Table of Contents Hide
- What is the Monetary Unit Assumption?
- How the Monetary Unit Assumption Works
- Why Is the Monetary Unit Assumption Included in GAAP?
- Examples of Monetary Unit Assumption
- Implications of Monetary Unit Assumption
- Problem with the Monetary Unit Assumption
- Monetary Unit Assumption FAQs
- What is monetary unit in GAAP?
- Why is monetary unit assumption a part of GAAP?
- Why stable monetary unit assumption is used in accounting?
- What is the basic problem with the monetary assumption when there has been significant inflation?
The monetary unit is a straightforward and globally accepted method of presenting financial information. It is the most appropriate and effective method of recording, transmitting, and evaluating financial facts on which to make reasonable business decisions. In this section, we’ll go through the concept and problem of the monetary unit assumption and stable monetary unit assumption, as well as look at several examples.
What is the Monetary Unit Assumption?
The accounting principle of monetary unit assumption is concerned with the value of transactions or events that a company reports in its financial statements.
Transactions or occurrences could be documented in the Financial Statements under Monetary Unit Assumption only if they could be measured in monetary terms when those currencies are stable and dependable. The US dollar is the most well-known example of a stable currency.
If you have ever seen an entity’s financial accounts, you will notice that all of the transactions and events in the financial statements are recorded and presented in monetary terms, such as USD or another currency.
The monetary unit assumption is explained in full below.
How the Monetary Unit Assumption Works
According to the monetary unit assumption, only transactions with monetary value should be documented in the books of accounts.
In other words, only transactions that can be measured in terms of money should be documented in the books of accounts, according to this approach.
Problems might occur as a result of changes in the value of money as well as a lack of understanding of qualitative aspects such as management quality and the expansion of competition. The money-measuring notion, on the other hand, is widely recognized because of its versatility and understandability.
It is now usual practice for documents that serve as the foundation for accounting records to be published in monetary terms. As a result, keeping accounting records in terms of money poses no difficulties.
Another critical issue is the assumption regarding the stability of the value of the monetary unit. In actuality, inflation reduces the purchasing unit of monetary units, although accounting records are based on the assumption that monetary units have a fixed value.
To effectively account for the results of a corporate entity’s operations, the results must be represented and recorded in conventional units of measurement.
It is commonly understood that a firm might have a variety of assets, such as land and buildings, government securities and shares in other companies, stocks of raw materials and completed items, cash, and claims against creditors.
However, it is impossible to directly sum up all of a company’s assets. There is no way, for example, to multiply thousands of square feet of building space by tons of coal and the number of banknotes.
This is due to changes in the physical characteristics of the measurement units. This problem, sometimes known as the “apples and oranges” problem, is handled by accounting for the shared economic value of assets (and obligations) stated in monetary terms rather than other physical characteristics.
The apples and oranges problem can be solved in this manner since cash, diverse physical things, and claims against others can all be described in terms of money. Money, as a result, lends itself to common measuring and accounting.
Importantly, this idea causes many problems in accounting since assets that cannot be adequately stated in monetary units are not typically reflected in business accounts.
Money serves several critical tasks, making it essential as the primary means of financial communication for businesses:
- It serves as a means of exchange.
- It functions as a value store.
- It’s used as a deferred payment standard.
- It is a monetary unit.
Assumptions in Two Parts
Assets, income, liabilities, and expenses must be reported in dollars or any other monetary unit. However, in other cases, this may be impossible to achieve. The expertise and talent of a company’s business or engineering staff may be its greatest asset.
This is much more difficult to quantify and hence will not be considered for inclusion in the books of accounts. This is because the corporation is only permitted to include transactions with monetary value.
In addition to the assumption, a corporation follows another similar idea while documenting in its books of accounts. According to the “stable dollar value assumption,” the dollar does not lose purchasing power over time. As a result, the entries in a company’s book of accounts do not account for inflation.
Both of these assumptions are crucial since they serve as the foundation for the creation of a company’s books of accounts. Analysts who examine a company’s books of accounts assume that the accountant who created them followed the rules outlined above. This enables people to comprehend the company’s performance, assess its financial status, and compare it to that of other companies.
Monetary Unit Assumption Characteristic
- Only transactions with a monetary value should be recorded.
- USD is the most widely used currency in all countries throughout the world.
- Inflation and deflation are ignored.
Why Is the Monetary Unit Assumption Included in GAAP?
The monetary unit assumption is included in Generally Accepted Accounting Principles (GAAP) because it offers a solid foundation for recording and reporting financial transactions. This approach enables firms to compare their financial performance to that of other enterprises that use the same common currency.
Furthermore, the assumption helps international business transactions. This means that organizations, regardless of location, can be more transparent and similar in their financial statements.
