Accounting: Basic Assumptions

• Accounting involves identifying, measuring, and communicating financial information to enable informed decisions.

Basic Accounting Assumptions

• Include economic entity, accounting period, and monetary unit.

Economic Entity

• Requires separating the financial activities of a business from its owners' activities
• Allows examination of a company's financial information without personal affairs included.

Accounting Period

• Financial information is captured and communicated over shorter periods like a month or a quarter, not exceeding a year
• Provides timely information on business success/failure for owners and interested parties.
• Aids in measuring performance and determining if a business strategy needs changes.
• Performance is typically measured in financial terms using numerical calculations.

Monetary Unit

• The dollar is the most effective means of communicating economic activity
• Only economic activities expressible in dollars are reported in the accounting system
• The attribute of interest defines key aspects; such as a drone purchase focusing on cost in dollars.

Going Concern

• Assumes a business will operate into the foreseeable future unless proven otherwise
• Is important in asset valuation e.g., a drone valued at its worth to the business, not its potential sale price

Income Statement (Profit and Loss / Statement of Comprehensive Income)

• Reports a company's revenues, expenses, and resulting profit or loss, comprehensive income, or net income
• Revenues represent increases in resources from the sale of goods/services
• Expenses represent decreases in resources from business operations, like wages, rent, etc
• The key question is whether the business is profitable
• Expenses should be recorded in the period resources are used (matching principle)
• Financial statement reports revenues and expenses over a specific period to demonstrate financial success or failure
• Net profit/loss is calculated as revenues minus expenses.

Conceptual Framework of Accounting

• Establishes objectives, characteristics, and concepts guiding accounting practices.

Glossary of Terms

• Asset: Resources the business owns, found on the balance sheet.
• Liability: Business obligations, found on the balance sheet.
• Equity: Difference between assets and liabilities (balance sheet).
• Contributed Equity: Owner investments (balance sheet).
• Retained Earnings: Profits kept by the business (balance sheet/statement of changes in equity).
• Revenue: Increase in assets from sales (income statement).
• Expense: Decrease in assets from business operations (income statement).
• Dividend: Distribution of profits to owners (statement of changes in equity).

Principles for Measuring Financial Information

• Revenue recognition means revenue is recorded when earned, not necessarily when received.
• Matching means expenses recorded when incurred to generate revenues.
• Cost means assets are recorded at their historical costs.

Assumptions

• Economic Entity: Business financial activity separate from its owner(s).
• Monetary Unit: The dollar as the best means for communicating accounting information.
• Accounting Period: Information communicated effectively over short periods.
• Going Concern: Business operations continue indefinitely absent evidence otherwise.

Qualitative Characteristics of Financial Reports

• Relevance relates to the information's ability to influence decisions, including materiality.
• Faithful Representation requires an accurate and unbiased depiction of the business.
• Prudence: the exercise of caution when making judgments under conditions of uncertainty
• Comparability is the ability to compare accounting data across businesses.
• Verifiability means independent observers should reach similar conclusions.
• Timeliness ensures information is available before decisions are made.
• Understandability implies information is comprehensible to those with accounting knowledge.

Financial Statements

• An income statement presents revenues and expenses over a period.
• A balance sheet shows assets, liabilities, and equity at a point in time.
• A statement of changes in equity details changes in retained earnings over time.
• A cash flow statement shows cash inflows and outflows.

Balance Sheet

• Is a financial statement that reports a business' assets, liabilities, and equity at a specific point in time
• Reveals what a business owns (assets) and owes (liabilities).
• Assets are economic resources objectively measurable that result from prior transactions and will provide future financial benefit
• Examples include cash, inventory, receivables, property, equipment, and intangible assets like copyright
• Accounts Receivable is money owed to the business which is an asset because it is expected to be exchanged for cash when paid.
• Assets are recorded and reported at their acquisition cost (cost principle).
• Liabilities are obligations requiring a future sacrifice of resources from past transactions
• Examples include accounts payable, salaries payable, and taxes payable
• Equity is the asset share claimed by the business' owner(s)
• Generated from contributed capital, resources from investors in exchange for ownership interest
• Retained earnings from profitable operations can also generate equity
• Dividends are distributions of company assets to owners

Balance Sheet Purpose

• Shows resources and claims against them as a snapshot in time
• Aligns with the accounting equation: Assets = Liabilities + Equity.

Statement of changes in Equity

• A financial statement that reports the change in a business' equity over a specific period
• Includes contributed equity, reserves, and retained earnings
• Demonstrates equity growth through profitable operations and distribution of dividends.
• Equation: Retained Earnings (end) = Retained Earnings (beginning) +/- Net Profit/Loss - Dividends.

Cash Flow Statement

• Financial statement reports cash inflows and outflows from operations, investing, and financing
• Answers where cash comes from and where it goes and whether there is enough to pay employees
• Financing Activities generate cash from creditors and investors
• Funds often needed to start a business
• Investing Activities involve buying/selling revenue generating assets
• Operating Activities involve transactions required to run the business
• Includes purchase of supplies, payment of employees, and sale of products
• Purpose: to inform about changes in cash during the period
• Formula: Cash Flows from Operations +/- Cash Flows from Investing +/- Cash Flows from Financing = Net Increase/Decrease in Cash, plus Cash at Beginning equals Cash at End

Objectives of Financial Reporting

• Provides financial information useful for investors, lenders and other creditors in making decisions about providing resources to the entity
• Decisions include buying/selling equity and debt, providing, or settling loans/credit
• Must possess relevance and faithful representation.

Relevance

• Accounting information must influence decisions, holding predictive and confirmatory value
• Information about revenue at period-end compared to predicted revenue helps predict future revenue
• Materiality refers to the threshold for affecting decisions if omitted or misstated
• Measurement uncertainty may affect relevance, particularly if estimates are difficult.

Faithful Representation

• Financial information must be complete, neutral, and free from error supported by notes to financial statements
• Neutrality requires moderation using prudence, with caution under uncertainty
• Assets and revenue not overstated to liabilities and expenses not understated
• Information must be relevant and faithfully represented
• Comparability is enhanced through other qualitative characteristics

Comparability

• The ability to compare accounting information to the financial activities of different businesses
• Used in in assessing market position and setting future goals
• Does not imply uniformity, as accounting rules allow discretion
• Businesses can use different acceptable accounting methods, disclosures must be made
• Accounting rules require disclosure of accounting methods to prevent comparability challenges

Verifiability

• Allows independent observers to arrive at the same or similar conclusions, supporting faithful representation
• Does not need a single outcome to be verifiable; a range of possibilities is acceptable

Timeliness

• Requires information to be provided quickly enough to act
• Older information is less helpful

Understandability

• Information must be comprehensible to anyone with reasonable understanding of business and accounting
• Accounting users are expected to be willing to study the information