IA Chapter 7

Accounting Assumptions, Principles, and Conventions

General Concept

• Accountants must follow rules known as accounting assumptions, principles, and conventions.

• Importance: Ensures consistency and comparability in financial statements.

7.2 Business Entity

• Defined: A business is a separate entity from its owners; only business transactions are recorded.

• Personal transactions of owners should not be included in business records, except for capital contributions or drawings.

7.3 Historical Cost

• Principle: Assets are recorded at their original purchase cost, irrespective of market value changes.

• Objective measurement: Historical cost is verifiable and consistent over time.

• Example: A machine bought for $20,000 remains recorded at that value, regardless of market fluctuations.

7.4 Going Concern

• Concept: Assumes that a business will continue to operate indefinitely; does not intend to liquidate.

• If bankruptcy is imminent, assets are revalued at liquidation value instead of historical cost.

• Related closely to the historical cost principle.

7.5 Consistency

• Definition: A firm must consistently use the same accounting policies for similar items; changes are allowed if more accurate.

• Disclosure: Any changes that significantly affect financial results must be clearly explained in statements.

7.6 Accrual

• Concept: Revenues and expenses are recorded when they are earned or incurred, not when cash is exchanged.

• Example: Sales made on credit should be recognized at the time of sale, regardless of payment receipt.

• This principle provides a more accurate measure of financial performance than cash basis accounting.