Financial Reporting AssumptionsThe domain of accounting consists of several areas that differ primarily in function and purpose. Financial accounting is concerned with the measurement and reporting of all the firm’s transactions. An aggregate report of those transactions is made available to investors and other external users on a periodic basis. This report must follow accounting policies and standards considered generally acceptable. These are the policies adopted by the rule-making bodies of the profession, which are in constant flux to adapt to changes in the economic environment and business activities. Managerial and cost accounting deals with measurement and reporting of information on the internal activities of the firm in such a way that would benefit management in decision-making, planning, and control. The nature of these tasks requires more disaggregated information and frequent measurement and reporting. Another facet of accounting includes accounting for taxation, which in many countries is governed by the prevailing tax laws and regulations and is much less impacted by professional accounting rules. Over the years, the development of the accounting body of knowledge has resulted in adhering to certain broad assumptions, conventions, and concepts.

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Through this post, I am going to discuss about assumptions used in reporting financial information that lead to specific accounting issues. Bear with me on this discussion, spot questions or share comments and ideas may add more value on your basic knowledge in accounting field. Enjoy!

 

Going Concern and Valuation

As with any venture, the success or failure of a business enterprise could not be known with certainty until it is concluded. Consequently, entrepreneurs start business enterprises with life spans not known in advance. In fact, many firms outlast their founders. This uncertainty about the duration of a business enterprise has led accountants to assume indefinite survival unless compelling evidence to the contrary comes to light. Accountants refer to this assumption as the going concern

Adhering to the going concern assumption implies that:

  • managers will continue making operating, investment, and financing decisions that add value to the firm; and
  • resources (assets) owned by the firm are then viewed as stores of benefits to be realized at future dates.

 

To realize those benefits, the firm’s assets are to be used in the normal course of business, not under distress conditions, which has implications for the measurement of values to be assigned to various assets. In particular, the value of an asset must emanate from the future benefits the asset is capable of generating. Those benefits are generally identified in terms of cash flows. If the cash flow streams associated with those expected future benefits are known, they can be represented in a common denominator using present-time monetary units (say, the dollar). This is accomplished by discounting future cash flows to present values using appropriate discount rates and taking account of the timing of each flow. The present value of future flows to be generated by using an asset is the economic value of that asset.

It is a rare occasion, however, to know the amounts and timing of future cash flows. Thus, the economic values of various goods and services cannot be determined merely by a simple calculation. Yet, people exchange goods and services all the time even with this lack of knowledge. In a world of rational expectations, people use known information to predict future outcomes, including the cash flow stream expected to be generated from using an asset. Different people make different predictions, resulting in their making different bids or asking for different prices. An exchange takes place when bid and ask prices match. Thus, it is reasonable to assume that exchange prices represent the traders’ best expectations of economic values at the time of the exchange. Accountants acknowledge this relationship and use the amount of cash given up to value the asset acquired in exchange.

As time passes and more information is generated about the performance of various assets, traders in the market place use the new information to revise their earlier predictions of the amounts, timing, and uncertainty of various cash flow streams. In the absence of perfect foresight, this revision is assumed to mirror changes in the economic value of the asset. Thus, assets similar to those held by the firm might be acquired at different times for amounts higher or lower than the firm is reporting them on the books; i.e., the current (replacement) cost differs from book values.

Similarly, assets held by the firm might be sold for prices higher or lower than their book values. In this case, exit values, or realizable values are different from book values. Once an asset is acquired, accounting policymakers have generally decided to use the value at the time of exchange for booking the asset, but typically ignore changes in values represented by deviations of either current replacement cost or exit values from book values. To make sure that users know that changes in asset values following acquisition are ignored, the market value at the time of acquiring the asset is denoted “historical cost.” Because of the ability to verify the calculation of historical cost, it was considered more objective than other competing measures. Its relevance for decision-making, however, is questioned.

Another source of variation in asset values is the change in the purchasing power of the monetary unit used in valuation. Changes in the prices of assets, goods, and services do occur because of inflationary conditions and technological advances. To reflect the effect of inflation on the financial conditions of the firm, financial statements that are based on historical costs are adjusted using a general price level index. The outcome of this process is known as financial statements in constant dollars.

The different reasons for changes in value has generated corresponding conceptual differences between historical cost, current (replacement) cost, exit values and historical cost adjusted for general price level changes. Although contemporary accounting practice is essentially based on a historic cost model, the ad hoc nature of making accounting policies resulted in producing financial statements that are in effect a depository of mixed measurements and judgments using different valuation rules. The end result of these measurement errors flows to the owners’ equity section on the balance sheet.

 

Conservatism and Revaluation

While the heritage of accountants is to favor the use of historical cost due to its alleged objectivity, they deviate from this tradition when it becomes convenient to selectively update historical cost by adjusting for changes in market values.

In some countries like the United Kingdom, Australia, and New Zealand, firms are allowed to substitute market values (or estimates thereof) for historical cost when the market values of assets held by the firm are judged to be materially different from historical cost (i.e., book values).

