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Assumptions,AccountingPrinciples
I. AccountingAssumptions
A. EntityAssumptionWeassumethereisaseparateaccountingentityforeachbusiness
organization.

Example:
Theownersandthecorporationareseparate.Theownersownsharesin
thecorporationtheydonotowntheassetsofthefirm.Thecorporation
ownstheassets.Thefinancialstatementsrepresentthecorporation,not
theowners.Afirmcannotownitself.Treasurysharesarenotassetstothefirm
nooneownstreasuryshares.Afirmcansueandbesued.Ifafirmissued,the
ownersarenotliable.

B. GoingConcernAssumption
1. Intheabsenceofinformationtothecontrary,abusinessisassumedtohaveanindefinite
life,thatis,itwillcontinuetobeagoingconcern.Therefore,wedonotshowitemsattheir
liquidationorexitvalues.
2. Thisassumption,alsocalledthecontinuityassumption,supportsthehistoricalcostprinciple
formanyassets.Incomemeasurementisbasedonhistoricalcostofassetsbecauseassets
providevaluethroughuse,ratherthandisposal.Thus,netincomeisthedifferencebetween
revenueandthehistoricalcostofassetsusedingeneratingthatrevenue.Withoutthe
goingconcernprinciple,historicalcostwouldnotbeanappropriatevaluationbasis.

Example:
Prepaidassets,suchasprepaidrent,wouldnotbeassetswithoutthe
assumptionofcontinuity.

C. UnitofMeasureAssumptionAssets,liabilities,equities,revenues,expenses,gains,losses,
andcashflowsaremeasuredintermsofthemonetaryunitofthecountryinwhichthebusinessis
operated.Pricelevelchangescausetheapplicationofthisassumptiontoweakentherelevanceof
certaindisclosures.

Example:
Theamountsofallassetsareaddedtogethereventhough
amountsrecordedatdifferenttimesrepresentdifferent
purchasingpowerlevels.

1. Capitalmaintenanceanddeparturesfromtheunitofmeasureassumption
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a. Theconceptofcapitalmaintenanceisrelatedtotheunitofmeasureassumption.
Capitalissaidtobemaintainedwhenthefirmhaspositiveearningsfortheyear,
assumingnochangesinpricelevels.Whenafirmhasincome,ithasrecognized
revenuesufficienttoreplacealltheresourcesusedingeneratingthatrevenue
(returnofcapital),andhasresourcesleftoverinaddition(income,whichisreturnon
capital).Thatincomecouldbedistributedasdividendswithouterodingthenetassets
(capital)existingatthebeginningoftheyear.GAAPisbasedontheconceptof
"financial"capitalmaintenance.Aslongasdividendsdonotexceedearnings,and
earningsisnotnegative,financialcapitalhasbeenmaintained.
b. Analternativeconceptofcapitalmaintenanceis"physical"capitalmaintenance.This
conceptholdsthatearningscannotberecognizeduntilthefirmhasprovidedforthe
physicalcapitalusedupduringtheperiod.Tomeasurethecapitalusedup,changes
inpricelevelmustbeconsidered.

Example:
Afirmusesup$5,000worthofsuppliesinprovidingitsservice
duringtheyear,buttoreplacethosesuppliesforusenextyear,
$5,500willhavetobepaid(10%increaseinspecificpriceof
supplies).The"financial"capitalmaintenancemodelusesthe$5,000cost
ofsuppliesasthemeasureofrevenueneededtomaintaincapital.If
revenueforthecurrentperiodis$5,000andthefirmhadnoother
expenses,earningswouldbezeroandcapitalwouldjustbemaintained.
The"physical"capitalmodelwouldrequirerevenueof$5,500forcapitalto
bemaintained.
GAAPdoesnotrequireadjustmentsforpricelevelchangesandthusapplies
the"financial"capitalmaintenanceconceptinfinancialreports.

