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Chapter 2: Question 12Q (page 61)

What are the four basic assumptions that underlie the financial accounting structure?

Short Answer

Expert verified

The four basic assumptions that form the basis of financial accounting structure are business entity assumption, accounting period assumption, going concern assumption, and money measurement assumption.

Step by step solution

01

Meaning of Financial Accounting

The objective of financial accounting is to find out the profitability and to provide information about the financial position of the concern. Two important statements of financial accounting are income and expenditure statement and balance sheet.

02

Four basic assumptions of financial accounting structure

  • Business entity assumption: According to this assumption business is treated as a separate entity from its owners. All transactions of the business are recorded in the books of the firm. Business transactions and business property are different from personal transactions and personal property. If business affairs are mixed with private affairs, the true picture of the business is not available. The business entity concept to all forms of business organization. The owner of the firm is treated as a creditor to the extent of his capital. From the accounting point of view, the owner is different and the business is different.
  • Accounting period assumption: According to this assumption, it is necessary to prepare the financial statements periodically to find out the profit or loss and financial position of the business. It also helps the interested parties to make a periodical assessment of its performance. Therefore, accountants choose some shorter period to measure the results and one year has been generally accepted as the accounting period. The accounting period may be a calendar year or any other period of twelve months. The final accounts are prepared at the end of each accounting period and financial reports assist the users in making a good decision, corrective measures, business expansion as well as making the assessment of the progress of the enterprise.
  • Going concern assumption: According to this concept, every business wants to survive in the market for a long time and earn profit from business operations. This notion is useful for the business to understand the major aspects of the business and helps in the conduct of the business. This concept ensures investors and stakeholders that the business is stable and earning revenue.
  • Money measurement assumption: According to this concept, the money is considered as the only way to record the transaction into the company’s book of accounts. Therefore, all recordings are made with reference to the standard currency of the country where the business is established. In simple words, in can be understood as only those transactions and events are recorded in the books of accounts which can be expressed in monetary terms.

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Most popular questions from this chapter

Wayne Cooper has some questions regarding the theoretical framework in which GAAP is set. He knows that the FASB and other predecessor organizations have attempted to develop a conceptual framework for accounting theory formulation. Yet, Wayne’s supervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e., in the real world). Wayne did notice that accounting rules seem to be established after the fact rather than before. He thought this indicated a lack of theory structure but never really questioned the process at school because he was too busy doing the homework. Wayne feels that some of his anxiety about accounting theory and accounting semantics could be alleviated by identifying the basic concepts and definitions accepted by the profession and considering them in light of his current work. By doing this, he hopes to develop an appropriate connection between theory and practice.Instructions

(a) Help Wayne recognize the purpose of and benefit of a conceptual framework.

(b) Identify any Statements of Financial Accounting Concepts issued by the FASB that may be helpful to Wayne in developing his theoretical background.

BE2-1 (L03) Match the qualitative characteristics below with the following statements. 1. Relevance 5. Comparability 2. Faithful representation 6. Completeness 3. Predictive value 7. Neutrality 4. Confirmatory value 8. Timeliness (a) Quality of information that permits users to identify similarities in and differences between two sets of economic phenomena. (b) Having information available to users before it loses its capacity to influence decisions. (c) Information about an economic phenomenon that has value as an input to the processes used by capital providers to form their own expectations about the future. (d) Information that is capable of making a difference in the decisions of users in their capacity as capital providers. (e) Absence of bias intended to attain a predetermined result or to induce a particular behavior.

BE2-11 (L06) Vande Velde Company made three investments during 2017.

(1) It purchased 1,000 shares of Sastre Company, a start-up company. Vande Velde made the investment based on valuation estimates from an internally developed model.

(2) It purchased 2,000 shares of GE stock, which trades on the NYSE.

(3) It invested $10,000 in local development authority bonds. Although these bonds do not trade on an active market, their value closely tracks movements in U.S. Treasury bonds.

Where will Vande Velde report these investments in the fair value hierarchy?

GROUPWORK (Accounting Principles and Assumptions—Comprehensive) Presented below are a number of business transactions that occurred during the current year for Gonzales, Inc.

Instructions

In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles.

(a) The president of Gonzales, Inc. used his expense account to purchase a new Suburban solely for personal use. The following journal entry was made.Miscellaneous Expense 29,000Cash 29,000

(b) Merchandise inventory that cost \(620,000 is reported on the balance sheet at \)690,000, the expected selling price less estimated selling costs. The following entry was made to record this increase in value.Inventory 70,000Sales Revenue 70,000

(c) The company is being sued for \(500,000 by a customer who claims damages for personal injury apparently caused by a defective product. Company attorneys feel extremely confident that the company will have no liability for damages resulting from the situation. Nevertheless, the company decides to make the following entry.Loss from Lawsuit 500,000Liability for lawsuit 500,000

(d) Because the general level of prices increased during the current year, Gonzales, Inc. determined that there was a \)16,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entryDepreciation Expense 16,000Accumulated Depreciation Equipment 16,000

(e) Gonzales, Inc. has been concerned about whether intangible assets could generate cash in case of liquidation. As a consequence, goodwill arising from a purchase transaction during the current year and recorded at \(800,000 was written off as follows.

(f) Because of a “fire sale.” equipment obviously worth \)200,000 was acquired at a cost of $155,000. The following entry was made.Equipment 2000Cash 155,000Sales Revenue 45,000

Question: Daniel Barenboim sells and erects shell houses, that is, frame structures that are completely finished on the outside but are unfinished on the inside except for flooring, partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring, plumbing, wall completion and finishing, and other work necessary to make the shell houses liveable dwellings.Barenboim buys shell houses from a manufacturer in unassembled packages consisting of all lumber, roofing, doors, windows and similar materials necessary to complete a shell house. Upon commencing operations in a new area, Barenboim buys or leases land as a site for its local warehouse, field office, and display houses. Sample display houses are erected at a total cost of \(30,000 to \)40,000 including the cost of the unassembled packages. The chief element of cost of display houses is the unassembled packages, in as much as erection is a short, low-cost operation. Old sample models are torn down or altered into new models every 3 to 7 years. Sample display houses have little salvage value because dismantling and moving costs amount to nearly as much as the cost of an unassembled package.Instructions

  1. A choice must be made between (1) expensing the costs of sample display houses in the periods in which the expenditure is made and (2) spreading the costs over more than one period. Discuss the advantages of each method.
  2. Would it be preferable to amortize the cost of display houses on the basis of (1) the passage of time or (2) the number of shell houses sold? Explain.
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