1.6: Underlying assumptions or concepts

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In recording business transactions, accountants rely on certain underlying assumptions or concepts. Both preparers and users of financial statements must understand these assumptions:

• Business entity concept (or accounting entity concept). Data gathered in an accounting system relates to a specific business unit or entity. The business entity concept assumes that each business has an existence separate from its owners, creditors, employees, customers, other interested parties, and other businesses.

• Money measurement concept. Economic activity is initially recorded and reported in a common monetary unit of measure—the dollar in the United States. This form of measurement is known as money measurement.

• Exchange-price (or cost) concept (principle). Most of the amounts in an accounting system are the objective money prices determined in the exchange process. As a result, we record most assets at their acquisition cost. Cost is the sacrifice made or the resources given up, measured in money terms, to acquire some desired thing, such as a new truck (asset).

• Going-concern (continuity) concept. Unless strong evidence exists to the contrary, accountants assume that the business entity will continue operations into the indefinite future. Accountants call this assumption the going-concern or continuity concept. Assuming that the entity will continue indefinitely allows accountants to value long-term assets, such as land, at cost on the balance sheet since they are to be used rather than sold. Market values of these assets would be relevant only if they were for sale. For instance, accountants would still record land purchased in 1988 at its cost of USD 100,000 on the 2010 December 31, balance sheet even though its market value has risen to USD 300,000.

• Periodicity (time periods) concept. According to the periodicity (time periods) concept or assumption, an entity’s life can be meaningfully subdivided into time periods (such as months or years) to report the results of its economic activities.

Now that you understand business transactions and the five basic accounting assumptions, you are ready to follow some business transactions step by step. To begin, we divide Metro’s transactions into two groups: (1) transactions affecting only the balance sheet in June, and (2) transactions affecting the income statement and/or the balance sheet in July. Note that we could also classify these transactions as operating, investing, or financing activities, as shown in the statement of cash flows.