D. TimePeriodAssumptionTheindefinitelifeofabusinessisbrokenintosmallertimeframes,
typicallyayear,forevaluationpurposesandreportingpurposes.Foraccountinginformationtobe
relevant,itmustbetimely.Thereliabilityoftheinformationoftenmustbesacrificedtoprovide
relevantdisclosures.Theuseofestimatesisrequiredfortimelyreportingbutalsoimpliesapossible
lossofreliability.
II. AccountingPrinciples
A. MeasurementAtthetimeoforigination,assetsandliabilitiesarerecordedatthemarket
valueoftheitemonthedateofacquisition,usuallythecashequivalent.Thisoriginationvalueis
referredtoashistoricalcost.Formanyassetsandliabilities,thisvalueisnotchangedeventhough
marketvaluechanges.Otherassets,suchasplantassetsandintangibles,aredisclosedat
historicalcostlessaccumulateddepreciationoramortization.Giventhegoingconcernassumption,
revaluationtomarketvalueisinappropriateforplantassets,becausethevalueoftheseassetsis
derivedthroughuse,ratherthanfromdisposal.
B. Therearemeasurementattributesotherthanhistoricalcostthatareusedtorepresentitems
reportedonthefinancialsstatements.Belowisabriefsummaryandexampleofeach
measurementattribute.
1. NetrealizablevalueThisvalueisusedtoapproximateliquidationvalueorselling
price.Itisthenetvaluetobereceivedafterthecostsofsalearedeductedfromthecurrent
marketvalue
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a. Example:LowercostormarketforinventoryvaluationusesNRV.
2. CurrentreplacementcostThisvaluerepresentshowmuchyouwouldhavetopayto
replaceanasset.Currentreplacementcostwouldrepresentcurrentmarketvaluefromthe
buyer'sperspective.
a. Example:Replacementcostisalsousedininventoryvaluation.
3. FairvalueThisvalueisalsoreferredtoascurrentmarketvalue.Itisthepricethat
wouldbereceivedtosellanasset(orthepricetosettlealiability)inanorderlytransaction
fromtheperspectiveofamarketparticipantatthemeasurementdate(seethefairvalue
lessonsforfurtherdiscussionoffairvalue).
a. Example:Currentmarketvalue(orfairvalue)isusedtovaluetradingandavailable
forsalesecurities.
4. AmortizedcostThisvalueishistoricalcostlesstheaccumulatedamortizationor
depreciationoftheasset.
a. Example:Buildingsandequipmentarereportedathistoricalcostlessaccumulated
depreciation.
5. NetpresentvalueThisisthevaluedeterminedfromdiscountingtheexpectedfuture
cashflows.
a. Example:Thediscountedfuturecashflowsareusedinmanycapitalbudgeting
decisions.

C. RevenueRecognitionPrincipleThisprincipleaddressesthreeimportantissuesrelatedto
revenues.Belowisageneralviewofrevenueseetherevenuerecognitionlessonsformore
details.
1. RevenueDefinedWhatrevenueis:Revenuereferstoincreasesinassetsorthe
extinguishmentofliabilitiesstemmingfromthedeliveryofgoodsortheprovisionofservices
themainactivitiesofthefirm.
2. WhentoRecognizeRevenueRevenuesarerecognizedwhentheentitycompletesits
performanceobligationtoacustomerandtherevenueisearnedandrealized(orrealizable)
.Theperformanceobligationiscompletedwhenthegoodsorservicesaredelivered
(revenueisearned)andcashorpromiseofcashisreceived(realized).Ingeneral,thereare
fivestepstoallocatethecomponentsofrevenue.
a. Identifythecontractwiththecustomer(promisetodeliveragoodorservice)
b. Identifyifthereismorethanoneperformanceobligation
c. Determinethetransactionprice
d. Allocatethetransactionpricetotheseparateperformanceobligations(ifthereis
morethanoneperformanceobligation)
e. Recognizerevenuewheneachperformanceobligationissatisfied.

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3. MeasureRevenueHowtomeasurerevenue:Revenuesaremeasuredatthecash
equivalentamountofthegoodorserviceprovided.

