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The Basic Assumptions Used in Accounting

Accounting Introduction

The Basic Assumptions Used in Accounting

I have discussed what financial statements on the previous post. You may want to read it if you haven’t yet.

Bookkeepers and accountants prepare the financial statements by following certain assumptions mandated in the accounting standard (i.e. the US GAAP or the IFRS.)

Accordingly, auditors tightly follow the same assumptions in conducting an audit; they will give a qualified or even disclaimer opinion when a violation of the assumptions is found.

If you are an accounting student, you must understand those assumptions very well, theoretically and practically. Because, almost every single work you do and every single judgment you make, in the accounting area, is based on these assumptions.

That is also important for business owners and managers since the language of your business (i.e. accounting) is built using the same assumptions. By knowing them you can at least understand why your accountant proposes an adjustment on an account balance, for example. And, it would be even better if you can save the external accountant fee as you are capable of reviewing the financial statements yourself, wouldn’t it?

Before going to the assumptions, let’s ask a simple question…

 

Why Does Accounting Use Assumption?

An assumption is “a thing that is accepted as true or as certain to happen” (Cambridge English Dictionary.)

In this life, we use a lot of assumptions, to a certain degree, to develop knowledge. Even the world of science relies on assumptions in the process of building scientific knowledge such as:

  • there are natural causes for things that happen in the world around us;
  • there is consistency in the causes that operate in the natural world; and thus
  • evidence from the natural world can be used to learn about those causes.

Accounting also uses numbers of basic assumptions in the view of how a company is organized and operates. These assumptions give structure to how transaction are recorded and reported by the accounting system.

That said, if any of those assumptions are proven to be untrue, then it may be necessary to alter the way of how financial transactions are recorded and reported. Those basic assumptions are as follows.

 

1. The Economic Entity Assumption

Accounting assumes a company (or organization) as a “living, fictional” being, apart from its owners and managers. It has a name (the company name), it has a date and place of birth (the incorporation date and place), it does activities (the business activities), it has assets and liabilities, it earns income, it spends resources to generate income, it pay taxes, it periodically checks and reports its health conditions (the financial statements), and it can file lawsuit, just like a person.

Why is economic entity assumed?

Firstly, it provides context that users of the financial statements are well informed about whose financial information they are reviewing and therefore they place the information into that context.

Secondly, it promotes a clear and legal ownerships that current and future owners of the company know their limited obligation in settling financial liabilities to the extent of the value of their investment while they’re (by the law) is shielded from any potential lawsuits brought against the company.

For example, you work for Google Inc (not for Larry Page, the owner of major shares, personally.) When dealing with externals, you act for and under the name of Google Inc (not yourself nor Larry Page.) Any money that you spend (or make) in the deal belongs to the Google Inc (not yours nor Mr. Page’s.) So, any costs occurred (or revenues earned) is accounted for Google Inc.’s and any liabilities (or assets) caused by the deal is also accounted for Google Inc. These all means that Google Inc is an economic entity.

If this assumption is not true, the transaction should not be recorded.

For example, one of the directors purchased a new car in credit. The car is under the name of his wife (not Google Inc.) So, you should not record the transaction; the car is not Google Inc.’s asset and the car loan is not Google Inc.’s liability.

If you record the purchase (thus the car is included in the Google Inc.’s asset and the car loan is included in the Google Inc.’s liabilities,) the auditor during an audit session will certainly ask you to make an adjustment accordingly or he will give unfavorable audit opinion because your record does not comply with the economic entity assumption.

FYI: There are four common types of opinion made by an auditor during an audit session:

(1) Unqualified Opinion is given when: (a) The Financial Statements have been consistently prepared using the GAAPs; (b) The Financial Statements comply with relevant statutory requirements and regulations; (c) There is proper disclosure of all matters relevant to the financial statements; (d) Any changes in the accounting principles or in the method of their application have been properly disclosed in the Financial Statements.

