Accounting Assumptions, Principles, and Constraints: A Short Review

Now, let’s backtrack a little to a short review of accounting theory to consider a few concepts useful to the process of extracting meaning from financial statements. All the accounting rules behind Generally Accepted Accounting Principles (GAAP) may seem overly complicated but they can be understood mostly as a complex give and take between the following accounting assumptions, principles, and constraints (Keiso, Weygandt, & Warfield, 2002). By the way, these concepts underpinning how financial statements are constructed really help unite the themes of most MBA-level financial accounting courses.

Accounting Assumptions

Economic Entity – the financial statements assume that we are dealing with a single organization, but this gets tricky when we want to slice and dice the financial statements to understand what is happening with a particular product or division within the organization.

Going Concern or Continuing Operations – we assume that the economic entity has a meaningful past and future for purposes of recording costs of assets and inventory, and decision making based on those costs in the present.

Monetary Unit – we keep score with money and we typically ignore inflation and deflation of currencies; the value and unit of currency is assumed to be stable, unless we are transacting with international divisions that use other currencies besides the U.S. Dollar.

Accounting Periods –we assume that it makes sense to have monthly, quarterly, and annual accounting periods where we stop to assemble financial statements. Fiscal years sometimes don’t align with calendar years.

Accounting Principles

Historical Costs – assets (and liabilities) are typically reported at the historical cost and then adjusted with fair market value when the needs of reporting require it. However, the cost of an asset 10 years ago does not reflect what it is worth to another buyer or the cost of replacement.

Revenue Recognition – we record revenues when they are realized (i.e., we become aware) and earned (i.e., we do or ship something). This is one of challenges that accrual-based accounting is trying to solve. Just because we received cash from a sales order doesn’t mean that we did everything we had to do to earn the revenue or ship the product. Also, we may have sold something but not received cash.

Matching Expenses to Revenues – we match expenses to the revenues, so recorded profit in the income statement is based on the best fit of revenues and expenses. This is another feature of accrual-based accounting; expenses are aligned with associated revenues in the same or future accounting period. For example, most fixed expenses for buildings and equipment must be depreciated to align the expense with the revenue that was earned.

Full Disclosure – in general, accountants record and report every bit of information in the numbers and footnotes of financial statements that fairly represent the activities of the business entity in that accounting period. That is fine and dandy but for decision-making we want to leave out or add things that are relevant to the decision we are making.

Accounting Constraints

Cost and Benefit Paradox – there is a very real cost to recording and reporting accounting information. Hence, some potentially important events relevant to a business may not be disclosed because it was too expensive or cumbersome to gather the data. We must read between the lines of financial statements and add information to which we have access in order to make the best decisions.

Materiality – small financial events are not as important large financial events to the typical, reasonable reader of financial statements. That makes sense but our decision making process may be different from the typical user of financial statements as understood by the accounting folks; some small financial event may not be disclosed even though it is very relevant to our decision.

Industry Practice – one size does not fit all when reporting financial activities. Some industries have peculiar products/services or have special ways of distributing the products/services to customers, so we cannot understand an Internet retailer the same way we would analyze and automobile manufacturer.

Conservatism – to avoid investor misinterpretation of assets and income, accountants choose accounting methods that do not overstate what the business owns or the profits achieved. Again, this is an important consideration for financial reporting, but we need to modify the notion somewhat to make decisions about the business between accounting periods.

Important! As an MBA-level manager, it will be your responsibility to challenge the assumptions behind accounting principles and constraints, when interpreting financial statements to make decisions. It is incumbent upon MBAs to logically and judiciously tweak available financial information to make sound financial or investment decisions that put our organizations ahead of the competition.

Reference

Keiso, D, Weygandt, J, & Warfield, T. (2002). Intermediate Accounting, 11th Ed. New York, New York: John Wiley & Sons.