How to navigate accounting assumptions

InterNorth began as Northern Natural Gas Company, organized in Omaha, Nebraska, in 1930. The arrangement stipulated that the merged entities would be known as HNG/InterNorth and be headquartered in Omaha with Segnar as chairman and CEO. However by 1986 Segnar had retired, Kenneth Lay was chairman and CEO, and the company was renamed Enron with corporate headquarters in Houston. The new company had the second accounting entity assumption largest pipeline network in the United States with over 36,000 miles of pipe stretching across the continent and north into Canada. They can differentiate between the actual company activity and the ownership involvement. In other words, an investor can see if the business has good cash flow from it’s profitable operations or because the owner keeps funding the business with owner contributions.

1. Based in Green Bay, Wisc., Jackie Lohrey has been writing professionally since 2009.
2. This may sound obvious at first, but in today’s complex business world, those boundaries aren’t always crystal clear.
3. The economic entity principle requires Jim and his company to keep activities separated, so the car must remain a personal vehicle unless Jim contributes it to the company or the company buys it from Jim personally.

The information is broken into time frames to make comparisons and evaluations easier. The information will be timely and current and will give a meaningful picture of how the company is operating. In Australia, readers of the annual financial statements for publicly listed companies can assume that the information contained within that statement pertain just to that specific financial year, and no other. In the USA, publicly listed firms are required to produce quarterly and annual financial statements. The periodicity assumption requires preparing adjusting entries under the accrual basis. Withoutthe periodicity assumption, a business would have only one time period running from its inception toits termination.

You can’t include any transactions from a future period, or one in the past that has already been reported on (otherwise you’d have double counting). The basic components of even the simplest accounting system are accounts and a general ledger. An account is a record showing increases and decreases to assets, liabilities, and equity—the basic components found in the accounting equation. As you know from Introduction to Financial Statements, each of these categories, in turn, includes many individual accounts, all of which a company maintains in its general ledger. A general ledger is a comprehensive listing of all of a company’s accounts with their individual balances. Some companies that operate on a global scale may be able to report their financial statements using IFRS.

Accounting entities can be established for specific product lines or geographical regions where a company’s products are sold. Also, specific accounting records can be maintained based on the core principles of an entity or segregated by customer base, if each customer base is distinguishable from the next. Examples of internal accounting entities include the investment division of a bank or the sales department of a corporation.

Expense Recognition (Matching) Principle

When a publicly traded company in the United States issues its financial statements, the financial statements have been audited by a Public Company Accounting Oversight Board (PCAOB) approved auditor. The PCAOB is the organization that sets the auditing standards, after approval by the SEC. The role of the Auditor is to examine and provide assurance that financial statements are reasonably stated under the rules of appropriate accounting principles. The auditor conducts the audit under a set of standards known as Generally Accepted Auditing Standards. The accounting department of a company and its auditors are employees of two different companies. The auditors of a company are required to be employed by a different company so that there is independence.

The Purpose of the Economic Entity Assumption

You will often see the terms debit and credit represented in shorthand, written as DR or dr and CR or cr, respectively. We can illustrate each account type and its corresponding debit and credit effects in the form of an expanded accounting equation. You will learn more about the expanded accounting equation and use it to analyze transactions in Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions. The cost principle, also known as the historical cost principle, states that virtually everything the company owns or controls (assets) must be recorded at its value at the date of acquisition. There are some exceptions to this rule, but always apply the cost principle unless FASB has specifically stated that a different valuation method should be used in a given circumstance.

Principles of accounting

Forecasting and financial analysis become easier by segregating financial data across different entities. Maintaining different accounting records allows for strategic analysis of the various product lines and helps with decisions regarding whether to discontinue or expand a particular business operation. With a small business, like a sole proprietor, the boundaries of the entity are fairly clear, but as a business grows and acquires new assets and even whole entities, the lines can become blurred. That’s why it’s important, when looking at financial accounting information, to know exactly the scope of the information; to know which business entities are included and which are not. It’s also important to know if the business as reported is a viable entity, and not just something temporary. That’s the second underlying assumption of GAAP—that the entity being observed is a going concern.

This is because most privately held businesses aren’t required to file an annual report with the U.S. Exceptions to the general rule exist when a privately held business contracts with a third party to conduct an external audit, offers stock shares to private investors or decides to convert to public company status. In addition, some businesses choose to voluntarily comply, mainly to provide financial transparency and heighten the business’s reputation. Accounting assumptions, along with accounting principles and concepts, provide professionals with the necessary framework for preparing financial statements. The assumptions ultimately help lay the foundation for reliable, valuable, and consistent information and, without them, the dependability and accuracy of financial reports can be in jeopardy.

A set of financial statements includes the income statement, statement of owner’s equity, balance sheet, and statement of cash flows. These statements are discussed in detail in Introduction to Financial Statements. This chapter explains the relationship between financial statements and several steps in the accounting process. We go into much more detail in The Adjustment Process and Completing the Accounting Cycle.

‘Operate as normal’ means that the business will have sufficient funds from revenue to pay their expenses and debts as they fall due. This can be worded in the business press in many different ways that can cause confusion – examples include ‘the business is experiencing difficulties in continuing as a going concern’, the business is ‘not a going concern’. The normal balance is the expected balance each account type maintains, which is the side that increases. As assets and expenses increase on the debit side, their normal balance is a debit. Since liabilities, equity (such as common stock), and revenues increase with a credit, their “normal” balance is a credit. The ending account balance is found by calculating the difference between debits and credits for each account.

Mixing personal transactions with the company’s business transactions will negatively affect the fair presentation of information in the financial statements and lead to distorted amounts. However, an entity may provide disclosures about inflation as recommended in Topic 255, Changing Prices, when applicable. According to the economic entity assumption, a person evaluating a company’s records assumes all the transactions pertaining to the business are being reviewed. A sole proprietor should keep their business transactions separate from their own personal transactions.

In Australia, that monetary unit of measurement is the Australian dollar and every country will have central bank that determines the monetary unit of measurement. Something within a business that cannot be accurately and reliably measured (such as the value of Instagram influencers who promote a business’s products) cannot be included in the financial statements. However, if an influencer is given products in exchange for a social media post – the retail value of those products can be used as the value of that transaction when preparing the accounting records.

Any entity (i.e., for-profit companies, non-profits, and government entities) that publicly releases financial statements is required to adhere to the GAAP principles and procedures. Consequently, it is important to be aware that a company would need to provide additional information in its financial statements if it does not expect to be able to fulfil its obligations in the coming year. The periodicity assumption, often referred to as the time period assumption, means that the entity has to report on its financial position, cash flows, and results of operations on a regular basis. To ensure comparability over time, the reporting must be provided consistently for the same time periods. Entities usually provide periodic reporting on at least a quarterly and annual basis. The people and entities interacting with businesses all around the world use accounting information to make decisions every single day.