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6. Key Assumptions

Accounting is perceived as concrete. Most casual observers associate the accounting discipline with science and math in terms of absolute precision. However, accounting is actually more like art and social science. This distinction is difficult to make in an abbreviated discussion, but an illustration may help. As you consider the following illustration, forget everything you know about accounting "rules" and simply try to answer the question based on economic truth.

Suppose you purchased a home for $200,000, and sold it 10 years later for $300,000. How much profit did you make? It seems simple enough, until you consider the following additional facts:

• You are moving to a new city, and the $300,000 will buy you an identical home to the one you sold, or

You are moving to a new city, and the $300,000 will buy you only a smaller home, or

You are moving to a new city, and the $300,000 will buy you a nicer home, or

You are retiring and moving to a condo that will cost less than $300,000, or

You are having children and needing a bigger home that will cost more than $300,000, and

• The general inflation during the past ten years has been low, and $300,000 today will buy more than $200,000 did ten years ago, or

The general inflation during the past ten years has been high, and $300,000 today will buy less than $200,000 did ten years ago, or

The general inflation during the past ten years has been modest, and $300,000 today will buy what $200,000 did ten years ago, and

• You paid $100,000 in interest and taxes on the home during the past ten years, or

You paid less than $100,000 in interest and taxes on the home during the past ten years, or You paid more than $100,000 in interest and taxes on the home during the past ten years.

You can see that there is not a single correct answer to the question. Rather, the answer depends on what methods and assumptions you employ in your measurement system. For example, suppose you were told to determine the profit by(l) comparing sales price to historical cost, (2) ignoring any subsequent reinvestment of the proceeds of the sale, (3) disregarding inflation, and (4) not factoring in the interest and taxes incurred during the holding period. Now you can assert that the profit is $100,000. You may not agree with this answer, but at least you know how it is derived. Accounting is not based on absolute truths.

Throughout this text, you have been exposed to many measurement methods and principles (e.g., entity concept, historical cost principle, revenue and expense recognition rules, objectivity principles, etc.). Underpinning this system are some fundamental assumptions. From your individual perspective, these assumptions may or may not be valid. However, agreement with these assumptions is secondary to knowing that they are a part of the measurement model in use.

Throughout this text, you have been exposed to many measurement methods and principles (e.g., entity concept, historical cost principle, revenue and expense recognition rules, objectivity principles, etc.). Underpinning this system are some fundamental assumptions. From your individual perspective, these assumptions may or may not be valid. However, agreement with these assumptions is secondary to knowing that they are a part of the measurement model in use.

6.1. Entity Assumption

Accounting information should be presented for specific and distinct reporting units. In other words, the entity assumption requires that separate transactions of owners and others not be commingled with the reporting of economic activity for a particular business. On one hand, an individual may prepare separate financial statements for a business they own even if it is not a separate legal entity. On the other hand, consolidated financial statements may be prepared for a group of entities that are economically commingled but are technically separate legal units.

 
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