What assumption disregards any inflation or deflation in the economy in which the entity operates?

The (Stable) Monetary Unit Assumption

🔥NEW If you go through an entity's financial statement, you will see that every business transaction or event is recorded in monetary term or currency. Why is that so? One of the recognizable and accepted accounting principles is "The Monetary Unit Assumption" which assumes money as a unit of measurement and that an entity should record only those business transactions or events in the financial statements which can be expressed or measured in monetary terms (unit of currency). For example, many companies use USD or EUR for recording their business transactions and events. • Long-run stability of currency • Currencies have purchasing power • Ignore deflation and inflation effects on the currency and/or the time value of money The monetary unit assumption consists of two main areas: • Every business transaction or event can be expressed in monetary terms and the events that are non-quantifiable should be omitted. • In the long run, the monetary unit should be stable and should not lose its purchasing power over time. In order to communicate the financial information properly, an entity should record only those business transactions or events in the financial statements which can be expressed or valued in monetary term. Every business event should be first translated into unit of currency such as USD, POND, YEN, EUR or PKR. Business transactions that can not be expressed in monetary terms are non-quantifiable events and thus should be omitted from the financial statements. Non-quantifiable items are for example employee skill levels, employee motivation, management expertise, and customer service quality.

On 20 April 2010, the largest oil spill ever was caused (the Deepwater Horizon oil spill). Because of the monetary unit assumption, accounting only records the financial impact of this disaster including cleanup cost, damages, and claims paid, etc. But revenue loss and workers' death was ignored.
Assume that ABC Company has very passionate, skilled and talented employees. These employees could be considered as valuable assets, but the company can not record them as its asset in its financial statements, because they cannot be measured or expressed in the monetary unit. The skillset and expertise of the employees can not be expressed in dollars.

The monetary unit assumption assumes that money will not lose its purchasing power over time and its value remains stable for the long term, thus ignoring the effects of deflation and inflation. Because of low inflationary rates in the United States, FASB currently prohibits recognizing inflation effects in the company's financial statements. The monetary unit assumption as well as the cost principle of accounting requires to value assets and liabilities on its original historical cost. The assumption is also known as the stable dollar assumption. According to FASB, it is stated in Statement of Financial Accounting Concepts No. 5 that "The monetary unit or measurement scale in current practice in financial statements is nominal units of money, that is, unadjusted for changes in purchasing power of money over time. The Board expects that nominal units of money will continue to be used to measure items recognized in financial statements". Assume that ABC Company purchased a plot of land at a cost of €45,000 in 2008. At that time, the company recorded this event at its original price of €45,000 in the company's books of account. In 2020, the company purchases another similar plot of land at a cost of €500,000. There is a huge difference between the prices because of the inflation rate and the time value of money. The company will record its 2 plots of land at a cost of €545,000 (€45,000 +€500,000) in the company's books of account. The company will not make adjustments in the amount of land purchased in 2008 because of the monetary unit assumption.

Sources Report: Statement of Financial Accounting Concepts No. 5 by Financial Accounting Standards Board

Article: Brain Mass, "The Stable-Monetary Unit Assumption"

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The Matching Principle

The concept of matching in accounting and finance is based on the relationship of the revenue and expense that demonstrate the cause and effect relationship between them. It requires to match the costs incurred in a specific time period with the revenue of that time period. The matching principle is one of the fundamental concepts of accrual accounting. The accrual accounting concept recognizes income at the time when it is earned and recognizes the expense when it is incurred; used, or consumed. Both of the accounting guidelines; IFRS and GAAP recommend accrual accounting to record the revenue and expense of an organization. Because it provides a clear and accurate view of the business operations and revenue earned of the company. It helps shareholders, creditors, and other stakeholders to understand and predict the company's financial performance. We might say that the concept of accrual accounting stems from the matching principle. The principle states that "all the expenses incurred in a specific time period must be recognized in the income statement of that time period in which the income is earned". Some of the applications of the matching principle in accounting are listed below:

The deferrals of prepaid expenses and accrued expenses are charged to the revenue of the current period.
The recognition of depreciation of the property, plant, and equipment with the revenue of the period in which they are utilized for generating revenue.
The recognition of the cost of goods sold under the revenue earned in a specific financial period. It requires matching the manufacturing or inventory cost of the product with the revenue of the financial period when it is sold.
the matching of tax expense with the taxable income of the specific period that sometimes results in little differences and creates deferred taxes. FAS 109 (Accounting for income taxes) and IAS 12 (Income taxes) requires accounting for taxable income.

