1. 6.1PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
ACCOUNTINGACCOUNTING
Financial and OrganisationalFinancial and Organisational
Decision MakingDecision Making
Chapter 6
Underlying assumptions of the
historical cost accounting system
Slides written and designed by
Tony Van Eekelen

2. Chapter 6: Underlying assumptions of the historical cost accounting system
6.2PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Learning ObjectivesLearning Objectives
• In this chapter you will be introduced to
– how a general theoretical framework can help
with choosing between alternatives
– a theoretical framework in terms of objectives,
assumptions, principles and rules
– the difference between an inductively and
deductively derived framework

3. Chapter 6: Underlying assumptions of the historical cost accounting system
6.3PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Learning ObjectivesLearning Objectives
– how the objectives,
assumptions and principles
impact on the recording and
reporting of accounting
information
– how the assumptions relate
to the objectives of
historical cost accounting
– the elements of historical
cost accounting reports

4. Chapter 6: Underlying assumptions of the historical cost accounting system
6.4PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
The problem of choiceThe problem of choice
• Should the event be included in the
accounting system?
• How will the accounting equation be
affected by this event?
• These two choices exist throughout
accounting and thus it is necessary to
establish some principles to guide the
process of decision making.

5. Chapter 6: Underlying assumptions of the historical cost accounting system
6.5PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
A general framework for designA general framework for design
Objectives
Assumptions
Principles
Rules

6. Chapter 6: Underlying assumptions of the historical cost accounting system
6.6PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
A general framework to aid decisionA general framework to aid decision
makingmaking
• Objectives
– set the purpose for why we are making the
decisions
• Assumptions
– are statements accepted by the designer as self-
evident facts without argument
– are varied by degree of certainty
– regard all assumptions with caution

7. Chapter 6: Underlying assumptions of the historical cost accounting system
6.7PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
General frameworkGeneral framework
• Principles
– must be justified entirely by logical argument
within the framework
• Rules
– application of principles
– are more specific and narrower than principles

8. Chapter 6: Underlying assumptions of the historical cost accounting system
6.8PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Deductive vs. InductiveDeductive vs. Inductive
• The above model of objectives,
assumptions, principles and rules can be
derived in two ways.
• The deductive approach is to start with the
objectives and work your way down.
• Thus the rules and principles are deduced
from the objectives and assumptions

9. Chapter 6: Underlying assumptions of the historical cost accounting system
6.9PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Deductive vs. InductiveDeductive vs. Inductive
• An alternative approach is to look at what
system already exists
• This method of inductive research involves
observing the current practice and inducing
the principle and objectives
• Historical cost accounting developed this
way

10. Chapter 6: Underlying assumptions of the historical cost accounting system
6.10PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Deductive vs. InductiveDeductive vs. Inductive
Objectives Assumption Principles Rules
Empirical inductive approach
Deductive approach

11. Chapter 6: Underlying assumptions of the historical cost accounting system
6.11PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
The objectives of historical costThe objectives of historical cost
accounting systemaccounting system
• The objective of an accounting system
involves the production of relevant and
reliable information to aid the users of this
information in their decision making
process.
• Problem: trade-off between reliability and
relevance

12. Chapter 6: Underlying assumptions of the historical cost accounting system
6.12PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
The assumptions of the historical costThe assumptions of the historical cost
accounting systemaccounting system
• Assumptions have been derived to achieve
the objective of reliability and relevance
Objectives
Usefulness of information for decision making
requiring
Relevance Reliability

13. Chapter 6: Underlying assumptions of the historical cost accounting system
6.13PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Relevance assumptionsRelevance assumptions
• Accounting entity
– Separation
• distinguishes between the affairs of the owners and
the entity
• in smaller firms (sole traders and partnerships) the
separation is more difficult as by law the two
accounting entities are one. Not so for companies.
– Viewpoint
• procedures relate to the entity
• owner is an external party

14. Chapter 6: Underlying assumptions of the historical cost accounting system
6.14PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Relevance assumptionsRelevance assumptions
• Ownership and economic resources
– Accountants have the task of measuring only
those resources that have economic value
– Two types of value
• value in exchange
• value in use
– resources must be scarce
• economic resources = creditors’ claims + owners’
claims

15. Chapter 6: Underlying assumptions of the historical cost accounting system
6.15PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Relevance assumptionsRelevance assumptions
• Money measurement
– the unit of measurement is important
– money as a medium of exchange is assumed to
be the unit of measurement
– use national currency $
– Problems
• inflation
• exchange rates
• time value of money

