Periodicity Assumption
The periodicity assumption, also known as the time period assumption, is an accounting guideline which states that the economic life of a business can be divided into artificial time periods. These time periods, or intervals, are typically a month, quarter, or a year, although it could be any interval of time over which the business wants to measure financial performance and financial position.
The periodicity assumption allows for the preparation of interim reports, balance sheets, and income statements at regular intervals. This is useful for investors, managers, and other stakeholders who need regular information to make informed decisions about the business.
For example, a company may prepare quarterly financial statements to give a snapshot of its performance over the past three months. These financial statements can then be used by management to track progress, make business decisions, and spot financial trends.
Despite these benefits, it’s important to remember that dividing a business’s life into time periods is an artificial construct. Some business activities span multiple time periods, and allocating these activities to a single time period can be somewhat arbitrary. But despite this limitation, the periodicity assumption is a fundamental concept in accounting that helps to provide timely and relevant financial information.
Example of the Periodicity Assumption
Let’s consider an example of a manufacturing company that buys a machine for its production process.
- Purchase of Equipment: The company buys a machine for $120,000. This machine has a useful life of 10 years and no salvage value at the end of its useful life. The machine’s cost will be spread over its useful life in the form of depreciation expense, which is a method of allocating the cost of a long-term asset over the periods in which the asset is used. This is a direct application of the periodicity assumption.
- Depreciation Expense : Using straight-line depreciation (which spreads the cost evenly over the useful life of the asset), the annual depreciation expense would be $120,000 / 10 years = $12,000 per year. This expense would be recorded each year, reducing the value of the machine on the company’s balance sheet by $12,000 and recording a $12,000 expense on the income statement.
- Interim Reporting: Furthermore, if the company is preparing quarterly reports, it will record a depreciation expense of $12,000 / 4 = $3,000 every quarter, further applying the periodicity assumption by dividing the year into smaller periods.
So, despite the machine being a single, long-term purchase, the periodicity assumption allows the company to split the cost of this asset over the periods in which it’s used. This provides a more accurate picture of the company’s financial performance and position during those periods.
