2. Assumptions, Accounting Principles

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Accounting Assumptions: Memory Tool: Every Girl Uses Tampons

Entity Assumption - it is assumed that there is a separate accounting entity for each business organization. Owners of a corporation are not personally liable when company is sued.

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. Therefore, we do not show items at their liquidation or exit values. Prepaid assets, such as prepaid rent, would not be assets without the assumption of continuity.

Unit-of-Measure Assumption - Assets, liabilities, equities, revenues, expenses, gains, losses, and cash flows are measured in terms of the monetary unit of the county in which the business is operated. Price level changes cause the application of this assumption to weaken the relevance of certain disclosures.

Capital maintenance and departures from 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. As long as dividend do not exceed earnings, and earnings is not negative, financial capital has been maintained.

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.

Accounting Principles: Memory Tool: MRRERFD: My Right Rear End Red Fire Department

Measurement - At the time of origination, assets and liabilities are recorded a the market value of the item on the date of acquisition, usually the cash equivalent. This origination value is referred to as historical cost. There are measurement attributes other than historical cost that are used to represent items reported on the financial statements. See bullets below.

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.

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.

Fair Value - (Current Market Value).

Amortized Cost - This value is historical cost less the accumulated amortization or depreciation of the asset.

Net Present Value - This is the value determined from discounting the expected future cash flows.

Revenue Recognition Principle - This principle addresses three important issues related to revenues. Below is a general view of revenue.

Revenue defined - 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.

When to Recognize Revenue - Revenues are recognized when the entity completes its performance obligation to a customer and the revenue is earned and realized. 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 5 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.

3. Measure Revenue - How to measure revenue: Revenues are measured at the cash equivalent amount of the good or service provided.

Expense Recognition Principle - This principle addresses when to recognize expenses and is sometimes referred to as the matching principle.

The matching principle says: recognize expenses only when expenditures help to produce revenues. Revenues are recognized when eared and realized or realizable; the related expenses are recognized, and the revenues and expenses are "matched" to determine net income or loss.

Expenses that are directly related to revenues can be readily matched with revenues they help produce.

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.

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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