Examples of Monetary Unit Assumption
Assume that XYZ Limited paid $50,000 for a block of land in 1992. It recorded the freshly purchased land with a $50,000 value in its books. Now, in 2019, XYZ Limited paid $300,000 for a neighboring block of land. It will value both parcels of land at $350,000 ($50,000 + $300,000).
There is a large variation in purchasing power between 1992 and 2019, but it is ignored under the assumption.
Assume IJ&K Creatives has a team of extremely talented, skilled, and passionate designers and animators. Under the assumption, the corporation cannot record them as assets. This is because it directs the corporation to record only those transactions in its accounts that can be measured in monetary value. Designers and animators cannot be measured in monetary terms. Similarly, an organization cannot convey an individual’s skills in monetary terms.
During the night, a retailer’s store is vandalized. The store’s windows are shattered, the interior is in ruin, and inventory has been stolen. In his financial statement, the retailer will only claim a loss on the destroyed property. He will not record the financial loss incurred as a result of the possible loss of sales as a result of the store closing for repairs. Lost sales are speculative and cannot be quantified in monetary terms.
ABC School has been the subject of a scandal, and many parents have protested by boycotting the school. ABC School does not record a loss on its financial statements because of the monetary unit assumption, even though income may have decreased. Hence, ABC should not record anything because a boycott is not deemed a business transaction, according to the assumption.
Implications of Monetary Unit Assumption
The use of the Monetary Unit Assumption has the following consequences:
- Every transaction in a business must be recorded in a monetary unit. The reason for this is that monetary units provide a great deal of long-unit stability.
- Every business event must be recorded in a monetary unit, such as USD. This is due to the fact that monetary units provide long-unit stability.
- The books of a unit should only record occurrences and transactions that can be measured in monetary terms. If an event or transaction cannot be quantified in monetary terms, it should not be recorded in a company’s books.
Problem with the Monetary Unit Assumption
Though the monetary unit assumption simplifies accounting, it can also cause issues. When a firm documents its books of accounts, the monetary unit assumption causes a problem:
The monetary unit assumption has a problem in that it ignores the impacts of inflation when recording. For example, as previously indicated, a parcel of property purchased in 1992 for $50,000 was still registered at $50,000 in 2019. The purchasing power of the dollar has changed significantly since 1992, but the assumption does not account for this.
Another problem with this assumption is that it can deceive or mislead external users of financial statements. For example, XYZ Limited owns $350,000 in land. It might not be $350,000 right now, because $50,000 of $350,000 is from 1992.
What Effect Does the Monetary Unit Assumption Have on Balance Sheet Accounts?
The balance sheet components are determined by the monetary unit assumption. Income, in particular, must be recorded in that format so that it may be stated in monetary terms. This is an essential consideration for a corporate organization because it cannot be determined automatically from other accounts on a balance sheet.
How Does the Monetary Unit Assumption Affect a Company’s Valuation?
The monetary unit assumption may result in a value loss or valuation distortion. This is because the valuation methods do not take into account the performance of the corporate entity or market developments.
How Does the Monetary Unit Assumption Affect Asset and Liability Accounting?
Assets and liabilities should be stated at cost less any subsequent revisions to asset cost via depreciation or amortization.
Because corporations do not have to convert long-term assets to their current value every year, the monetary unit assumption simplifies accounting. The dollar is the most effective medium for communicating economic activity. It assigns a monetary value to any action, making it easier to account for that activity in financial statements.
Money is ubiquitous, clear, and understanding, and it is the most convenient way to communicate financial operations. All economic and financial transactions have it as a common denominator. As a result, it provides a solid foundation for comparing companies and other accounting metrics. Accounting, in other words, evaluates transactions that can be communicated in monetary value.
Monetary Unit Assumption FAQs
What is monetary unit in GAAP?
According to the monetary unit concept, you should only record business transactions that can be stated in terms of a currency. As a result, a corporation cannot track non-quantifiable items such as personnel skill levels, customer service quality, or engineering staff creativity.
Why is monetary unit assumption a part of GAAP?
GAAP presupposes that the monetary unit is consistent, dependable, relevant, and beneficial to all businesses. It is also widely available. In global markets, all currencies are freely swapped at varied exchange rates.
Why stable monetary unit assumption is used in accounting?
The idea of a stable monetary unit assumption is that the value of the dollar remains stable over time. This notion simply allows accountants to ignore the effect of inflation, which is a decrease in what a dollar can buy in terms of real commodities.
What is the basic problem with the monetary assumption when there has been significant inflation?
The monetary unit assumption assumes that the unit of measure (the dollar) remains relatively stable, allowing dollars from different years to be added without adjustment.