Principles of Financial Accounting: Introduction to Accounting - Assumptions Economic, Entity Going Concern Monetary Unit Time Period

What It Is

The four fundamental assumptions in financial accounting are essential for preparing financial statements. These assumptions help accountants make decisions about how to record and report financial information. The four assumptions are:

1. Economic Entity: A business is treated as a separate entity from its owners and other businesses. This means that the business's financial transactions are recorded separately from those of its owners.

Example: If a company buys $10,000 of inventory, it will be recorded as an asset on the company's balance sheet, not as an asset on the owner's personal balance sheet.

1. Going Concern: A business is assumed to continue operating for the foreseeable future. This assumption allows accountants to use historical cost accounting, which means that assets are recorded at their original cost, rather than their current market value.

Example: If a company purchases a piece of equipment for $50,000, it will be recorded as an asset on the balance sheet, even if the equipment's current market value is $30,000.

1. Monetary Unit: Financial transactions are recorded in a common currency, such as the US dollar. This assumption allows accountants to compare financial information across different businesses and time periods.

Example: If a company sells $100,000 worth of goods, it will be recorded as revenue on the income statement, regardless of the country in which the goods were sold.

1. Time Period: Financial information is reported on a periodic basis, such as monthly, quarterly, or annually. This assumption allows accountants to report financial information in a timely manner and to make decisions about how to allocate resources.

Example: If a company earns $10,000 in revenue in a given month, it will be recorded as revenue on the income statement for that month, rather than being accumulated over a longer period of time.

Key Concepts & Formulas

• Economic Entity: A business is treated as a separate entity from its owners and other businesses.
  • Example: A company's financial transactions are recorded separately from those of its owners.
• Going Concern: A business is assumed to continue operating for the foreseeable future.
  • Example: A company's assets are recorded at their original cost, rather than their current market value.
• Monetary Unit: Financial transactions are recorded in a common currency.
  • Example: A company's revenue is recorded in the same currency as its expenses.
• Time Period: Financial information is reported on a periodic basis.
  • Example: A company's revenue is recorded on a monthly basis, rather than being accumulated over a longer period of time.
• Historical Cost: Assets are recorded at their original cost, rather than their current market value.
  • Example: A company's equipment is recorded at $50,000, even if its current market value is $30,000.
• Matching Principle: Expenses are matched with the revenues they help to generate.
  • Example: A company's salaries expense is matched with the revenue generated by the employees who earned the salaries.
• Materiality: Financial information is considered material if it is significant enough to affect a user's decision.
  • Example: A company's revenue of $100,000 is considered material, while a revenue of $10 is not.
• Consistency: Financial information is reported consistently from one period to another.
  • Example: A company reports its revenue on a monthly basis in one period, and continues to report it on a monthly basis in subsequent periods.

Journal Entry Examples

1. Economic Entity: A company purchases $10,000 of inventory from a supplier.

Dr. Inventory $10,000 Cr. Accounts Payable $10,000

Explanation: The company's inventory account is debited to record the purchase, and the accounts payable account is credited to record the liability to the supplier.

1. Going Concern: A company purchases a piece of equipment for $50,000.

Dr. Equipment $50,000 Cr. Cash $50,000

Explanation: The company's equipment account is debited to record the purchase, and the cash account is credited to record the payment.

1. Monetary Unit: A company sells $100,000 worth of goods to a customer.

Dr. Accounts Receivable $100,000 Cr. Sales Revenue $100,000

Explanation: The company's accounts receivable account is debited to record the sale, and the sales revenue account is credited to record the revenue.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts.
   • Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
2. Mistake: Failing to match expenses with revenues.
   • Correction: Use the matching principle to match expenses with the revenues they help to generate.
3. Mistake: Ignoring materiality.
   • Correction: Consider whether financial information is significant enough to affect a user's decision.

Exam Tips

1. Tip: Remember that a debit increases assets and expenses, while a credit increases liabilities and equity.
2. Tip: Use the matching principle to match expenses with the revenues they help to generate.
3. Tip: Consider whether financial information is material enough to affect a user's decision.

Quick Practice

1. Problem: A company purchases $5,000 of inventory from a supplier. What is the adjusting entry?

Answer: Dr. Inventory $5,000 Cr. Accounts Payable $5,000

Explanation: The company's inventory account is debited to record the purchase, and the accounts payable account is credited to record the liability to the supplier.

1. Problem: A company sells $10,000 worth of goods to a customer. What is the adjusting entry?

Answer: Dr. Accounts Receivable $10,000 Cr. Sales Revenue $10,000

Explanation: The company's accounts receivable account is debited to record the sale, and the sales revenue account is credited to record the revenue.

1. Problem: A company purchases a piece of equipment for $20,000. What is the adjusting entry?

Answer: Dr. Equipment $20,000 Cr. Cash $20,000

Explanation: The company's equipment account is debited to record the purchase, and the cash account is credited to record the payment.

Last-Minute Cram Sheet

1. Economic Entity: A business is treated as a separate entity from its owners and other businesses.
2. Going Concern: A business is assumed to continue operating for the foreseeable future.
3. Monetary Unit: Financial transactions are recorded in a common currency.
4. Time Period: Financial information is reported on a periodic basis.
5. Historical Cost: Assets are recorded at their original cost, rather than their current market value.
6. Matching Principle: Expenses are matched with the revenues they help to generate.
7. Materiality: Financial information is considered material if it is significant enough to affect a user's decision.
8. Consistency: Financial information is reported consistently from one period to another.
9. Dividends are NOT an expense – they go directly to retained earnings.
10. Expenses are matched with the revenues they help to generate, not with the revenues they help to reduce.