Though not emphasized in the FASB’s concepts statements, four basic assumptions underlie GAAP: (1) the economic entity assumption, (2) the going concern assumption, (3) the periodicity assumption, and (4) the monetary unit assumption. These assumptions identify the entity that is being reported on, the assumption that the entity will continue to exist, and the frequency and denomination in which reports occur
Economic Entity Assumption
An essential assumption is that all economic events can be identified with a particular economic entity . Investors desire information about an economic entity that corresponds to their ownership interest. For example, if you were considering buying some ownership stock in Google , you would want information on the various operating units that constitute Google. You would need information not only about its United States operations but alsoabout its European and other international operations. The financial information for the various companies (subsidiaries) in which Google owns a controlling interest (greater than 50% ownership of voting stock) should be combined with that of Google (the parent) to provide a complete picture. The parent and its subsidiaries are separate legal entities but one accounting entity Another key aspect of this assumption is the distinction between the economic activities of owners and those of the company. For example, the economic activities of a sole proprietorship, Uncle Jim’s Restaurant, should be separated from the activities of its owner, Uncle Jim. Uncle Jim’s personal residence, for instance, is not an asset of the business.
Going Concern Assumption
Another necessary assumption is that, in the absence of information to the contrary, we anticipate that a business entity will continue to operate indefinitely. Accountants realize that the going concern assumption does not always hold since there certainly are many business failures. However, this assumption is critical to many broad and specific accounting principles. For example, the assumption provides justification for measuring many assets based on their historical costs. If it were known that an enterprise would cease operations in the near future, assets and liabilities would be measured at their current liquidation values. Similarly, when we depreciate a building over an estimated life of 40 years, we assume the business will operate that long.
Periodicity Assumption
The periodicity assumption relates to the qualitative characteristic of timeliness. External users need periodic information to make decisions. This need for periodic information requires that the economic life of a company (presumed to be indefinite) be divided into artificial time periods for financial reporting. Corporations whose securities are publicly traded are required to provide financial information to the SEC on a quarterly and annual basis. 43 Financial statements often are prepared on a monthly basis for banks and others that might need more timely information.
For many companies, the annual time period (the fiscal year) is the calendar year. However, other companies have chosen a fiscal year that does not correspond to the calendar year. The accounting profession and the SEC advocate that companies adopt a fiscal year that corresponds to their natural business year. A natural business year is the 12-month period that ends when the business activities of a company reach their lowest point in the annual cycle. For example, many retailers, Walmart for example, have adopted a fiscal year ending on January 31. Business activity in January generally is quite slow following the very busy Christmas period. We can see from the Dell financial statements that the company’s fiscal year ends at the end of January. The Campbell Soup Company ’s fiscal year ends in July; Clorox ’s in June; and Monsanto ’s in August
Monetary Unit Assumption
The monetary unit or measurement scale used in financial statements is nominal units of money, without any adjustment for changes in purchasing power. In the United States, the U.S. dollar is the monetary unit used in financial statements. In the EU, the euro is the monetary unit. Other countries use other currencies as their monetary units
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