Example:
Acontractisenteredintowiththecustomertodeliveran
automobileandprovideawarrantyonthepartsassociatedwith
theautomobile.
Therearetwoseparateperformanceobligations:delivertheautomobile
andprovidepartsifneeded.
Determinethepriceoftheautomobilewithoutthewarrantyortheprice
thatthewarrantyissoldforseparatefromtheautomobile.
Allocatethetransactionpricetotheseparateperformanceobligations.
Recognizerevenuewheneachperformanceobligationissatisfied.With
respecttotheautomobile,revenuewouldberecognizedupondelivery,
withrespecttothewarranty,therevenuewouldberecognizedoverthe
warrantyperiod.

D. ExpenseRecognitionPrincipleThisprincipleaddresseswhentorecognizeexpensesandis
sometimesreferredtoasthematchingprinciple.
1. Thematchingprinciplesays:recognizeexpensesonlywhenexpenditureshelptoproduce
revenues.Revenuesarerecognizedwhenearnedandrealizedorrealizabletherelated
expensesarerecognized,andtherevenuesandexpensesare"matched"todeterminenet
incomeorloss.
2. Expensesthataredirectlyrelatedtorevenuescanbereadilymatchedwithrevenuesthey
helpproduce.
3. Costofgoodssoldandsalescommissionsareexpensesthataredirectlyassociatedand
thereforematchedwithrevenue.Otherexpensesareallocatedbasedonthetimeperiodof
benefitprovided.Depreciationandamortizationareexamples.Suchexpensesarenot
directlymatchedwithrevenues.Stillotherexpensesarerecognizedintheperiodincurred
whenthereisnodeterminablerelationshipbetweenexpendituresandrevenues.
Advertisingcostsareanexample.
E. FullDisclosurePrincipleFinancialstatementsshouldpresentallinformationneededbyan
informedreadertomakeaneconomicdecision.Thisprincipleissometimesreferredtoasthe
adequatedisclosureprinciple.

Example:
Anaircraftmanufacturerentersintoacontracttobuild200airplanesfor
anairlinecompany.Asofthebalancesheetdate,productionhasnot
begun.Thus,thereisnorecognitionofthiscontractintheaccounts.
However,afootnoteshouldexplainthefinancialaspectsofthecontract.This
informationispotentiallyofgreaterinterestthanmanyitemsrecognizedinthe
accounts.

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Flashcards
Flashcard#1 (FC5757)

Whatistheentityassumption?

Weassumethereisaseparateaccountingentityfor
eachbusinessorganization.

Flashcard#2 (FC5758)

Whatisthegoingconcernassumption?

Intheabsenceofinformationtothecontrary,a
businessisassumedtohaveanindefinitelife,thatis,
itwillcontinuetobeagoingconcern.

Flashcard#3 (FC5759)

Whatistheunitofmeasurementassumption?

Assets,liabilities,equities,revenues,expenses,gains,
losses,andcashflowsaremeasuredintermsofthe
monetaryunitofthecountryinwhichthebusinessis
operated.

Flashcard#4 (FC5760)

Whatistheconceptofcapitalmaintenance?

Capitalissaidtobemaintainedwhenthefirmhas
positiveearningsfortheyear,assumingnochangesin
pricelevels.

Flashcard#5 (FC5761)

Whatisthetimeperiodassumption?

Theindefinitelifeofabusinessisbrokenintosmaller
timeframes,typicallyayear,forevaluationpurposes
andreportingpurposes.

Flashcard#6 (FC5762)

Whatdoesthehistoricalcostaccountingprinciple
state?

Assetsandliabilitiesarerecordedathistoricalcost,
thatis,theircashequivalentamountattimeof
origination.Thisvalueisthemarketvalueoftheitem
onthedateofacquisition.

Flashcard#7 (FC5763)

Whatarerevenues?

Revenuesareincreasesinassetsorextinguishmentof
liabilitiesstemmingfromdeliveryofgoodsorfrom
providingservicesthemainactivitiesofthefirm.

Flashcard#8 (FC5764)

Whenshouldacompanyrecognizerevenues?

Revenuesarerecognizedwhentheyareearnedand
collectabilityisreasonablyassured.

Flashcard#9 (FC5765)

Whendoesrealizationoccurintheaccountingperiod?

