Which principle assumed that business will continue indefinitely and that liquidations is not in prospect?

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The FASB’s Conceptual Framework was influenced by several underlying assumptions. Some of these assumptions were addressed in the Conceptual Framework, and others are implicit in the Framework. These assumptions, along with the Conceptual Framework, are considered when a GAAP is established. Accountants, when confronted with a situation lacking an explicit standard, should resolve the situation by considering the Conceptual

Framework and the traditional assumptions of the accounting model.

In all cases, the reports are to be a “fair representation. ” Even when there is an explicit GAAP, following the GAAP is not appropriate unless the end result is a “fair representation. ”

Following GAAP is not an appropriate legal defense unless the statements represent a “fair representation. ”

Business Entity

The concept of separate entitymeans that the business or entity for which the financial statements are prepared is separate and distinct from the owners of the entity. In other words, the entity is viewed as an economic unit that stands on its own.

For example, an individual may own a grocery store, a farm, and numerous personal assets. To determine the economic success of the grocery store, we would view it separately from the other resources owned by the individual. The grocery store would be treated as a separate entity.

A corporation such as the Ford Motor Company has many owners (stockholders). The entity concept enables us to account for the Ford Motor Company entity separately from the transactions of the owners of the Ford Motor Company.

Going Concern or Continuity

The going - concern assumption, that the entity in question will remain in business for an indefinite period of time, provides perspective on the future of the entity. The going concern assumption deliberately disregards the possibility that the entity will go bankruptor be liquidated. If a particular entity is in fact threatened with bankruptcy or liquidation, then the going-concern assumption should be dropped. In such a case, the reader of the financial statements is interested in the liquidation values, not the values that can be used when making the assumption that the business will continue indefinitely. If the going concern assumption has not been used for a particular set of financial statements, because of the threat of liquidation or bankruptcy, the financial statements must clearly disclose that the statements were prepared with the view that the entity will be liquidated or that it is a failing concern.

In this case, conventional financial report analysis would not apply. Many of our present financial statement figures would be misleading if it were not for the going - concern assumption. For instance, under the going - concern assumption, the value of prepaid insurance is computed by spreading the cost of the insurance over the period of the policy. If the entity were liquidated, then only the cancellation value of the policy would be meaningful. Inventories are basically carried at their accumulated cost. If the entity were liquidated, then the amount realized from the sale of the inventory, in a manner other than through the usual channels, usually would be substantially less than the cost. Therefore, to carry the inventory at cost would fail to recognize the loss that is represented by the difference between the liquidation value and the cost.

The going - concern assumption also influences liabilities. If the entity were liquidating, some liabilities would have to be stated at amounts in excess of those stated on the conventional statement. Also, the amounts provided for warranties and guarantees would not be realistic if the entity were liquidating.

The going - concern assumption also influences the classification of assets and liabilities. Without the going - concern assumption, all assets and liabilities would be current, with the expectation that the assets would be liquidated and the liabilities paid in the near future. The audit opinion for a particular firm may indicate that the auditors have reservations as to the going-concern status of the firm. This puts the reader on guard that the statements are misleading if the firm does not continue as a going concern. For example, the 1994 annual report of Brown Disc Products Company indicated a concern over the company’s ability to continue as a going concern.

The Brown Disc Products Company’s annual report included these comments in Note1 and the auditor’s report.

Note 1 (in Part)

BASIS OF PRESENTATION -The accompanying financial statements have been prepared on a going - concern basis, which contemplates the realization of assets and the liquidation of liabilities in the normal course of business. However, Brown Disc has sustained substantial operating losses in recent years. In addition, total liabilities exceed total assets as of June 30, 1994. These factors, among others, adversely affect the ability of Brown Disc to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities that might be necessary should Brown Disc be unable to continue as a going concern.

Auditor’s Report (in Part)

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company emerged from bankruptcy proceedings on May 5, 1993. The Company had a net capital deficiency as of June 30, 1994, and losses have continued subsequent to emerging from bankruptcy. These factors, among others, raise substantial doubt about its ability to continue as a going concern. Management’s plans concerning these matters are also described in Note 1. The financial statements do not include any adjustments that might arise from the outcome of this uncertainty.

