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In order to study managerial accounting, we will have to understand the basics of accounting theory and assumptions. Accounting theory consists of the underlying assumptions, rules of measurement, major principles, and modifying conventions in the study of financial reporting. Accounting theories are a basis for understanding financial reporting, as well as how financial reporting principles are applied in the accounting industry. The following sections describe the aspects of accounting theory that greatly influence accounting practice.
In recording business transactions, accountants rely on certain underlying assumptions or concepts. Both preparers and users of financial statements must understand these assumptions. The major underlying assumptions or concepts of accounting are going concern, monetary unit, time period, and business entity.
When accountants record business transactions for an entity, they assume it is a going concern. The going concern assumption states that an entity will continue to operate indefinitely unless strong evidence exists that the entity will terminate. The termination of an entity occurs when a company ceases business operations and sells its assets. The process of termination is called liquidation. If liquidation appears likely, the going-concern assumption is no longer valid.
Accountants often cite the going-concern assumption to justify using historical costs, rather than market values, in measuring assets. Market values are of less significance to an entity using its assets as opposed to selling them. On the other hand, if an entity is liquidating, it should use liquidation values to report assets.
EXAMPLE
East-West Plumbing is unable to pay its debts to creditors, and as a result, they are ordered by a court to liquidate the company. By doing so, they are no longer a going concern, since there is evidence that they can’t continue their operations.The economic activity of a business is normally recorded and reported in money terms. Money measurement is the use of a monetary unit, such as the dollar instead of physical or other units of measurement—it is the difference between trading a dozen eggs for a sack of potatoes or trading a dozen eggs for a five dollar bill. Using a particular monetary unit provides accountants with a common unit of measurement to report economic activity. Without a monetary unit, it would be impossible to add such items as buildings, equipment, and inventory to a balance sheet. Financial statements identify their unit of measure (such as the dollar in the United States), so the statement user can make valid comparisons of amounts.
EXAMPLE
A corporation that produces copper wire would not describe the amount of raw copper assets they possess in ounces or length of feet. Instead, they would disclose the amount of the raw copper in the amount of US dollars they purchased it for. This allows financial statement users to make a convenient and easily understandable comparison.In the United States, accountants make another assumption regarding money measurement—the stable dollar assumption. Under the stable dollar assumption, the dollar is accepted as a reasonably stable unit of measurement. Thus, accountants make no adjustments for the changing value of the dollar in the primary financial statements.
Using the stable dollar assumption creates a difficulty in depreciation accounting, which is a method for allocating the cost of a physical asset over the course of its useable life. Assume, for example, that a company acquired a building in 1975, and computed the 30-year straight-line depreciation on the building, without adjusting for any changes in the value of the dollar. Thus, the depreciation deducted in 2008 is the same as the depreciation deducted in 1975. The company makes no adjustments for the difference between the values of the 1975 dollar and the 2008 dollar. Both dollars are treated as equal monetary units of measurement, despite substantial price inflation over the 30-year period. Accountants and business executives have expressed concern over this inflation problem, especially during periods of high inflation. Despite this concern, the stable dollar assumption is effective in providing a stable unit of measurement when we are not experiencing inflation.
According to the time period assumption, accountants divide an entity's life into months or years to report its economic activities. Then, accountants attempt to prepare accurate reports on the entity's activities for these periods. Although these time-period reports provide useful and timely financial information for investors and creditors, they may be inaccurate for some of these time periods, because accountants must estimate depreciation expense and certain other adjusting entries.
Financial statements cover relatively short periods. These time periods are usually of equal length so that statement users can make valid comparisons of a company's performance from period to period. The length of the accounting period must be stated in the financial statements. Companies that publish their financial statements, such as publicly held corporations, generally prepare monthly financial statements for internal management and publish financial statements quarterly and annually for external statement users.
EXAMPLE
The time period assumption allows long periods of time to be divided into consecutive periods of time such as months, quarters, and years. This permits companies and external users to make month-to-month or year-to-year comparisons which provides useful performance data. The SEC requires public companies to submit quarterly and annual reports.Data gathered in an accounting system must relate to a specific business unit or entity. A business unit is an organization formed to conduct business. The business entity concept assumes that each business has an existence separate from its owners, creditors, employees, customers, interested parties, and other businesses. For each business (such as a horse stable or a fitness center), the business itself is the business entity. Therefore, financial statements are identified as belonging to a particular business entity, with the content of these financial statements reporting only on the activities, resources, and obligations of that entity.
