Explain How the Continuity Assumption and the Historical Cost Principle

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The Answer is Expenses, a component of earnings, are measured in terms of the historical cost of resources (assets) consumed or used in producing revenue because, under the continuity assumption, there is no assumption that the assets used in operations will be sold. Using historical cost allows an evaluation of how management created value with the assets entrusted to them, measured at the actual cost of those resources. Thus, income reflects the excess of revenues over the historical cost, rather than market value, of the resources used.
An alternative approach to earnings measurement, not supported by the continuity assumption, would employ market values of revenues and costs (expenses) to determine an "opportunity" cost measure of earnings.
The continuity assumption also supports the inclusion of certain costs in assets used in operations, as opposed to immediate expensing of those costs, even though there is no expectation that such costs will be recouped on sale of the asset. The value of such operational assets is derived through use, rather than from sale, under the continuity assumption. Specific examples include installation costs of equipment, and many prepaid assets such as prepaid rent. In the latter example, if the firm were not a going concern, prepaid rent would not represent an asset beyond the liquidation date.

Explain How the Continuity Assumption and the Historical Cost Principle

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