-the amount to be received on sale of the asset.

C. Historical cost is the original cost of acquiring an asset, plus any associated costs. Historical cost is an entry

price but, usually, is not equal to the current price required to be paid to obtain the asset currently held.

D. Net realizable value is an example of an exit price. It equals the estimated selling price less the cost to

complete and sell.


A. The going concern assumption states that in the absence of information to the contrary, the corporate entity

has an indefinite existence- there is no foreseeable end to the entity under current circumstances.

B. The periodicity assumption states that in order for financial statement information to be useful, it must be

available on a periodic basis rather than at the end of the reporting entity's existence.

C. (Correct!) The monetary unit assumption provides the basis for using the home-country currency as the

reporting basis in the financial statements and also tends to imply that the unit of currency is stable (little or no

inflation or deflation).

D. Also known as the separate entity assumption, this concept recognizes that the corporation is the reporting

entity, not the owners. The financial statements are those of the corporation. The shareholders are separate from

the corporation. The reporting firm is a separate legal entity.

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