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Assets and services are recorded at their purchase cost and that the accounting record of the assets continues is to be based on cost rather than on current market value. By specifying that assets be recorded at cost, this principle also governs the recording of liabilities and owner equity. The underlying basis for the cost principle is the reliability principle. Cost is a reliable value for assets and services because cost is supported by completed transactions between parties with opposing interests. Buyers try to pay the lowest price possible, and sellers try to sell for the highest price. The actual cost of an asset or service is objective evidence of its value. (Charles T. Horngren et al. 1995, pg.483)
Companies record assets at their cost. This is true not only at the time the asset is purchased, but also the time the asset is held. Critics contend that the cost principle is irrelevant. They argue that market value (the value determined by the market at any particular time) is more useful to financial decision makers. Proponents of the cost principle counter that cost is the best measure. The reason: Cost can easily be verified, whereas market value is often subjective. (Jerry J. Weygandt et al. 2008, pg.8)
Money Measurement Concept (or Monetary Principle)
Accounting information has traditionally been concerned with only those facts covered by (a) and (b) which follow:
It can be measured in monetary unit
Most people will agree to the monetary value of the transaction.
This limitation is referred to as money measurement concept, and it means that accounting can never tell everything about a business. For example, accounting do not show the following:
Whether the business has good or bad managers,
Whether there are serious problems with the workforce,
Whether a rival product is about to take away many of the best customers,
Whether the government is about to pass a law which will cost the business a lot of extra expense in the future.
The reason for (c) to (f) or similar items are not recorded is that it would be impossible to work out a monetary value for them which most people would agree to. Some people think that accounting and financial statements tell you everything you want to know about a business. The above show thatit shows otherwise. (Frank Wood & Alan Sangster 2009, pg.110)
Accounting information is expressed primarily in monetary terms. The monetary unit is the prime means of measuring assets. This measure is not surprising, given that money is the common denominator in business transactions. In the United States, the monetary unit is the dollar; in Great Britain, the pound sterling; in Japan, the yen. The stable-monetary-unit concept provides an orderly basis for handling account balances to produce the financial statements.
Unlike a litter, a foot, and many other measurements, the value of the monetary unit may change over time. Most of us are familiar with inflation. Groceries that cost $50 a few years ago may cost $60 today. The value of the dollars changes. In view of the fact that the dollar doesn? maintain a constant value, how does a business measure the worth of assets and liabilities acquired over a long span of time? The business records all assets and liabilities at cost. Each asset and each liability on the balance sheet is the sum of all the individual dollar amounts added over time. The stable-monetary-unit concept is the accountant? basis for ignoring the effect of inflation and making no restatements for the changing value of the dollar. (Charles T. Horngren et al. 1995, pg.484)
Monetary principle requires that companies include in the accounting records only transaction data that enables accounting to quantify (measure) economic events. The monetary principle is vital to applying the cost principle. This assumption prevents inclusion of some irrelevant information in the accounting records. For example, the health of the owner, the quality of the service, the morale of the employees are not included. The reason: Companies cannot quantity this information in terms of money. Though this information is important, only events that can be measured in money are recorded. (Herry J. Weygandt et al. 2008, pg.9)
The Business Entity Concept (or Accounting Entity Assumption/Concept)
Affairs of a business are to be treated as being quite separate from the non-business activities of its owner(s).
The items recorded in the books of the business are, therefore, restricted to the transactions of the business. No matter what activities the proprietor(s) get up to outside the business, they are completely disregarded in the books kept by the business.
The only time that the personal resources of the proprietor(s) affect the accounting records of a business is when they introduce new capital into the business, or take drawings out of it. (Frank Wood & Alan Sangster 2009, pg.110)
Entity concept is the most basic concept in accounting because it draws a boundary around the organization being accounted for. That is, the transactions of each entry are accounted for separately from transactions of all other organizations and persons, including the owners of the entity. This separation allows us to measure the performance and the financial position of each entity independent of all other entities.
A business entity may be a sole proprietorship (owned and operated by a single individual), a partnership of two or more persons, or a large corporation such as Exxon. The entity concept applies with equal force to all types and sizes of organizations.
The entity concept also provides the basis for consolidating subentities into a single set of financial statements. (Charles T. Horngren et al. 1995, pg.493)
If the transactions of an entity are to be recorded, classified and summarised into financial statements, the accountant must be able to identity clearly the boundaries of the entity being accounted for. Under the accounting entity assumption, the entity is considered a separate entity distinguishable from its owner and from all other entities. It is assumed that each entity controls its assets and incurs its liabilities. The records of assets, liabilities and business activities of the entity are kept completely separate from those of the owner of the entity as well as from those of other entities. A separate set of accounting records is maintained for each entity, and the financial statements prepared provide information on that entity only.