A business entity may be made up of several different legal entities. For instance, a large business may consist of several separate corporations, each of which is a separate legal entity. For reporting purposes, however, the corporations may be considered as one business entity, because they have a common ownership.
EXAMPLE
Angela owns a catering company and has purchased a truck to deliver food to her clients. Angela also owns a car for her personal use. If Angela was to list both vehicles as assets on her business’s balance sheet, she would be violating the separate entity assumption.Generally accepted accounting principles (GAAP) set forth standards or methods for reporting financial accounting information. A standardized presentation format enables users to compare the financial information of different companies more easily. Generally accepted accounting principles have either been developed through accounting practice or established by authoritative organizations. The four general accounting principles include cost principle (measurement principle), revenue recognition principle, matching principle (expense recognition principle), and full disclosure principle.
While GAAP issues the standards for the United States, the International Accounting Standards Board (IASB) issues the International Financial Reporting Standards (IFRS), which are the global standards that are practiced by businesses outside of the US. The IFRS is the international accounting framework that is currently required in more than 120 countries. Similar to GAAP, the IFRS provides global businesses with the standards for properly organizing and reporting financial information. The idea is to provide uniformity in financial reporting, making it easier to compare and contrast the financial results of businesses.
Whenever resources are transferred between two parties, such as buying merchandise on account, the accountant must follow the cost principle in presenting that information. The cost principle requires an accountant to record transfers of resources at prices agreed on by the parties to the exchange at the time of exchange. If cash is given for a service, its cost is measured by the cash paid. If something besides cash is exchanged (such as a machine traded for a different machine), the cost is measured as the cash value of what is given up or received.
EXAMPLE
When a retailer purchases inventory from a vendor, they record the purchase at the cash price that was paid for the inventory.This principle sets forth the following:
EXAMPLE
When a business purchases a plant asset, the cost recorded includes not only the purchase price but all reasonable and necessary costs to acquire and prepare an asset for use. If a restaurant purchases a new stove, the acquisition price would include the price of the stove as well as the costs associated with delivery and installation.The revenue recognition principle states that revenue should be recorded when it has been earned, not when the related cash is collected. Revenue is the amount of cash received from selling products and services. The accrual accounting method of recognizing revenue records transactions related to revenue earnings as they occur, not when cash is collected.
EXAMPLE
Joleen contracts a landscaping company every summer. She pays $600 at the start of the six month contract. The landscaping company records revenue each month when they have completed her services. Joleen's neighbor Mike, on the other hand, uses the landscaping company on an as-needed basis and pays them each time they come to his home. They are able to record his revenue immediately since they are completing the service each time they come to his home.When the cash basis of accounting is used, revenue should be recorded when a cash payment has been received. Based on the previous example of the landscaping company, the revenue will not be recognized until the client pays for the service, even if it is weeks or months after the landscaping company completes the job.
In accordance with the matching principle, when a company recognizes revenue, the related expenses should be matched to the revenue. Additionally, it results in a liability to appear on the balance sheet for the end of the accounting period. The matching principle relates to the accrual basis of accounting. If an expense is not directly tied to revenues, the expense should be reported in the accounting period in which it expires or is used up. If the future benefit of a cost cannot be determined, it should be charged to expense immediately.
EXAMPLE
A retail clothing store owner records the expense of the clothing they sell on the day that they sell the clothing, not when they buy the clothing and place them in inventory–this matches the expense of the clothing with the revenue of the clothing.The full disclosure principle requires a company to provide the necessary information so that the users of financial statements are able to make informed decisions related to the financial information. The disclosures required under this principle could be included in the notes to the financial statements, the company’s annual report, and quarterly earnings reports. The full disclosure principle offers explanations and details behind the numbers, which are reported in the various financial statements. The notes that are included in the disclosure statement might include a description of the company’s significant accounting policies, how they depreciate their assets, or how their inventory is accounted for.
EXAMPLE
A business purchases an asset using a note payable instead of cash; therefore, they will disclose this non-monetary transaction in the financial statements.Source: THIS TUTORIAL HAS BEEN ADAPTED FROM “ACCOUNTING PRINCIPLES: A BUSINESS PERSPECTIVE” BY hermanson, edwards, and maher. ACCESS FOR FREE AT www.solr.bccampus.ca. LICENSE: CREATIVE COMMONS ATTRIBUTION 3.0 UNPORTED.
