A sole proprietor who owns a small consulting business deposits interest earned on her personal savings account into the business's accounting records as business revenue, because she considers all of her financial affairs to be part of one household budget. Which foundational assumption underlying U.S. GAAP financial reporting does this practice violate?
- The going concern assumption
- The economic entity assumption
- The periodicity assumption
- The full disclosure principle
Why B? And why not the others?
Correct answer: B. The economic entity assumption
The economic entity assumption requires that an entity's financial statements report only the economic activities that can be distinguished as belonging to that entity, separate from the personal financial activities of its owner or from any other economic entity, consistent with FASB Concepts Statement No. 8, Chapter 2's description of a reporting entity as a circumscribed area of economic activities distinguishable from other entities' activities; folding personal, non-business interest income into the business's books blends two separate economic entities together and breaks that boundary. The option describing the going concern assumption is wrong because that assumption addresses whether the entity is presumed to continue operating for the foreseeable future, not whose transactions belong on its books. The option describing the periodicity assumption is wrong because that assumption addresses dividing an entity's life into artificial, discrete reporting periods, which has nothing to do with separating owner and entity transactions. The option describing the full disclosure principle is wrong because that principle concerns providing sufficient information for users' needs once the correct transactions have already been identified, not which transactions belong on the entity's books in the first place.
Source: FASB Concepts Statement No. 8, Chapter 2, The Reporting Entity