ASSUMPTIONS



An assumption is a statement that is presumed to be true without concrete evidence to support it. In the business world, assumptions are used in a wide variety of situations to enable companies to plan and make decisions in the face of uncertainty. Perhaps the most common use of assumptions is in the accounting function, which uses assumptions to facilitate financial measurement and reporting.

According to Glenn A. Welsch, Robert N. Anthony, and Daniel G. Short, authors of Fundamentals of Financial Accounting, there are four basic, underlying assumptions in accounting: the separate-entity assumption, the continuity or going concern assumption, the time-period assumption, and the unit-of-measure assumption. The separate-entity assumption holds that the particular business entity being measured is distinct and separate from similar and related entities for accounting purposes. The continuity or going-concern assumption holds that the entity will not cease operations or liquidate its assets during the accounting period. The time-period assumption holds that accounting reports are applied to short time periods, usually one year. Finally, the unit-of-measure assumption holds that the U.S. dollar is the common denominator or measuring stick for all accounting measurements taken for American companies.

In addition to these underlying accounting assumptions, there are also a number of smaller assumptions that are commonly made in certain calculations. For example, companies must make several assumptions in computing the value of pension and medical benefits that will be provided to retirees in the future. These funds—which are built up over time and held as investments until needed, but are actually owed to employees at some future point—are reported by companies as assets and liabilities on their financial statements. The assumptions made by a company help determine the monetary amounts that are reported, and thus may affect the company's current reported earnings and tax liability.

In the case of pensions that are provided to employees following retirement, companies must make assumptions regarding the likely rate of wage inflation and the discount rate to be applied to projected future payments. Similarly, the calculation of health care benefits provided to retirees includes assumptions about the discount rate and medical cost trend rate, as well as demographic assumptions such as the employee turnover rate, the average age of employees at retirement, and the percentage of married retirees. Changing one of these assumptions can have a marked effect on a company's results. For example, increasing the discount rate reduces the present value of the company's liabilities and the amount of annual contributions that must be made to fund the retirement accounts, and therefore increases the company's current earnings.

In fact, as Peggie R. Elgin reported in an article for Corporate Cashflow Magazine, companies may be able to reduce their liabilities for retirement benefits by as much as 15 percent simply by changing their accounting assumptions. It is important to note, however, that companies must be able to justify any changes they choose to make. Some legitimate reasons for changing assumptions might include changes in the economy or in company policies, inflation in health care costs, trends in the use of medical services, or technological advances in medicine. Given the possibilities for increasing reported earnings or reducing taxes, experts recommend that companies review their accounting assumptions every few years to see whether making a change would be beneficial.

FURTHER READING:

Atrill, Peter. Accounting and Finance for Nonspecialists. Prentice Hall, 1997.

Elgin, Peggie R. "Fine-Tuning FAS 106 Assumptions Can Help Balance Sheet." Corporate Cashflow Magazine. March 1994.

Welsch, Glenn A., Robert N. Anthony, and Daniel G. Short. Fundamentals of Financial Accounting. 4th ed. Homewood, IL: Irwin, 1984.



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