Time Period Assumption
Time period assumption is the period in which businesses divide ongoing business into shorter periods to prepare the financial statements. The time period assumption usually monthly, quarterly, or annually. The business operation will continue for a long time, but accountant needs to prepare financial statements for the management to make a proper and timely decision. Annual reports are usually called the physical year, and any report less than that is called an interim report.
The time period assumption will be the header of company financial statements such as income statement, balance sheet, and cash flow. The income statement will show us the company performance over a period of one month, quarterly, or annually. On the other hand, balance sheet will show the financial position of accounting equation (Asset = Liability + Equity). Finally, the Cash Flow Statement will show the change of company cash flow during one accounting period.
The accounting period needs to be consistent from one period to the next, we cannot change the period so often as it will impact the comparative report. The management will find it difficult to use the report while the coverage period keeps changing. In the end, it will lead to the wrong decision due to a misunderstanding of the accounting period.
Important of Time Period Assumption
To Access Performance and Set Overall Business Strategy
With financial information at the end of each accounting period, we will be able to tell how good the company is performing. The management needs to continue the right thing and prevent any past mistakes from occurring again. By looking at the result, we will be able to know the cause of actions to improve future plans. This also a tool to access employee and team performance to give rewards for future motivation.
The top management needs this information to prepare for the business strategy such as seeking more loans, sell or purchase a new asset, and so on.
Provide Information to both Internal and External Parties
All related parties need to know company performance and financial position to make proper decisions.
Bank need to review the financial statement before deciding to provide more loans or overdrafts.
Shareholders always keep an eye on company performance, they will buy more shares if they believe company is on the right track. On the other hand, they will dump the share when the company has poor performance and does not have good planning.
So it is very important for the company to publish a reliable financial report to let them know about company performance.
Relationship between the Time Period Assumption and Accrual Accounting
The accounting period will reflect the amount of revenue and expense recording within each period. Under accrual accounting, revenue and expense are expected to record when it occurs rather than paid or collect. The transactions are not easily separate between each accounting period especially the sale and expense happen the end of the period. The accountant needs to estimate and make an assumption on the amount which needs to record into the income statement.
Matching Principle
Under matching principle, revenue and expenses need to record in the same period if they are connected. The revenues are the result of the occurrence of expense, so both need to record in the same accounting period otherwise the profit will fluctuate.
Example
Company ABC has engaged in a new contract amount of $ 5 million and it needs to spend 5 years to complete the work. Base on the budget, they expect to make a profit of 20% from this contract. Company publishes the financial statement every year after they are audited by an independent auditor.
Company needs to allocate the total revenue into 5 separate accounting periods.
Revenue = $ 5 million / 5years = $ 1 million per year
Cost = ($ 5million * 80%) / 5years = $ 0.8 million per year
We assume the cost and work in progress are equally allocated within 5 years. It is a very straightforward example, which we try to illustrate the concept of the matching principle. The real construction contract is very complicated and it requires further explanation which you can find in the following link.