Time Period

The only accurate way to account for the success or failure of an entity is to accumulate all transactions from the opening of business until the business eventually liquidates. Many years ago, this time period for reporting was acceptable, because it would be feasible to account for and divide up what remained at the completion of the venture. Today, the typical business has a relatively long duration, so it is not feasible to wait until the business liquidates before accounting for its success or failure.

This presents a problem: Accounting for the success or failure of the business in midstream involves in accuracies. Many transactions and commitments are incomplete at any particular time between the opening and the closing of business. An attempt is made to eliminate the in accuracies when statements are prepared for a period of time short of anentity’s life span, but the in accuracies cannot be eliminated completely. For example, the entity typically carries accounts receivable at the amount expected to be collected. Only when the receivables are collected can the entity account for them accurately. Until receivables are collected, there exists the possibility that collection cannot be made. The entity will have outstanding obligations at any time, and these obligations cannot be accurately accounted for until they are met. An example would be a warranty on products sold. Anentity may also have a considerable investment in the production of inventories. Usually, until the inventory is sold in the normal course of business, the entity cannot accurately account for the investment in inventory.

With the time period assumption, we accept some in accuracies of accounting for the entity short of its complete life span. We assume that the entity can be accounted for with reasonable accuracy for a particular period of time. In other words, the decision is made to accept some inaccuracy, because of incomplete information about the future, in exchange for more timely reporting.

Some businesses select an accounting period, known as a natural business year, that ends when operations are at a low ebb in order to facilitate a better measurement of income and financial position. Other businesses use the calendar yearand thus end the accounting period on December 31. Some select a 12-month accounting period, known as a fiscal year, which closes at the end of a month other than December. The accounting period may be shorter than a year, such as a month. The shorter the period of time, the more in accuracies we typically expect in the reporting.

Monetary Unit

Accountants need some standard of measure to bring financial transactions together in a meaningful way. Without some standard of measure, accountants would be forced to report in such terms as 5 cars, 1 factory, and 100 acres. This type of reporting would not bevery meaningful.

There are a number of standards of measure, such as a yard, a gallon, and money. Of the possible standards of measure, accountants have concluded that money is the best for the purpose of measuring financial transactions.

Different countries call their monetary units by different names: Germany uses themark, France uses the franc, and Japan uses the yen. Different countries also attach different values to their money - 1 mark is not equal to 1 yen. Thus, financial transactions may be measured in terms of money in each country, but the statements from various countries cannot be compared directly or added together until they are converted to a common monetary unit, such as the U. S. dollar.

In various countries, the stability of the monetary unit has been a problem. The loss in value of money is called inflation. In some countries, inflation has been more than 300% per year. In countries where inflation has been significant, financial statements are adjusted by an inflation factor that restores the significance of money as a measuring unit. However, a completely acceptable restoration of money as a measuring unit cannot be made in such cases because of the problems involved in determining an accurate index.

To indicate one such problem, consider the price of a car in 1991 and in 2001. The price of the car in 2001would be higher, but the explanation would not be simply that the general price level has increased. Part of the reason for the price increase would be that the type and quality of the equipment have changed between 1991 and 2001. Thus, an index that relates the 2001 price to the 1991 price is a mixture of inflation, technological advancement, and quality changes.

The rate of inflation in the United States prior to the 1970s was relatively low. Therefore, it was thought that an adjustment of money as a measuring unit was not appropriate, because the added expense and in accuracies of adjusting for inflation were greater than the benefits. During the 1970s, however, the United States experienced double - digitinflation. This made it increasingly desirable to implement some formal recognition of inflation.

In September 1979, the FASB issued Statement of Financial Accounting Standards No. 33, “Financial Reporting and Changing Prices, ” which required that certain large, publicly held companies disclose certain supplementary information concerning the impact of changing prices in their annual reports for fiscal years ending on or after December 25, 1979. This disclosure later became optional in 1986. Currently no U. S. company provides this supplementary information.

