The Conceptual Framework of Accounting(GAAP), Assumption, Principles and Constraint of Accounting.

The Conceptual Framework of Accounting:

Assumptions:

As noted above assumption provides a foundation for the accounting process. The assumptions are monetary unit, economic entity, time period and going concern assumption.

• Monetary Unit Assumption:The monetary unit assumption states that only transaction data that can be expressed in term of money be included in the accounting records. For example, the value of a company president is not reported in a company’s financial records because it cannot be expressed easily in dollars.
• Economic Entity Assumption: The economic entity assumption states that the activities of the entity be kept separate and distinct from the activities of the owner and of all other economic entities. For example, it is assumed that the activities of IBM can be distinguished from those of other computer companies such as Apple, Dell, and Hewlett-Packard
• Time Period Assumption: The time period assumption states that the economic life of a business can be divided into artificial time periods. Thus it is assumed that the activities of business enterprises such as General Electric, Time Warner, or any enterprise can be subdivided into months, quarters, or a year for meaningful financial reporting purposes.
• Going Concern Assumption: The going concern assumption assumes that the enterprise will continue in operation long enough to carry out its existing objectives. In spite of numerous business allures, companies have a fairly high continuance rate. It has proved useful to adopt a going concern assumption for accounting purposes.

Principles:

On the basis of the fundamental assumption of accounting the accounting profession has developed principles that dictate how economic events should be recorded and reported. The principles are revenue recognition principle, matching principle, full disclosure principle, cost principle,

• Revenue Recognition Principle: The revenue recognition principle dictates that revenue should be recognized in the accounting period in which it is earned. But applying this general principle in practice can be difficult. For example some companies improperly recognize revenue on goods that have not been shipped to customers. Similarly. Until recently financial institutions immediately recorded a large portion of their fees for granting a loan as revenue rather than spreading those fees over the life of the loan.
• Matching Principle: Expense recognition is traditionally tied to revenue recognition. “Let the expense follow the revenue”. It dictates that expense be matched with revenues in the period in which efforts are made to generate revenues that is called matching principle. Expenses are not recognized when cash is paid, or when the work is performed, or when the product is produced. Rather they are recognized when the labor (service) or the product actually makes its contribution to revenue.
• Full Disclosure Principle: The full disclosure principle requires that circumstances and events that make a difference to financial statement users be disclosed. For example, investors who lost money in Euro, WorldCom, and Global Crossing have complained that the lack of full disclosure regarding some of the company’s transactions caused the financial statements to be misleading. Investors want to be made aware of events that can albeit the financial health of a company.
• Cost Principle: The cost principle dictates that assets be recorded at their cost. Cost is used because it is both relevant and reliable. Cost is relevant because it represents the price paid the assets sacrificed or the commitment made at date of acquisition. Cost is reliable because it is objectively measurable, factual, and verifiable. It is the result of an exchange transaction . Cost is the basis used in preparing financial statements.

Constraints:

A constraint permits a company to modify generally accepted accounting principles without reducing the usefulness of the reported information. The constraints are materiality, conservatism, cost benefit, and industry practice.

• Materiality: Materiality relates to an item’s impact on a firms overall financial condition and operations. An item is material when it is likely to influence the decision of a reasonably prudent investor or creditor. It is immaterial it its inclusion or omission has no impact on a decision maker. In short, if the item does not make a difference in decision making. GAAP does not have to be followed. To determine the materiality of an amount, the accountant usually compares it with such items as total assets, total liabilities, and net income.
• Conservatism: The Conservatism constraint dictates that when in doubt; choose the method that will be least likely to overstate assets and income. It does not mean understating assets or income. Conservatism provides a reasonable guide in difficult situations. Do not overstate assets and income.
• Cost Benefit: When choosing between two solutions, the one that will be least likely to overstate assets and income should be picked. This constraint is basically in place to show that the information provides should be beneficial enough to justify the cost to provide it. In establishing GAAP, it is important to consider the costs it will take for companies to prepare such information and the benefits that users will derive from it.
• Industry Practice: It means that the company uses the same accounting principles and methods from year to year. Pretty much this is there to ensure that the accounting procedures follow industry practices.

The conceptual framework for developing sound reporting practices starts with a set of objectives for financial reporting. It follows with the description of qualities that make information useful. In addition elements of financial statements are defined. More detailed operating guidelines are than provided. These guidelines take the form of assumptions and principles. The conceptual framework also recognizes that constraints exist on the reporting environment.