Exercise-6: Accounting practices and their underlying principles and assumptions

Learning objective:
This exercise describes the basic accounting practices, procedures, and guidelines, as well as their underlying principles and assumptions.

Exercise-6 (a) – matching an accounting practice or procedure with the most appropriate principle or assumption:

Following is a list of accounting principles and assumptions that companies generally follow in recording transactions, maintaining accounting records, and constructing financial statements:

• Going concern assumption
• Economic entity assumption
• Monetary unit assumption
• Periodicity assumption
• Historical cost principle
• Full disclosure principle
• Expense recognition principle

Required: Mention the accounting principle or assumption that best describes each of the following situations:

1. Requires companies to report all relevant information in their financial statements so that the users of those statements can get enough information to make appropriate decisions.
2. Requires the allocation of expenses to revenues in the appropriate accounting period.
3. Justifies why property, plants, equipment etc. are not presented at their liquidation values.
4. Requires keeping the business records separate from those of its owners.
5. States that the dollar is the measuring stick for reporting financial data and performance in a business.
6. Divides the life of a business into equal time periods for reporting purpose.
7. Requires companies not to recognize the fair value changes that occur after the balance sheet date.

Solution:

1. Full disclosure principle
2. Revenue recognition principle
3. Going concern assumption
4. Economic entity concept
5. Monetary unit assumption
6. Time period assumption
7. Historical cost concept

Exercise-6 (b) – identifying the underlying principle or assumption of accounting:

Listed below are some of the practices and operational guidelines that have emerged over time:

1. Companies don’t recognize changes in the fair value of their assets.
2. Companies present all necessary financial information in a way so that investors are not misled when making their decisions.
3. Companies initially capitalize their intangible assets and amortize them later in the periods that they help generate revenue.
4. Many companies expense small repair tools and items at the time of their purchase.
5. Companies involved in agricultural businesses value their crops at the fair market value.
6. A business unit is kept distinct from its owner(s).
7. Companies report all significant events that occur after the balance sheet date.
8. Businesses record revenue when a sale is made or a service is provided.
9. Companies present all important information about a bond indenture in their financial statements.
10. Companies that follow GAAPs or IFRSs adopt an accrual system to maintain their accounting records.
11. Companies with multiple subsidiaries and divisions issue consolidated financial statements.
12. Companies must prepare financial statements at defined time intervals.
13. Companies often establish an allowance for doubtful accounts.
14. Companies record goodwill only at the time it is purchased.
15. Companies expense their sales commission costs.

Required: Mention the accounting principle or assumption that most appropriately justifies the above practices and/or procedures.

Solution:

1. Historical cost principle
2. Full disclosure principle
3. Expense recognition principle
4. Materiality
5. Fair value principle
6. Economic entity assumption
7. Full disclosure principle
8. Revenue recognition principle
9. Full disclosure principle.
10. Expense recognition and revenue recognition principle
11. Economic entity assumption
12. Periodicity assumption
13. Fair value principle
14. Historical cost principle
15. Expense recognition principle