(2) Qualified Opinion is given when: (a) The financial statements are materially misstated in one particular account balance, class of transaction or disclosure that does not have pervasive effect on the financial statements; (b) The auditor is unable to obtain audit evidence regarding particular account balance, class of transaction or disclosure that does not have pervasive effect on the financial statements.

(3) Adverse Opinion is given when the financial statements are materially misstated and such misstatements have a pervasive effect on the financial statements.

(4) Disclaimer Opinion is given when: (a) the auditor is not independent (there is a conflict of interest); OR (b) The limitation on scope is imposed by a client which then is causing the auditor is unable to obtain sufficient appropriate audit evidence; (c) there are significant uncertainties in the business of client.

2. The Going Concern Assumption

Accounting assumes that a company is viable and a “going concern” for indefinitely long time. It will live in tens of year to come. With this assumption, accounting believes in that the company will not sell its office building or equipment in within next year, for example. And, because of this accounting also assumes few long-term liabilities are something normal for the company to have.

Why is going concern assumed?

Because no company is set to soon bankrupt, especially in the case of a publicly-held corporation. On the contrary, a company is established to generate profits over a long-enough period.

For example, AT&T was founded in 1983, General Motor was founded in 1908, Chevron Corp was founded in 1879, IBM since 1911, Sony Corp since 1946, and Apple inc since 1976. If you work for any of that corporation, you would record a new building purchase as ‘long-term assets’ and allocate the cost over a long period to come (through depreciation) because you assume the company will not sell its equipment anytime soon.

If this assumption is not true, in the middle of a period the management tell you that the building will be sold immediately because too far from the main office for example, then you have to remove the new building from the company’s asset (through a certain entry) upon the sale of the building.  Otherwise, an auditor will catch it during an audit session and ask you to make an adjustment so that the financial statements comply with going concern assumption.

Under the Generally Accepted Auditing Standard (GAAS), an independent auditor is mandated to make an exclusive ‘Going Concern’ commentary in the audit report in addition to the audit opinion. However, note also that an auditor will not automatically doubt company’s ability to going concern merely because of company’s asset sold. They have certain techniques and procedures to come to such conclusion.

FYI: Generally Accepted Auditing Standards (GAAS) are a set of guidelines followed by auditors when conducting an auditee’s financial statements. The AU 341, “The Auditor’s Consideration of an Entity’s Ability to Continue Going Concern,” provides auditors with procedures on how to verify company’s ability to continue as a going concern.

 

3. The Periodicity Assumption

Accounting assumes the continuous life of a company (see the preceding assumption) can be divided into uniform and consistent periods of time for which financial statements are prepared and issued. Under this assumption, the financial statements should cover a uniform and consistent period of time.

Why is periodicity assumed?

Doing business, in general, is about two things; seeing momentum and taking action. In more practical words, you want to know if any good things happened to your business (i,e. making a good profit,) and you also want to know if bad things happened to the business (in a loss position,) so that you can take an appropriate action. The sooner you know is the better.

For that reason, the SEC requires corporations (publicly-held ones) to issue financial statement in quarterly basis (10-Q) in addition to the annual (10-K.) The shareholders want to take an immediate action whether to keep the share on their hand (when making a good profit) or to sell it to other investors (when making a not so good profit.)

For internal review purpose, however, management of the company may ask its accounting department to prepare and issue financial statements on even a shorter period, monthly basis.

Another good reason is that users is able to compare one period to another (or tow) preceding periods (horizontal analysis) by having financial statements in periodical time. Smart analysts, including the investors’, are also able to compare the company’s financial result with the industry benchmark (benchmarking analysis.)

FYI: Benchmarking is comparing one’s business processes and performance metrics to industry bests. Dimensions typically measured are quality, time and cost. It is used to measure performance using a specific indicator (cost per unit of measure, productivity per unit of measure, a cycle time of x per unit of measure or defects per unit of measure) resulting in a metric of performance that is then compared to others. In this way, analysts learn how well the targets perform and, more importantly, the business processes that explain why these firms are successful.