(1)Goodsorserviceshavebeenprovided,(2)
Collectabilityofcashisassured,(3)Expensesof
providinggoodsandservicescanbedetermined.

Flashcard#10 (FC5766)

Howdowemeasurearevenue?

Revenuesaremeasuredasthecashequivalent
amountofthegoodorserviceprovided.

Flashcard#11 (FC5767)

Whatisthematchingprinciple?

Recognizeexpensesonlywhenexpenditureshelpto
producerevenues.

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Flashcard#12 (FC5768)

Whatisthefulldisclosureprinciple?

Financialstatementsshouldpresentallinformation
neededbyaninformedreadertomakeaneconomic
decision.Thisprincipleissometimesreferredtoasthe
adequatedisclosureprinciple.

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ProficiencyQuestions
Question#1 (PQ2416)
Canallexpensesbedirectlymatchedwithrevenue?

Yes
No

Question#2 (PQ2407)
Ifthegoingconcernassumptionwerenotmet,adherencetothehistoricalcostprinciplewould
continuetobeappropriate.

True
False

Question#3 (PQ2408)
Amanagerusesacompanycarforbothbusinessandpersonaluse.Therefore,thecarshouldnot
beincludedamongthefirm'sassets.

True
False

Question#4 (PQ2409)
Afirmhasnegativeincomeforaperiod.Hasthefirmexperiencedareturnoncapital?

Yes
No

Question#5 (PQ2412)
Underthehistoricalcostprinciple,aremostassetsrecordedatmarketvalueonthepurchase
date?

Yes
No

Question#6 (PQ2413)
Aremostassetssubsequentlyadjustedforchangesinmarketvalueunderthehistoricalcost
principle?

Yes
No

Question#7 (PQ8496)
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Matchingisnotanaccountingassumption.

True
False

Question#8 (PQ8497)
Afirmhasincomeofexactlyzeroforayearduringwhichbothspecificandgeneralprices
(inflation)haveincreased.Thefirmmaintaineditscapitalunderthefinancialconceptofcapital
maintenance.

True
False

Question#9 (PQ8498)
Theaccountingassumptionofseparateentitysupportstheinclusionofprepaidinsuranceintotal
assets.

True
False

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PastExamQuestions
Question#1 (AICPA.940503FARFA)
Reportinginventoryatthelowerofcostormarketisadeparturefromtheaccountingprincipleof:

A.Historicalcost.
B.Consistency.
C.Conservatism.
D.Fulldisclosure.

Question#2 (AICPA.940501FARFA)
Accordingtotheconceptualframework,theprocessofreportinganiteminthefinancial
statementsofanentityis:

A.Allocation.
B.Matching.
C.Realization.
D.Recognition.

Question#3 (AICPA.930505FARTHFA)
Whenaparentsubsidiaryrelationshipexists,consolidatedfinancialstatementsarepreparedin
recognitionoftheaccountingconceptof:

A.Reliability.
B.Materiality.
C.Legalentity.
D.Economicentity.

Question#4 (AICPA.930503FARTHFA)
OnDecember31,2002,BrooksCo.decidedtoendoperationsanddisposeofitsassetswithin
threemonths.AtDecember31,2002,thenetrealizablevalueoftheequipmentwasbelow
historicalcost.WhatistheappropriatemeasurementbasisforequipmentincludedinBrooks'
December31,2002,BalanceSheet?

A.Historicalcost.
B.Currentreproductioncost.
C.Netrealizablevalue.
D.Currentreplacementcost.

Question#5 (AICPA.101043FAR)
AndeCo.estimatesuncollectibleaccountsexpenseusingtheratioofpastactuallossesfrom
uncollectibleaccountstopastnetcreditsales,adjustedforanticipatedconditions.Thepractice
followstheaccountingconceptof:

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A.Consistency.
B.Goingconcern.
C.Matching.
D.Substanceoverform.

Question#6 (AICPA.082114FARI.A.II)
AccordingtotheFASBconceptualframework,certainassetsarereportedinfinancialstatements
attheamountofcashoritsequivalentthatwouldhavetobepaidifthesameorequivalent
assetswereacquiredcurrently.Whatisthenameofthereportingconcept?