Historical Cost

SFAC No. 5 identified five different measurement attributes currently used in practice: historical cost, current cost, current market value, net realizable value, and present value. Often, historical cost is used in practice because it is objective and determinable. A deviation from historical cost is accepted when it becomes apparent that the historical cost cannot berecovered. This deviation is justified by the conservatism concept. A deviation from historical cost is also found in practice where specific standards call for another measurement attribute such as current market value, net realizable value, or present value.

Conservatism

The accountant is often faced with a choice of different measurements of a situation, with each measurement having reasonable support. According to the concept of conservatism, the accountant must select the measurement with the least favorable effect on net income and financial position in the current period.

To apply the concept of conservatism to any given situation, there must be alternative measurements, each of which must have reasonable support. The accountant cannot use the conservatism concept to justify arbitrarily low figures. For example, writing inventory down to an arbitrarily low figure in order to recognize any possible loss from selling the inventory constitutes inaccurate accounting and cannot be justified under the concept of conservatism. An acceptable use of conservatism would be to value inventory at the lower of historical cost or market value.

The conservatism concept is used in many other situations, such as writing down or writing off obsolete inventory prior to sale, recognizing a loss on a long - term construction contract when it can be reasonably anticipated, and taking a conservative approach in determining the application of overhead to inventory. In estimating the lives of fixed assets, a conservative view is taken. Conservatism requires that the estimate of warranty expense reflects the least favorable effect on net income and the financial position of the current period.

Realization

Accountants face a problem of when to recognize revenue. All parts of an entity contribute to revenue, including the janitor, the receiving department, and the production employees. The problem becomes how to determine objectively the contribution of each of the segments toward revenue. Since this is not practical, accountants must determine whenit is practical to recognize revenue.

In practice, revenue recognition has been the subject of much debate. This has resulted in fairly wide interpretations. The issue of revenue recognition has represented the basis of many SEC enforcement actions. In general, the point of recognition of revenue should be the point in time when revenue can be reasonably and objectively determined. It is essential that there be some uniformity regarding when revenue is recognized, so as to make financial statements meaningful and comparable.

Point of Sale Revenue is usually recognized at the point of sale. At this time, the earning process is virtually complete, and the exchange value can be determined.

There are times when the use of the point - of - sale approach does not give a fair result. An example would be the sale of land on credit to a buyer who does not have a reasonable ability to pay. If revenue were recognized at the point of sale, there would be a reasonable chance that sales had been overstated because of the material risk of default. In such cases, there are other acceptable methods of recognizing revenue that should be considered, such as the following:

1. End of production
2. Receipt of cash
3. Revenue recognized during production
4. Cost recovery

End of Production The recognition of revenue at the completion of the production process is acceptable when the price of the item is known and there is a ready market. The mining of gold or silver is an example, and the harvesting of some farm products would also fit these criteria. If corn is harvested in the fall and held over the winter in order to obtain a higher price in the spring, the realization of revenue from the growing of corn should be recognized in the fall, at the point of harvest. The gain or loss from the holding of the corn represents a separate consideration from the growing of the corn.

Receipt of Cash The receipt of cash is another basis for revenue recognition. This method should be used when collection is not capable of reasonable estimation at the time of sale. The land sales business, where the purchaser makes only a nominal down payment, is one type of business where the collection of the full amount is especially doubtful. Experience has shown that many purchasers default on the contract.

During Production Some long - term construction projects recognize revenue as the construction progresses. This exception tends to give a fairer picture of the results for a given period of time. For example, in the building of a utility plant, which may take several years, recognizing revenue as work progresses gives a fairer picture of the results than does having the entire revenue recognized in the period when the plant is completed.

Cost Recovery The cost recovery approach is acceptable for highly speculative transactions. For example, an entity may invest in a venture search for gold, the outcome of which is completely unpredictable. In this case, the first revenue can be handled as a return of the investment. If more is received than has been invested, the excess would be considered revenue.

