Monetary unit assumption states that only transactions which can be measured in monetary terms are recorded in a company’s books of accounts. If a transaction cannot be expressed in dollar value, it should not be included in the company’s financial books. It is considered useless for financial accounting purposes.
The monetary unit is an easy and universally recognized form of communicating financial information. It is an effective basis of recording, reporting and analyzing financial data which can help businesses make rational decisions.
Why Money?
Money performs several key functions, making it important to be the main form of financial communication for businesses:
- It is a medium of exchange
- It serves as a store of value
- It is used as a standard of deferred payments
- It is a unit of account
Two-Part Assumptions
Assets, revenues, liabilities, and expenses have to be recorded at their dollar values or any other monetary unit. However, this may be quite difficult to do in certain situations. A company’s greatest strength could be the skill and talent of its business or engineering team.
This is significantly harder to put a monetary value upon and so, will not be considered for inclusion in the books of accounts. This is because the company is allowed to only include those transactions that have a monetary value.
In addition to the monetary unit assumption, another related concept is also followed by a company when recording in its books of accounts. The “stable dollar value assumption” states that the dollar is not subject to the loss of purchasing power over time. This is why the entries in a company’s book of accounts do not take inflation into account.
Both these assumptions are significant as they help form the foundation on which a company’s books of accounts are created. Analysts who study a company’s books of accounts assume that the accountant who has prepared them has followed the aforementioned principles. This helps them to understand the company’s performance, assess its financial situation and compare it with other firms.
Monetary Unit Assumption Examples
Example 1
Let’s suppose XYZ Limited bought a plot of land in 1992 at a cost of $50,000. It recorded the newly purchased land with a value of $50,000 in its books. Now, in 2019, XYZ Limited bought an adjacent plot of land at a cost of $300,000. It will record both plots of land at an amount of $350,000 ($50,000 + $300,000).
There is a significant difference in the purchasing power between 1992 and 2019, but under the monetary unit assumption, it is ignored.
Example 2
Suppose IJ&K Creatives has very talented, skilled, and passionate designers and animators. The company cannot record them as their assets under the monetary unit assumption. This is because the monetary unit assumption instructs the company to record only those transactions that can be measured in monetary value in its books. The designers and animators cannot be expressed in dollars. Similarly, an organization cannot express the skills of an individual in dollars.
Example 3
In the night a retailer has his store vandalized. The windows are broken, the inside of the store is in shambles and inventory has been stolen. The retailer will only report a loss on the damaged property in his financial statement. He will not report the financial loss occurred due to the potential loss of sales from the store closing down for repairs. Lost sales are hypothetical and can’t be measured in real monetary value.
Example 4
ABC School has been headlined in a scandal and many parents have boycotted the school in protest. ABC School does not report a loss at all on its financial statements because of the monetary unit assumption, even though it might have experienced a decrease in revenue. Since a boycott is not considered a business transaction, the monetary unit dictates that ABC shouldn’t report anything.
Implications of Monetary Unit Assumption
There are certain implications that come with the usage of Monetary Unit Assumption:
- A company has to record every transaction in a monetary unit. The reason for this is that the monetary unit brings a lot of stability in the long run.
- A company has to record every business event in a monetary unit i.e. USD. This is because the monetary unit brings stability in the long run.
- A company’s books should contain only those events and transactions that can be measured in the form of a monetary unit. If an event or transaction cannot be measured in dollar form, it should not be included in a company’s books of accounts.
Problems with Monetary Unit Assumption
Though the monetary unit assumption makes accounting more manageable, it can sometimes present problems. The monetary unit assumption comes with a few problems when a company records its books of accounts:
- One problem with the monetary unit assumption is that it disregards the effects of inflation when recording. For example, as stated in the previous example, a plot of land purchased in 1992 at a cost of $50,000 was still recorded at $50,000 even in 2019. There has been a definitive change in the purchasing power of the dollar since 1992, but the monetary unit assumption does not take this into account.
- Another problem with this assumption is that it can be deceiving or misleading for external users of financial statements. For example, XYZ Limited has land worth $350,000. It might not be $350,000 currently, as $50,000 out of $350,000 is from 1992.
Conclusion
Monetary unit assumption helps makes accounting simpler, as companies do not have to convert long-term assets to their current value every year. The most effective way to communicate economic activities is through the dollar. It gives a quantifiable value to any activity, making it easier to record that activity in the financial statements.
Money is universal, comprehensible, understandable, and the easiest way to convey financial activities. It is the common denominator in all economic and financial transactions. This is why it makes for a good basis when comparing companies and other accounting measurements. In other words, accounting considers transactions that can be communicated in monetary value.
FAQs
1. What is the monetary unit assumption?
The monetary unit assumption is the principle that every business event and transaction must be expressed in terms of a common denominator currency.
This assumption dictates that a company records its books of accounts in terms of a specific global currency, usually the US dollar.
2. What are monetary units?
The monetary unit is an easy and universally recognized form of communicating financial information. It is an effective basis for recording, reporting, and analyzing financial data which can help businesses make rational decisions.
3. What is a problem with the monetary unit assumption?
One problem with the monetary unit assumption is that it disregards the effects of inflation when recording. Another problem with this assumption is that it can be deceiving or misleading for external users of financial statements.
4. Why is monetary unit assumption a part of GAAP?
The monetary unit assumption is a part of Generally Accepted Accounting Principles (GAAP) because it provides a sound basis for recording and reporting financial transactions. This principle allows businesses to compare their financial performance with other organizations using the same common currency.
Moreover, the monetary unit assumption facilitates international business transactions. This means that companies can be more transparent and comparable in their financial statements, regardless of their location.
5. Is the monetary unit assumption affected by inflation?
Yes, the monetary unit assumption is affected by inflation. Inflation is a general increase in the prices of goods and services in an economy. This means that the purchasing power of a currency diminishes over time as the cost of goods and services rises.