A.Replacementcost.
B.Currentmarketvalue.
C.Historicalcost.
D.Netrealizablevalue.

Question#7 (AICPA.061241FAR)
Whichofthefollowingassumptionsmeansthatmoneyisthecommondenominatorofeconomic
activityandprovidesanappropriatebasisforaccountingmeasurementandanalysis?

A.Goingconcern.
B.Periodicity.
C.Monetaryunit.
D.Economicentity.

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ProficiencyQuestionAnswers
Question#1: :False
Question#2: False
Question#3: False
Question#4: :False
Question#5: :True
Question#6: :False
Question#7: True
Question#8: True
Question#9: False

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PastExamQuestionAnswers
Question#1 (AICPA.940503FARFA)
A.(Correct!)LCMdepartsfromhistoricalcostbecauseitprovidesanendingvaluationbelowcostwhenmarket
valueisbelowcost.Theinventoryisactuallywrittendowntoavaluebelowwhatwasoriginallypaid.Thisisone
ofthefewsuchdepartures.
B.LCMdoesnotimplyadeparturefromconsistency.Itisanaccountingprincipleappliedconsistentlywhenever
marketislessthancost,indicatingadeclineintheutilityoftheinventory.
C.Justtheopposite,LCMisanexampleofconservatism.Themarketvalueofinventory,evenifitisknowntobe
belowcost,isneveradefinitenumber.Underuncertainty,conservatismdemandsthatthelessoptimisticvalue
bereported.
D.LCMdoesnotviolatefulldisclosure.Itcanbearguedthat,givenadeclineinmarketvaluebelowcost,LCM
actuallyprovidesmorerelevantinformationthanmaintainingthehistoricalcostvaluation.

Question#2 (AICPA.940501FARFA)
A.Allocationmayaffecttheamountsofitemsreported,butallocationdoesnotnecessarilyimplyreportinginthe
financialstatements.Recognitionisthecorrectterm.
B.Matchingisonlyoneaccountingprinciplethatrequiresreporting.Inthiscase,expensesarerecognized
(reported)whentheycontributetothegenerationofrevenue.Butmatchingisnottheonlyreasonitemsare
recognizedintheaccounts.
C.Realizationimpliesthecompletionofatransactionandthereceiptofliquidassets(orotherresourcesif
acceptabletothetransferee).Mostrealizationsrequirereportingintheaccounts(recognition),butthereare
manyothereventsthatcauserecognition.Inotherwords,mostrealizationsarerecognitions,butnotall
recognitionsarerealizations.
D.(Correct!)Recognitionisthestrongestreportingactionthatcanbetaken.Whenanitemisrecognized,that
meansitwillappearinthefinancialstatements,perhapsnotasanindividuallineitem,butdefinitelypartofone.
Manyotheritemsfindtheirwayintothefootnotes,butarenotrecognized.

Question#3 (AICPA.930505FARTHFA)
A.Consolidatedfinancialstatementsareanexampleoftryingtoaccountfortheeconomicentitythatcomprises
morethanonelegalentity.Allfinancialstatementsneedtobereliable,butthatisnotrelatedtotheissueat
handandis,therefore,notthecorrectresponse.
B.Consolidatedfinancialstatementsareanexampleoftryingtoaccountfortheeconomicentitythatcomprises
morethanonelegalentity.Materialityisamodifyingcriteriaforallfinancialstatements,butitisnotrelatedto
theissueathandandis,therefore,notthecorrectresponse.
C.Consolidatedfinancialstatementsareanexampleoftryingtoaccountfortheeconomicentitythatcomprises
morethanonelegalentity.Actually,consolidationis,inherently,aviolationofthelegalentityconceptsinceitis
thecombinationofmorethanonelegalentityintoonereport.Therefore,thisisincorrect.
D.(Correct!)Consolidatedfinancialstatementsareanexampleoftryingtoaccountfortheeconomicentitythat
comprisesmorethanonelegalentity,makingthisthecorrectresponse.