In addition to the methods of recognizing revenue described in this chapter, there are many other methods that are usually industry specific. Being aware of the method(s) used by a specific firm can be important to your understanding of the financial reports.

Matching

The revenue realization concept involves when to recognize revenue. Accountants need a related concept that addresses when to recognize the costs associated with the recognized revenue: the matching concept. The basic intent is to determine the revenue first and then match the appropriate costs against this revenue.

Some costs, such as the cost of inventory, can be easily matched with revenue. When we sell the inventory and recognize the revenue, the cost of the inventory can be matched against the revenue. Other costs have no direct connection with revenue, so some systematic policy must be adopted in order to allocate these costs reasonably against revenues. Examples are research and development costs and public relations costs. Both research and development costs and public relations costs are charged off in the period incurred. This is inconsistent with the matching concept because the cost would benefit beyond the current period, but it is in accordance with the concept of conservatism.

Consistency

The consistency conceptrequires the entity to give the same treatment to comparable transactions from period to period. This adds to the usefulness of the reports, since there ports from one period are comparable to the reports from another period. It also facilitates the detection of trends.

Many accounting methods could be used for any single item, such as inventory. If inventory were determined in one period on one basis and in the next period on a different basis, the resulting inventory and profits would not be comparable from period to period.

Entities sometimes need to change particular accounting methods in order to adapt to changing environments. If the entity can justify the use of an alternative accounting method, the change can be made. The entity must be ready to defend the change - a responsibility that should not be taken lightly in view of the liability for misleading financial statements. Sometimes the change will be based on a new accounting pronouncement. When an entity makes a change in accounting methods, the justification for the change must be disclosed, along with an explanation of the effect on the statements.

Full Disclosure

The accounting reports must disclose all facts that may influence the judgment of an informed reader. If the entity uses an accounting method that represents a departure from the official position of the FASB, disclosure of the departure must be made, along with the justification for it.

Several methods of disclosure exist, such as parenthetical explanations, supporting schedules, cross-references, and footnotes. Often, the additional disclosures must be made by a footnote in order to explain the situation properly. For example, details of a pension plan, long-term leases, and provisions of a bond issue are often disclosed in footnotes.

The financial statements are expected to summarize significant financial information. If all the financial information is presented in detail, it could be misleading. Excessive disclosure could violate the concept of full disclosure. Therefore, a reasonable summarization of financial information is required.

Because of the complexity of many businesses and the increased expectations of the public, full disclosure has become one of the most difficult concepts for the accountant to apply. Law suits frequently charge accountants with failure to make proper disclosure. Since disclosure is often a judgment decision, it is not surprising that others (especially those who have suffered losses) would disagree with the adequacy of the disclosure.

Materiality

The accountant must consider many concepts and principles when determining how to handle a particular item. The proper use of the various concepts and principles may be costly and time-consuming. The materiality concept involves the relative size and importance of an item to a firm. A material item to one entity may not be material to another. For example, an item that costs $100 might be expensed by General Motors, but the same item might be carried as an asset by a small entity.

It is essential that material items be properly handled on the financial statements. Immaterial items are not subject to the concepts and principles that bind the accountant. They may be handled in the most economical and expedient manner possible. However, the accountant faces a judgment situation when determining materiality. It is better to err infavor of an item being material than the other way around.

A basic question when determining whether an item is material is: “Would this item influence an informed reader of the financial statements?” In answering this question, the accountant should consider the statements as a whole.

Industry Practices

Some industry practices lead to accounting reports that do not conform to the general theory that underlies accounting. Some of these practices are the result of government regulation. For example, some differences can be found in highly regulated industries, such as insurance, railroad, and utilities.

In the utility industry, an allowance for funds used during the construction period of a new plant is treated as part of the cost of the plant. The offsetting amount is reflected asother income. This amount is based on the utility’s hypothetical cost of funds, including funds from debt and stock. This type of accounting is found only in the utility industry.

