This chapter will introduce you to the fundamental theories and rules that guide the system of accounting. The key tenets of accounting are explained, including: double entry, substance over form, the matching principle, the revenue recognition principle, cost-benefit, materiality, and conservatism, as is their impact on the overall application of GAAP (Generally Accepted Accounting Principles). The underlying intent behind creating financial reports is for the information in the reports to be reliable enough to support sound business decision-making. By the time you finish this chapter, you should have a better understanding of the overall structure of accounting rules and guiding principles.
Underlying assumptions or concepts
The major underlying assumptions or concepts of accounting are (1) business entity, (2) going
concern (continuity), (3) money measurement, (4) stable dollar, and (5) periodicity. This section
discusses the effects of these assumptions on the accounting process.
Data gathered in an accounting system must relate to a specific business unit or entity. 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, not the business owner, is the accounting entity.
Therefore, financial statements are identified as belonging to a particular business entity. The content
of these financial statements reports 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
(such as General Motors Corporation) 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. Chapter 14 illustrates this concept.
When accountants record business transactions for an entity, they assume it is a going concern. The
going-concern (continuity) 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 If liquidation appears likely, the going-concern assumption is no longer valid.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
rather than selling them. On the other hand, if an entity is liquidating, it should use liquidation values
to report assets.
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. 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 on 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. For example, it would be difficult to compare
relative asset amounts or profitability of a company reporting in US dollars with a company reporting
in Japanese yen.
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. 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.
According to the periodicity (time periods) 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
Accounting reports 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. For instance, so far, the
income statements in this text were for either one month or one year. Companies that publish their
financial statements, such as publicly held corporations, generally prepare monthly statements for
internal management and publish financial statements quarterly and annually for external statement
Accrual basis and periodicity Chapter 3 demonstrated that financial statements more
accurately reflect the financial status and operations of a company when prepared under the accrual
basis rather than the cash basis of accounting. Under the cash basis, we record revenues when cash is
received and expenses when cash is paid. Under the accrual basis, however, we record revenues when
services are rendered or products are sold and expenses when incurred.
The periodicity assumption requires preparing adjusting entries under the accrual basis. Without
the periodicity assumption, a business would have only one time period running from its inception to
its termination. Then, the concepts of cash basis and accrual basis accounting would be irrelevant
because all revenues and all expenses would be recorded in that one time period and would not have to
be assigned to artificially short periods of one year or less.
Approximation and judgment because of periodicity To provide periodic financial
information, accountants must often estimate expected uncollectible accounts (see Chapter 9) and the
useful lives of depreciable assets. Uncertainty about future events prevents precise measurement and
makes estimates necessary in accounting. Fortunately, these estimates are often reasonably accurate.