An assumption is a statement that is presumed to be true without concrete evidence to support it. In the business world, assumptions are used in a wide variety of situations to enable companies to plan and make decisions in the face of uncertainty. Perhaps the most common use of assumptions is in the accounting function, which uses assumptions to facilitate financial measurement, forecasting, and reporting.
There are four basic types of assumptions used regularly in accounting. They are:
In addition to these underlying accounting assumptions, there are also a number of smaller assumptions that are commonly made in certain calculations. For example, companies must make several assumptions in computing the value of pension and medical benefits that will be provided to retirees in the future. These funds—which are built up over time and held as investments until needed, but are actually owed to employees at some future point—are reported by companies as assets and liabilities on their financial statements. The assumptions made by a company help determine the monetary amounts that are reported, and thus may affect the company's current reported earnings and tax liability.
In the case of pensions that are provided to employees following retirement, companies must make assumptions regarding the likely rate of wage inflation and the discount rate to be applied to projected future payments. Similarly, the calculation of health care benefits provided to retirees includes assumptions about the discount rate and medical cost trend rate, as well as demographic assumptions such as the employee turnover rate, the average age of employees at retirement, and the percentage of married retirees. Changing one of these assumptions can have a marked effect on a company's results. For example, increasing the discount rate reduces the present value of the company's liabilities and the amount of annual contributions that must be made to fund the retirement accounts, and therefore increases the company's current earnings.
The ease with which a company's current earnings may be "improved" by changed assumptions in forecasting highlights the need to avoid the natural inclination towards overly optimistic assumptions. The early 2000s have exposed serious problems for many companies and public institutions because of the overly optimistic assumptions made in the 1990s about pension fund financing.
Edward Siedle, a former Securities and Exchange Commission attorney, discusses assumption in the pension field in a Fort Worth Star-Telegram article. "In my experience, every pension fund I've ever seen has an actuarial assumption that is more akin to wishful thinking than what is reasonably foreseeable. You just want to laugh out loud." Assumptions about pension fund obligations may be somewhat more difficult than forecasting other obligations because of the long time period over which they must extend. Nonetheless, the mass failure of companies to accurately assess pension fund requirements in the 1990s shows just how important it is to base assumptions on as sound a footing as possible and avoid overly optimistic forecasts.
Experts recommend that companies review their accounting assumptions every few years to see whether making a change would be beneficial and to verify that assumptions about the economy generally are still accurate.
SEE ALSO Forecasting
Allen, Steve L. Financial Risk Management. John Wiley & Sons, 2003.
Berard, Yamil. "Overly Optimistic Assumption About Public Pension Plans Haunts Officials." Fort Worth Star-Telegram. 16 February 2005.
Gilman, Joan, and Sarah White. Business Plans that Work. Adams Media, 2001.
Pison, Linda. Anatomy of a Business Plan. Fifth Edition. Dearborn Trade Publishing, 2001.
Hillstrom, Northern Lights
updated by Magee, ECDI