The accounting entity assumption is important since it leads to the derivation of the accounting equation. Given this assumption, if the entity receives $50000 cash from the owner as capital, the accountant for the entity records that it has an asset of $50000 in the form of cash but also has to recognise that the entity is now indebted to the owner for $50000. In other words, the owner has an equity in the assets of the entity and it follows that:
Assets = Equity
Similarly, if the entity borrows cash from a lender, the asset(cash) increases, and the entity must acknowledge this interest of the creditor in the total assets of the entity. The equation would now be expressed as:
Assets = Liabilities + Equity (John Hogett et al. 2006, pg.40)
The Time Interval Concept (or Accounting Period Assumption / Principle) One of the underlying principles, the time interval concept, is that financial statements are prepared at regular intervals of one year. For internal management purposes they may be prepared far more frequently, possibly on a monthly basis or even more frequently. (Frank Wood & Alan Sangster 2009, pg.109)
Time-period concept ensures that accounting information is reported at regular intervals. This timely presentation of accounting data aids the comparison of business operations over time; from year to year, quarter to quarter, and so on. Managers, owners, lenders, and other people and businesses need regular reports to assess the business? success or failure. These persons are making decisions daily. Although the ultimate success of a company cannot be known for sure until the business liquidates, decision makers cannot wait until liquidation to learn whether operations yielded a profit.
Nearly all companies use the year as their basic time period. Annual reports are common in business. Companies also prepare quarterly and monthly reports-called interim reports-to meet managers? investors? and creditors?needs for timely information.
The time-period concept underlies the use of accruals. Suppose the business? accounting year ends at December 31 and tomplhe business has accrued-but will not pay until the next accounting period. (Charles T. Horngren et al. 1995, pg.493)
All entities need to report their results in the form of either profit or operating surplus. Profit is determined for particular periods of time, such as a month or a year, in order to get comparability of results. There are also statutory requirements for entities to determine periodic profit figures, e.g. for taxation. This division of the life of the entity into equal time intervals is known as the period assumption.
As a result of this assumption, profit determination involves a process of recognising the income for a period and deducting the expenses incurred for that same period. (John Hogett et al. 2006, pg.41)
Going Concern Assumption
It is assumed that the business will continue to operate for at least twelve months after the end of the reporting period.
Suppose, however, that a business is drawing up its financial statements at 31 December 2008. Normally, using the historical cost concept, the assets would be shown at a total value of $100,000. It is known, however, that the business will be forced to close down in February 2009, only two months later, and the assets are expected to be sold for only $15,000.
In this case it would not make sense to keep the going concern concept, so we can reject the historical cost concept for asset valuation purposes. In the balance sheet at 31 December 2008 the assets will therefore be shown at the figure $15,000. Rejection of the going concern concept is the exception rather than the rule.
Examples when the going concern assumption should be rejected are:
If the business is going to close down n the near future;
Where shortage of cash makes it almost certain that the business will have to cease trading;
Where a large part of the business will almost certainly have to be closed down because of a shortage of cash. (Frank Wood & Alan Sangster 2009, pg.111)
The going-concern (or continuity) concept, accountants assume that the business will continue operating for the foreseeable future. The logic behind the going-concern concept is best illustrated by considering the alternative assumption: going out of business.
When a business stops, it sells its assets, converting them to cash. This process is called liquidation. With the cash, the business pays off it liabilities, and the owners keep any remaining cash. In liquidation, the amount of cash for which the assets are sold measures their current value. Likewise, the liabilities are paid off at their current value.
For a going concern, the balance sheet reports assets and liabilities on the basis of historical cost. To consider what the asset may be worth in the current market requires making an estimate. This estimate may or may not be made objectively. Under the going-concern concept, it is assumed that the entity will continue long enough to recover the cost of its assets.
The going-concern concept allows for the reporting of assets and liabilities as current or long-term, a distinction that investors and creditors find useful in evaluating a company. For example, a creditor wants to know the portion of the company? liabilities that are scheduled to come due within the next year and the portion payable beyond the year. The assumption is that the entity wi ll continue in business and honour its commitments. (Charles T. Horngren et al. 1995, pg.492)
Financial reports are prepared normally on the assumption that the existing entity will continue to operate in the future-the going concern assumption. It is assumed that the entity will not be sold in the near future but will continue its activities, and so the liquidation values (prices in a forced sale) of the assets are not generally reported.
When management plans the sale or liquidation of the entity, the going concern assumption is set aside and the financial statements are prepared on the basis of estimated sales or liquidation values. The statements should then identity clearly the basis upon which asset values are determined. In order for decision makers to understand information contained in financial reports, it is important that they know whether the assets are valued at cost, at fair values, or on some other basis. (John Hogett et al. 2006, p41)