In some industries, it is very difficult to determine the cost of the inventory. Examples include the meat-packing industry, the flower industry, and farming. In these areas, it may be necessary to determine the inventory value by working backward from the anticipated selling price and subtracting the estimated cost to complete and dispose of the inventory. The inventory would thus be valued at a net realizable value, which would depart from the cost concept and the usual interpretation of the revenue realization concept. If inventory is valued at net realizable value, then the profit has already been recognized and is part of the inventory amount.

The accounting profession is making an effort to reduce or eliminate specific industry practices. However, industry practices that depart from typical accounting procedures will probably never be eliminated completely. Some industries have legitimate peculiarities that call for accounting procedures other than the customary ones.

Transaction Approach

The accountant records only events that affect the financial position of the entity and, at the same time, can be reasonably determined in monetary terms. For example, if the entity purchases merchandise on account (on credit), the financial position of the entity changes. This change can be determined in monetary terms as the inventory asset is obtained and the liability, accounts payable, is incurred.

Many important events that influence the prospects for the entity are not recorded and, therefore, are not reflected in the financial statements because they fall outside the transaction approach. The death of a top executive could have a material influence on future prospects, especially for a small company. One of the company’s major suppliers could go bankrupt at a time when the entity does not have an alternative source. The entity may have experienced a long strike by its employees or have a history of labor problems. A major competitor may go out of business. All these events may be significant to the entity. Theyare not recorded because they are not transactions. When projecting the future prospects of an entity, it is necessary to go beyond current financial reports.

Cash Basis

The cash basisrecognizes revenue when cash is received and recognizes expenses when cash is paid. The cash basis usually does not provide reasonable information about the earning capability of the entity in the short run. Therefore, the cash basis is usually not acceptable.

Accrual Basis

The accrual basisof accounting recognizes revenue when realized (realization concept) and expenses when incurred (matching concept). If the difference between the accrual basis and the cash basis is not material, the entity may use the cash basis as an alternative to the accrual basis for income determination. Usually, the difference between the accrual basis and the cash basis is material.

A modified cash basis is sometimes used by professional practices and service organizations. The modified cash basis adjusts for such items as buildings and equipment.

The accrual basis requires numerous adjustments at the end of the accounting period. For example, if insurance has been paid for in advance, the accountant must determine the amounts that belong in prepaid insurance and insurance expense. If employees have not been paid all of their wages, the unpaid wages must be determined and recorded as an expense and as a liability. If revenue has been collected in advance, such as rent received in advance, this revenue relates to future periods and must, therefore, be deferred to those periods. At the end of the accounting period, the unearned rent would be considered a liability.

The use of the accrual basis complicates the accounting process, but the end result is more representative of an entity’s financial condition than the cash basis. Without the accrual basis, accountants would not usually be able to make the time period assumption - that the entity can be accounted for with reasonable accuracy for a particular period of time.

The following illustration indicates why the accrual basis is generally regarded as a better measure of a firm’s performance than the cash basis.

Assumptions:

1. Sold merchandise (inventory) for $25, 000 on credit this year. The merchandise cost $12, 500 when purchased in the prior year.
2. Purchased merchandise this year in the amount of $30, 000 on credit.
3. Paid suppliers of merchandise $18, 000 this year.
4. Collected $15, 000 from sales.

The accrual basis indicates a profitable business, whereas the cash basis indicates a loss. The cash basis does not reasonably indicate when the revenue was earned or when to recognize the cost that relates to the earned revenue. The cash basis does indicate when the receipts and payments (disbursements) occurred. The points in time when cash is received and paid do not usually constitute a good gauge of profitability. However, knowing the points in time is important; the flow of cash will be presented in a separate financial statement (statement of cash flows).

In practice, the accrual basis is modified. Immaterial items are frequently handled on a cash basis, and some specific standards have allowed the cash basis.

What accounting principle assume that the company will continue indefinitely?

Why is it assumed that the business entity will continue to operate indefinitely?

What assumption states that a business is able to financially continue operations and is not planning to liquidate?

What is an example of going concern principle?