Monetary Unit Principle
The Monetary Unit Principle, also known as the Monetary Unit Assumption, is a basic principle of accounting that assumes a stable currency is going to remain the principal currency for the foreseeable future. This principle allows businesses to keep their accounting records in one single currency, without considering inflation or deflation.
In essence, the Monetary Unit Principle implies two things:
- Only transactions that can be expressed in terms of money are recorded in the accounts. For example, a company’s reputation or the skills of its employees cannot be expressed in monetary terms, so they aren’t reflected in the financial statements.
- The value of the unit of currency (say, the U.S. dollar) is assumed to be stable; it does not change over time. This means that accountants do not adjust the value of assets or liabilities for changes in the purchasing power of money. For example, if a company purchased a piece of machinery for $50,000 five years ago, it will still be recorded at its original cost (plus or minus any depreciation or impairment) regardless of inflation or deflation since the purchase date.
It’s important to note that this principle doesn’t hold up perfectly in times of high inflation or hyperinflation. In these situations, adjustments for changes in purchasing power may be necessary for the financial statements to present a fair view. However, such adjustments are not commonly applied under the traditional historical cost accounting model, which is widely used in many countries.
Example of the Monetary Unit Principle
Let’s illustrate the Monetary Unit Principle with an example:
Imagine a company, JKL Corp., which bought a piece of land for $100,000 in the year 2000. Now, it’s the year 2023 and due to inflation, the general price level has risen significantly over these years. The same piece of land could be worth $200,000 in today’s market. However, according to the Monetary Unit Principle, JKL Corp. would continue to report this land on its balance sheet at the original purchase price of $100,000, not its current market value.
Similarly, JKL Corp. may have a talented team of engineers whose skills and experience significantly contribute to the company’s profitability. However, these skills and experience cannot be quantified in terms of money and hence, would not appear as an asset in the company’s financial statements.
These examples illustrate the two key assumptions of the Monetary Unit Principle:
- The accounting records are kept in terms of money, and only transactions that can be expressed in monetary terms are recorded.
- The value of money is assumed to be stable over time. Despite the effects of inflation or deflation, the original cost of assets and liabilities does not change in the company’s accounting records.
Remember, while the Monetary Unit Principle simplifies accounting, it does have its limitations. It doesn’t account for changes in purchasing power due to inflation or deflation, and it can’t capture or quantify some types of value, like the value of human capital or a strong brand name, that can’t be expressed in monetary terms.