Question#4 (AICPA.930503FARTHFA)
A.Thishistoricalcostoftheassetisnolongerrelevant.Thefirmisnolongeragoingconcerntheassumption
thatsupportsthehistoricalcostprinciple.AllthatmattersnowiswhatBrookscanreceivefortheequipment.
B.Afterthedecisionismadetoliquidatethebusiness,theonlyrelevantvaluesareexitvaluesthenetamounts
thatcanbereceivedfromsaleoftheassets.
C.(Correct!)Whenafirmisinliquidation,historicalcostandentryvalues(replacementcost)arenolonger
relevant.Thegoingconcernassumptionsupportsthehistoricalcostprinciple.Thefirmisnolongeragoing
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concern.Theonlyamountsrelevantaretheamountstobereceivedonsaleoftheassets.Netrealizablevalueis
thenetvaluetobereceived,afterthecostsofgettingtheassetreadyforsalearededucted.
D.CurrentreplacementcostistheamountBrookswouldhavetopaytoreplaceitsassets.Brookshasnointerest
inreplacingitsassets,butratherwishestosellitsassets.Thus,therelevantvaluesarethenetamountsthat
canberealizedonsale.

Question#5 (AICPA.101043FAR)
A.Consistencyisthedesiredcharacteristicsoftheapplicationofaccountingprinciplesinthesamemannerfrom
yeartoyear.Consistencypermitscomparisonwithinonecompanyoveraperiodoftime.Comparabilitypermits
comparisonbetweencompanies.
B.Goingconcernistheassumptionthattheentitywillcontinueintothefuture.
C.(Correct!)Thematchingprinciplerequiresthatwerecognizeandmatchexpenseswiththerevenues
generated.Forallsalesinagivenperiod,somewillbeuncollectible.Thecostofthoseuncollectibleaccountsis
matchedintheperiodthattherevenueisrecognized.
D.Substanceoverformisaneconomicconceptthatreferstotheeconomicsubstanceofatransactionorevent
ratherthanthewaythatthetransactionoreventispresented.

Question#6 (AICPA.082114FARI.A.II)
A.(Correct!)Replacementcostistheamounttobepaidforanitematthecurrenttime.Thisconceptisusedin
thelowerofcostormarketinventoryvaluationprocedure.Replacementcostisanexampleofanentrypricethe
amountrequiredtobepaidcurrentlytoobtainanassetalreadyheld.
B.Currentmarketvalueisalsocalledfairvalue,whichisthepricethatwouldbereceivedtosellanassetinan
orderlytransactionbetweenmarketparticipantsatthemeasurementdate.Marketvalueisanexampleofanexit
pricetheamounttobereceivedonsaleoftheasset.
C.Historicalcostistheoriginalcostofacquiringanasset,plusanyassociatedcosts.Historicalcostisanentry
pricebut,usually,isnotequaltothecurrentpricerequiredtobepaidtoobtaintheassetcurrentlyheld.
D.Netrealizablevalueisanexampleofanexitprice.Itequalstheestimatedsellingpricelessthecostto
completeandsell.

Question#7 (AICPA.061241FAR)
A.Thegoingconcernassumptionstatesthatintheabsenceofinformationtothecontrary,thecorporateentity
hasanindefiniteexistencethereisnoforeseeableendtotheentityundercurrentcircumstances.
B.Theperiodicityassumptionstatesthatinorderforfinancialstatementinformationtobeuseful,itmustbe
availableonaperiodicbasisratherthanattheendofthereportingentity'sexistence.
C.(Correct!)Themonetaryunitassumptionprovidesthebasisforusingthehomecountrycurrencyasthe
reportingbasisinthefinancialstatementsandalsotendstoimplythattheunitofcurrencyisstable(littleorno
inflationordeflation).
D.Alsoknownastheseparateentityassumption,thisconceptrecognizesthatthecorporationisthereporting
entity,nottheowners.Thefinancialstatementsarethoseofthecorporation.Theshareholdersareseparatefrom
thecorporation.Thereportingfirmisaseparatelegalentity.

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