 

4.  The Measurement and Units of Measure Assumption

Accounting believes in a fact that not all things in the company can be measured and expressed in monetary units. Some of them are non-quantifiable such as the health of company’s owners, the morale of company’s employees, the quality of services to customers, and any other internally generated intangibles, and these can not be recorded.

Accounting only record and reports quantifiable economic events that can be expressed in monetary unit such as assets, liabilities, common stocks, revenues, cost of making products, expenses to keep the business running, payroll expenses, wages, maintenance expenses, and it ignores anything that can not be measured and expressed in monetary unit.

Why are measurements and units of measure is assumed?

Because the essence of accounting is measuring and reporting. Things that can not be measured can not be expressed in monetary units and can not be reported thus are beyond the accounting process.

Under the same assumption, a company’s financial statements should be expressed in certain currency referred to as presentation currency.

FYI: IAS 21 of IFRS requires internationally-operated entities to present financial statements in the currency of the primary economic environment in which the entity operates referred to as functional currency.

 

5. The Arm’s-Length Transactions Assumption

The main function of accounting is processing the company’s transactions. The process involves the following activities: identifying, recording, reporting, interpreting, and analyzing. In performing its functions, accounting assumes that both parties—for example, a buyer and a seller— are rational and free to act independently, each is trying to make the best deal possible in establishing the terms of the transaction, referred to as “arm’s-length transactions.

Why is “arm’s-length transactions” assumed?

Becuase, accounting works on a financial information and is expected to present financial statements accurately, no erroneous, no frauds, referred to as “free from material misstatements.” To be able to generate accurate financial statements the accounting need accurate transaction data that are free from bias; both parties on each transaction are assumed to have no conflict of interest.

If that is not the case, meaning the assumption isn’t true, then a further verification is needed before deciding whether or not to record the transaction.

For example, a purchasing staff purchased 2 unit machines for production @$1000 from ABC Inc. So you have conducted a 3-way matching procedure (the Purchase Order, the invoice, and the Receiving Slips.) Everything looks normal and legitimate. Up to this point, you record the transaction with the assumption of arm’s-length transactions; that is, you make the assumption that the purchasing staff and the ABC Inc. have no special relationship what so ever, so both parties are free from any conflict of interest.

But if later on, the company’s controller finds your assumption wasn’t true, the purchasing staff received a ‘kickback,‘ for example, then you may need to make an adjustment entry following the controller’s instruction.

FYI: A kickback is a form of negotiated bribery in which a commission is paid to the bribe-taker in exchange for services rendered. The most common form of kickback involves a vendor submitting a fraudulent or inflated invoice (often for goods or services which were not needed, of inferior quality, or both), with an employee of the victim company assisting in securing payment. For his or her assistance in securing payment, the individual receives some sort of payment (cash, goods, services) or favor such as a hiring of a relative, employment, etc.)

 

6. The Reliability Assumption

Accounting believes in an idea that company’s run in various risks. The act of fraud could be done by any parties, internal and external. The management could fictitiously issue invoices to inflate its revenues. Staffs could duplicate existed bills to steal money. Vendors could submit the same bills twice to get more payments.

For those reasons accounting only records adequately proven transactions and only presents reliable financial statements to users. If this is not the case, the financial statements do not represent the actual condition of the company’s financial position. During an audit session, however, an auditor checks the reliability of the financial statements by conducting account balance verification to make sure the financial statements does not contain any material misstatements.

FYI: To make sure the company’s financial statements is reliable, during an audit session, an external auditor run an audit procedure called “substantive tests.” This is usually done with a random sampling just to get an initial “sense” whether the auditee’s internal control is strong enough to prevent erroneous and frauds or not. If a doubt arises then he will dive deeper in that particular suspicious accounts until a conclusion can be made.

 

7. The Consistency Assumption

There are some different methods of counting and valuing things in accounting such as valuing assets, counting depreciation of long-term assets, counting interest charges, valuing inventory, counting the cost of goods sold, and etc. And different method obviously results in different values.