16. Chapter 6: Underlying assumptions of the historical cost accounting system
6.16PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Relevance assumptionsRelevance assumptions
• Accounting period
– requirement for information at regular intervals
– problems
• ‘cut-off’ date may result in incomplete venture
• thus measurement problem
• valuing of inventory, value of asset

17. Chapter 6: Underlying assumptions of the historical cost accounting system
6.17PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Relevance assumptionsRelevance assumptions
• Continuity or going concern
– the entity is assumed to continue in operation
into the foreseeable future
– at end of accounting period this assumption of
continuity assumes that incomplete ventures
will be completed in the future
– assets are placed in the balance sheet to show
the future economic benefit

18. Chapter 6: Underlying assumptions of the historical cost accounting system
6.18PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Relevance assumptionsRelevance assumptions
• Capital maintenance and profit
– no dividends can be paid except out of profits
– profits are defined as the growth in net assets over a
period of time after owners’ contributions are taken
into account
$100,000
Capital
$100,000
Increase $20,000
Net assets
beginning
Net assets end

19. Chapter 6: Underlying assumptions of the historical cost accounting system
6.19PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Reliability assumptionsReliability assumptions
For information to be reliable it must not
contain bias or errors
• Faithful representation
– financial statements faithfully represent all the
transactions and events in the accounting period
– historical cost system does this well

20. Chapter 6: Underlying assumptions of the historical cost accounting system
6.20PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
• Verifiability
– similar measures or conclusions would be
reached if two or more qualified persons
examined the same data
– again historical cost performs this well
Reliability assumptionsReliability assumptions

21. Chapter 6: Underlying assumptions of the historical cost accounting system
6.21PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
The broad principle of historical cost accountingThe broad principle of historical cost accounting
• Using the objectives of reliability and
relevance and the assumptions, principles
can now be derived
• Two main principles are
– primary transaction basis
– dollar measurement

22. Chapter 6: Underlying assumptions of the historical cost accounting system
6.22PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Primary transactions basisPrimary transactions basis
• No primary entry may be entered into the
accounting system unless it is evidenced by a past
external transaction involving the entity
• external event involving the transfer of something
of value between two entities
• evidence includes all documents
• secondary entries do exist
– essentially reallocation of amounts from primary
entries

23. Chapter 6: Underlying assumptions of the historical cost accounting system
6.23PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Events vs. transactionsEvents vs. transactions
External
transactions
All economic events
affecting entity
Data
processing
Reports on
entity

24. Chapter 6: Underlying assumptions of the historical cost accounting system
6.24PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Dollar measurementDollar measurement
• Every transaction or event recorded in the
accounts shall be measured in dollars
• Follows from the money measurement
assumption

25. Chapter 6: Underlying assumptions of the historical cost accounting system
6.25PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Statement elementsStatement elements
• Assets
– are economic resources controlled by the entity for the
purpose of providing future benefits to that entity
– Related assumptions are
• resources offering future benefits through use or exchange -
ownership & economic resources
• under the control of the entity - entity, ownership and
economic resources
• It must have been acquired in a past, external transaction -
primary transaction principle

26. Chapter 6: Underlying assumptions of the historical cost accounting system
6.26PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Statement elementsStatement elements
• Liabilities
– regarded as an obligation and meets the
following
• A claim on the entity involving a future sacrifice of
economic resources - ownership and economic
resources
• the resources are to be sacrificed by the entity to an
external entity - entity assumption
• Must arise out of a past external transaction -
primary transactions principle

27. Chapter 6: Underlying assumptions of the historical cost accounting system
6.27PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Statement elementsStatement elements
• Owners’ equity
– Interest of owners in the net asset of an entity at
any time
– Owners’ equity = assets - liabilities
– Capital
• changes due to contributions or withdrawals not
profits
– Profits
• is the change in net assets after capital changes

28. Chapter 6: Underlying assumptions of the historical cost accounting system
6.28PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Statement elementsStatement elements
• Revenue
– are accomplishments of the earning process of a
business enterprise during a period
– usually represent cash inflows that have
occurred or will probably eventuate
– will be as a result of the entity’s operations
during the period
– Capital contributions are not revenue

29. Chapter 6: Underlying assumptions of the historical cost accounting system
6.29PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust.
Statement elementsStatement elements
• Expenses
– maybe regarded as expired assets
– as economic resources that have been consumed during
the period
• resources consumed must have been acquired in a past
transaction - primary transaction basis
• resources that have expired during the period - ownership and
economic resources
• Withdrawals by owners are not expenses but capital reduction
- capital maintenance
– Problem - when a resource has been consumed and how
much has been consumed?