Hello readers, in this series of posts I will discuss some of the basic foundations of accounting theory. Specifically I will talk about the principles, assumptions and constraints of accounting. From these we can find justification for every rule. Also with the transition from the US GAAP to the International accounting standards (IFRS) which is more so principle based than our current system, I though it would be a good topic to write about.
Assumptions
Let’s start with the assumptions in accounting. As you no doubt already know in life sometimes you just have to assume some facts, which you may not know. Accounting is no different. In order to ‘account’ for something we have to assume that some points are true. In accounting we have four assumptions. They are: Economic entity, Monetary unit, and the Time period assumption.
Economic entity assumption
The economic entity assumption requires that we account for the activities of one distinct and independent enterprise. In other words we need to draw the line between a firm and its owners, employees, vendors, customers etc. To illustrate this consider the following example. Silda owns a consulting business called Silda’s Consulting. The business has a few employees but provides Silda with the means to live on (i.e. its her only job). Every two weeks she pays her employees and draws out some money for her self. In addition to her business she owns a summer home in Milan which she uses only for personal recreation. If you were the accountant for Silda’s Consulting you would need to separate the activities of the firm from the activities of its owner. For example, the mortgage on Silda’s summer home is a personal expense, and should not be an expense of the company, likewise office supplies (for company use) should be expensed through the companies books and not through her personal accounts. This can sometimes be a challenge, some small firms don’t mind paying their personal bills through their company…while that is not necessarily wrong it does create some difficultly in determine the success of the business. In general, we must define what entity we are going to account for before we can account for it.
Monetary unit assumption
This is an easy one! Everything we account for is going to be measured in money. Transactions will be measured in dollars, not some other unit like time. And that only transactions that can be measured in money will be reflected in the accounting records. Some text books give problems where they list a series of events and the student selects which will be accounted for. For example select the one which won’t be accounted for:
A) Purchase of a truck
B) Payment of the electrical bill
C) Death of the company’s president
If you selected C you’ve got a great hold on the monetary unit assumption. The company president’s passing, while tragic, isn’t an event that can be measured in money, while the other two events clearly involve the exchange of money and thus can be measured through that exchange.
Time period assumption
Last but most certainly not least. The time period assumption states that the activities of an entity can be divided into artificial time periods such as months, years, or even accounting cycles. This assumption while simply creates the most headaches for auditors, salespeople and many others affected by an enterprise. Most business operate on a calendar year. In other words, on January 1st they begin a new accounting cycle, and look at the transactions to see how the previous year preformed. This is closely tied to the accounting function of Closing which is the end of the accounting cycle. While well known time measurements such as a year are common accounting cycles some business run their books through a production cycle or a sales cycle. For example, a ship builder who spends 2 years building one ship and only builds one ship at a time, may only close their books after completing the ship. This way they can closely match the economic events to the production of the one ship.
Well that concludes assumptions stay tuned for constraints and principles!
