1.5 Assumptions, Principles & Constraints of Financial Accounting

Question 1

Identify the 4 assumptions of financial accounting

HINT: Every Good Man Pray

Answer 1

• economic entity assumption
• going concern assumption
• monetary unit assumption
• periodicity assumption

Question 2

Define economic-entity assumption

Answer 2

• the reporting (accounting) entity is separately identified for the purpose of economic and financial accountability
• economic affairs of owners & managers are segregated from those of the reporting entity
• can sue and be sued in its own name

Question 3

Are the legal entity and the economic entity the same under the economic-entity assumption? Provide an example:

Answer 3

• no, they are not necessarily the same

- example, a parent and a subsidiary belong to one economic entity but are distinct legal entities

Question 4

Define going-concern assumption

Answer 4

• assumed to operate indefinitely unless evidence indicates otherwise

Question 5

Is liquidation basis of accounting used in standard reporting?

Answer 5

No, because it is assumed the entity will not be liquidated in the near future according to the going-concern assumption.

Question 6

Define monetary unit assumption

Answer 6

• Accounting records are stated in units of money

- changing purchasing power (inflation) of the monetary unit is assumed not to be material

Question 7

Define periodicity assumption

Answer 7

• economic activity can be divided into distinct time periods
• requires reporting estimates in the financial statements
• sacrifices some degree of faithful representation (accuracy) of information for increased relevance

Question 8

Identify the 4 principles of financial accounting

HINT: Real Men Hate Fear

Answer 8

• matching principle
• historical cost principle
• revenue recognition principle
• full disclosure principle

Question 9

Define revenue recognition principle also known as recognition concept

Answer 9

revenue reported in the period earned

Question 10

Define matching principle also known as measurement concept

Answer 10

costs required to produce revenues are matched with those revenues (meaning those costs are recognized in the same period as the revenue)

Question 11

Define historical cost principle

Answer 11

transaction initially recorded at cost b/c it is the most objective determination of fair value

Question 12

Define full-disclosure principle

Answer 12

• financial statements report any and all information that could influence investor and creditor decisions
• often require footnotes in addition to GAAP

Question 13

Identify the 3 constraints of financial accounting

HINT: Cause I Care

Answer 13

• Cost constraint
• Industry practices constraint
• Conservatism constraint

Question 14

Define cost constraint

Answer 14

• pervasive constraint limits reporting

- benefits of reporting must exceed cost of reporting

Question 15

Define industry practices constraint & provide an example

Answer 15

• GAAP may be modified in certain industries to avoid reporting misleading / unnecessary information
• Banks & insurers measure marketable securities at FV instead of cost

Question 16

Define conservatism constraint & provide an example

Answer 16

• a response to uncertainty
• use the appropriate accounting method with the least favorable effect on net income and total assets
• Example: using the lowest of the reasonable estimates of the useful life and residual value of a depreciable asset