 

Since many used assets have no ready second-hand markets, estimates and appraisals are often relied upon, which requires an extra effort in assuring users of information about the reliability of the newly reported information. This practice of allowing upward revaluation of assets is not shared by the accounting profession in many countries. Universally, however, accounting policy-makers fully agree on the necessity of asset revaluation only when evidence shows material decline of market (or equivalent) values below book values. Only if there is a significant impairment of assets do accounting policies require substituting market values for historical cost.

This general asymmetric adherence to market value changes (i.e., ignore them if market value is higher than book values, but take them into account if the reverse is true) has been the hallmark of accounting policies for reporting information about the firm to its stockholders, creditors, and other external users of information. Adopting conservative policies is a deep-rooted tradition that has failed to adapt to changes in the socioeconomic environment.

Up until the start of the 20th century, the typical business firm was small in comparison with modern corporations and was managed by their owners. Both features, the size and coupling of ownership and management, allowed owners to exercise control over the business firm’s activities by means of direct observation and personal involvement. The need to inform others outside the firm was very limited.

 

However, when owners sought financing from lending institutions, lenders, who were at an informational disadvantage as compared to the owner-manager, requested that:

  • the firm must follow conservative policies for investing and operating as well as in its accounting for financial reporting; and
  • the firm must disclose privately to bankers and lenders sufficiently disaggregated information about the performance of the firm so that they can undo the conservative reporting and understand the true economic picture of the firm.

 

To date, these conditions have a lasting and, to a large extent, a progress-hindering effect on the development of accounting policies.

Conservative accounting policies essentially call for ignoring expected gains or anticipated increases in values, but must recognize the effects of expected losses or decline in values. Information users other than management must not be informed about good news until an exchange takes place, but bad news is to be told and taken into account as soon as it is anticipated with a reasonable degree of confidence. For example, if a firm holds goods in inventory, the decline in the market value of this inventory implies that a loss is likely to occur at a future date. To the extent that the market value falls below book value, a loss must be recognized when this expectation is formed. In contrast, an increase in the market value of inventories above book value must not be reported for external users until the earning cycle is complete.

The conservative approach has led to concocting the “lower-of-cost-or-market” (LOCOM) measurement rule. Since market values could refer to either current (replacement) cost or exit value, various combinations of LOCOM have evolved. In addition, the physical flow of inventory is irrelevant because accountants could assume an entirely different flow for costing purposes. Because of its appeal to lenders and to those who fear the consequences of optimism, LOCOM was extended to other assets such as short-term investments. Even in recent times when policy-makers have shown more inclination to use market (or equivalent, fair) values for some accounting measurements, LOCOM was retained for some types of investments, while ”management intent” has replaced LOCOM for other types. In fact, the book measurement of accounts and notes receivable also follow LOCOM, where market is defined as net realizable value; estimating uncollectible amounts effectively produces net realizable value.

Conservatism has also led to ignoring assets when measurements require judgment. While business firms undertake research and development activities with the anticipation of generating future benefits, most accounting policy-making around the world has followed the US lead by expensing R&D as incurred and thereby ignoring the valuation of those benefits.

 

Accounting Period and Temporal Allocation

Adhering to the going concern assumption was one way of recognizing that the business firm will live indefinitely, but it also raised the problem of evaluating the success of a business venture. The issue is complicated by the fact that the duration of expected future benefits that are associated with any asset varies by its interaction with other assets. Different assets are likely to have different expected productive lives, but often enough the practice of accounting allows using different productive lives for the same assets, especially under varying conditions.

An accounting convention has evolved to partition the unknown life of the firm into known periods, which has the advantage of standardizing the period to which various activities can be attributed. The typical reporting period is one year, with corporations in the more developed countries reporting on a quarterly basis.

 

External users, however, are demanding more timely and more frequent reporting. For assets having expected benefits longer than one year (i.e., long-lived assets) attribution of benefits to a given period can be conceptually undertaken by assessing the change in its economic value during that period. However, the accountants’ preoccupation with objective and verifiable calculations, that has initially led to a preference for using a historic-cost basis, has also led to developing what are called “systematic and rational” methods of attributing costs to reporting periods. Typically, such methods involve estimating the useful life of an asset and choosing one of several alternative methods of allocating its historic cost to the different periods encompassed by that life. These inter-temporal allocation methods are known as depreciation (for tangible assets) and as amortization (for intangible assets). Some allocation methods do not differentiate between the extent of asset use in different periods (e.g., straight line), while others attempt to allocate larger proportions to earlier periods (accelerated) based on various assumptions, including maintenance cost, technological obsolescence, and conservatism.

It is important, however, to note that none of these methods attempts to relate periodic allocation of cost to the actual degree of consuming the benefits stored in a long-lived asset. In effect, the so-called “systematic and rational” aspects of these methods lie in their calculation feature. It is, therefore, often argued that book values of long-lived assets are the products of two independent decisions: (1) the valuation, or more appropriately the cost measurement, decision that basically maintains the historic cost basis, and (2) the inter-temporal allocation decision, which is rarely related to the degree of asset utilization or its economic depreciation.