Assume that ABC Company has purchased an insurance policy of €1200 for a year on the June 5th, 2020. At the year-end (so December 2020), the company earned €100.000. Although the company purchased an insurance policy for 12 months in 2020, it will report the insurance policy used for 7 months in the income statement. Because the entire insurance policy has not been used in the year 2020. Only the used portion of the insurance will be matched with the income of the year. Let's see a demonstration in the following table.

Sources Book: Principles of Accounting Volume 1 - Financial Accounting (2019) by Mitchell Franklin, Patty Graybeal, Dixon Cooper Book: Accounting: The basis for business decisions - 11th edition by Robert F. Meigs, Jan R. Williams, Susan F. Haka, and Mark S. Bettner

Article: Accrual Accounting Concept in IFRS and GAAP by Finance Train.

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Economic Entity Assumption – Under the economic entity assumption, an economic activity can be identified to a separate entity accountable for that activity. In other words, this assumption states that businesses must keep their transactions separate from their owners’, business units’ or other businesses’ transactions. For example, the business activities of the neighborhood coffee house are to be kept separate from the financial activities of its owners or managers. The financial statements for the coffee house will only reflect the revenue and expenses for the coffee house. Thus, it is possible to compare the financial statements of this coffeehouse with its competitors’ reports, since these statements should be reported separately under the economic entity assumption. Important to note, a separate entity does not necessary mean a legal entity. For example, financial statements for a parent company and its subsidiaries (i.e. separate legal entities) can be presented together (i.e. consolidated financial statements).

Going Concern Assumption – For accounting purposes, the going concern assumption states that the financial activities of a business are assumed to be in operation for an indefinite period of time. This allows a business to operate with a view towards a long term. This is a very critical assumption as it provides that there is no short term end point in which all assets need to be sold and all debt must be paid off. Thus, the going concern assumption makes it possible to depreciate or amortize assets because we assume that businesses will have a long life. For example, if the coffee house was going to be sold, its assets would be valued at their disposal or liquidation value (sales price less expense of disposal). Under the going concern assumption, the coffee house values its assets at their original cost. As we can see, the going concern assumption is only inapplicable when business liquidation is imminent, and it should be used in all other business situations.

Monetary Unit Assumption – This assumption states that information in the financial statements must be expressed in monetary units. The reason is that economic activity is expressed in monetary unit, and thus, it makes sense to apply the same basis for accounting purposes. Monetary units are relevant, universally available, and understandable. Using the neighborhood coffeehouse as an example, the intrinsic value of the best coffee server cannot be valued in the financial statements, regardless of how many customers frequent the coffeehouse due to this individual. The inherent value of this person cannot be quantified in the financial statements as an asset.

The monetary unit assumption also states that a stable unit of currency is to be used as the unit of record. In the United States, the US Dollar is typically the currency of choice. Important to note, accounting ignores inflation or deflation and assumes that US Dollar remains reasonably stable. For instance, no adjustments are necessary when adding 1990 dollars to 2010 dollars, unless economic conditions change dramatically (e.g. hyperinflation).

Time Period Assumption – This assumption allows for the division of businesses operational activities into artificial time periods for reporting purposes as determined by the business owners. The coffeehouse can record information on a daily, weekly, monthly, quarterly and yearly basis during a time frame they deem relevant. However, there is a trade-off between the accuracy (reliability) and relevancy in preparing financial statements: the more quickly a company presents financial data, the more likely such data contains errors (i.e. less reliable information).

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