Accounting believes that a consistent method of accounting should be used from period to period unless it can be replaced by a more relevant method.

Why is consistency assumed?

Consistency makes the financial statements are comparable from period to period. If this is not the case, the managers and analysts won’t be able to conduct trend analysis and the idea of presenting comparative financial statements does not make sense.

For example, you used the straight-line method in depreciating the company’s machines in 2016 to produce 2000 units finished goods and resulted in $350 depreciation cost charged to the income statements which then resulted in $2000 profit. By this assumption, you’re mandated to use the straight-line method in 2017  (then 2018, 2019, 2020 and so forth.) So if in 2017 the company produce 4000 of the same kind finished goods, the depreciation cost charge will be $700 (=2 x $350.)

But, if you use double-declining-balance method instead, the depreciation cost will be $1400 (=2 x $700) which can not be compared to 2016. It means that your depreciation method does not comply with the consistency assumption so is not allowed.

FYI: A significant change in accounting method is allowed as long as it is more relevant to the current business conditions but, it must be clearly disclosed in the notes of the financial statements.

 

8. The Accrual Assumption

The recording activity is most critical in the accounting process because everything is started from here. The reliability of the company’s financial statements depends on the recording activities. All of the assumptions will be useless when an adequate record keeping has not performed.

In recording transaction, accounting uses the accrual basis of accounting where the recognition of revenues arises when earned and recognition of expenses occurs when used, with or without cash involved.

If that is not the case, a company should instead use the cash basis of accounting to develop financial statements which are based on the cash flows.

Why accrual assumption?

Because the cash basis of accounting generates financial statements that can not be audited.

For example, on the March 20 the sales staff sold 1000 pcs of merchandises @$5 with a 30-days credit term.  The merchandises is delivered in the same day. Meaning that the company will only receive the payment by April 20 although the merchandises have been delivered on the March 20.

If the company use the cash basis of accounting, you will record sales (revenue account) on April 20. But, since the company uses accrual basis, you have to record the sales right away upon the deliverance of the merchandizes, that is March 20. The same case when an expense occurs.

That is all.  Note, however, some of the preceding are more to concepts rather than assumption such as the measure and unit measurement, the consistency, the reliability, and the accrual. This is inevitable that both concept and assumption often interchngeable.

All of the above assumption is the basis of the accounting principles that I will discuss in the coming post.

 

Executive Summary

Remember these:

1. Accounting follows assumptions mandated by the accounting standard (either under the US’s GAAP or the IFRS.)

2. Accordingly, accountants follow those assumptions when preparing financial statements and auditors also use the same assumptions when conducting a financial statement audit.

3. Economic Entity Assumption – Accounting treat the company as an entity apart from its owners and managers. It only records transactions that are related to the company.

4. Going Concern Assumption – Accounting assumes that a company is viable and a “going concern” for indefinitely long time. Using this assumption the company divide its assets into current and long-term and divide its liabilities into short and long-term.

5. Periodicity Assumption – Accounting assumes the continuous life of a company can be divided into uniform and consistent periods of time for which financial statements are prepared and issued.

6.  Measurement and Units of Measure Assumption – Accounting only records and reports quantifiable economic events that can be expressed in monetary unit. Under the same assumption, a company’s financial statements should be expressed in certain currency referred to as presentation currency.

7. Arm’s-Length Transactions Assumption – Accounting assumes that both parties involve in a transaction—for example, a buyer and a seller— are rational and free to act independently, each is trying to make the best deal possible in establishing the terms of the transaction.

8. Reliability Assumption – Accounting only records adequately proven transactions and only presents reliable financial statements to users.

9. Consistency Assumption – Accounting believes that a consistent method of accounting should be used from period to period unless it can be replaced by a more relevant method.

10. Accrual Assumption – In recording transaction, accounting uses the accrual basis where the recognition of revenues arises when earned and recognition of expenses occurs when used, with or without cash involved.

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