Page 202 - Accounting Principles (A Business Perspective)

5. Accounting theory

Assumption or Concept Description Importance
Business entity Each business has an existence separate Defines the scope of the business such as a horse
from its owners, creditors, employees, stable or physical fitness center. Identifies which
customers, other interested parties, and transactions should be recorded on the company's
other businesses. books.
Going concern (continuity) An entity will continue to operate indefinitely Allows a company to continue carrying plant assets
unless strong evidence exists that the entity at their historical costs in spite of a change in their
will terminate. market values.
Money measurement Each business uses a monetary unit of Provides accountants with a common unit of
measurement, such as the dollar, instead of measure to report economic activity. This concept
physical or other units of measurement. permits us to add an d subtract items on the
financial statements.
Stable dollar The dollar is accepted as a reasonably Permits us to make no adjustments in the financial
stable unit of measure. statements for the changing value of the dollar.
This assumption works fairly well in the United
States because of our relatively low rate of
inflation.
Periodicity (time periods) An entity's life can be subdivided into Permits us to prepare financial statements that
months or years to report its economic cover periods shorter than the entire life of a
activities. business. Thus, we know how well a business is
performing before it terminates its operations. The
need for adjusting entries arises because of this
concept and the use of accrual accounting.
General-purpose financial One set of financial statements serves the Allows companies to prepare only one set of
statements needs of all users. financial statements instead of a separate set for
each potential type of user of those statements.
The financial statements should be free of bias so
they do not favor the interests of any one type of
user.
Substance over form Accountants should record the economic Encourages the accountant to record the true
substance of a transaction rather than its nature of a transaction rather than its apparent
legal form. nature. This approach is the accounting equivalent
of "tell it like it is." An apparent lease transaction
that has all the characteristics of a purchase should
be recorded as a purchase.
Consistency Generally requires that a company use the Prevents a company from changing accounting
same accounting principles and reporting methods whenever it likes to present a better
practices every accounting period. picture or to manipulate income. The inventory and
depreciation chapters (Chapters 7 and 10) both
mention the importance of this concept.
Double entry Every transaction has a two-sided effect on Uses a system of checks and balances to help
each company or party engaging in the identify whether or not errors have been made in
transaction. recording transactions. When the debits do not
equal the credits, this inequality immediately
signals us to stop and find the error.
Articulation Financial statements are fundamentally Changes in account balances during an accounting
related and articulate (interact) with each period are reflected in financial statements that are
other. related to one another. For instance, earning
revenue increases net income on the income
statement, retained earnings on the statement of
retained earnings, and assets and retained
earnings on the balance sheet. The statement of
retained earnings ties the income statement and
balance sheet together.
Exhibit 27: The underlying assumptions or concepts
The major principles

Generally accepted accounting principles (GAAP) set forth standards or methods for presenting financial
accounting information. A standardized presentation format enables users to compare the financial information of
different companies more easily. Generally accepted accounting principles have been either developed through
accounting practice or established by authoritative organizations. Organizations that have contributed to the

development of the principles are the American Institute of Certified Public Accountants (AICPA), the Financial
Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), the American Accounting
Association (AAA), the Financial Executives Institute (FEI), and the Institute of Management Accounting (IMA).
This section explains the following major principles:
• Exchange-price (or cost) principle.
• Revenue recognition principle.
• Matching principle.

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