FUNDAMENTAL ACCOUNTING ASSUMPTIONS

Going Concern AssumptionThe 'going concern' concept directs accountants to prepare

financial statements on the assumption that the business is not about to go broke or be liquidated (i.e. where the business closes and sells all the assets for whatever price they can get).

So, unless there is significant evidence to the contrary, accountants will base their valuations and their reporting of financial data on the assumption that the business will remain in existence for an indefinite period.

An indefinite period means the foreseeable future or long enough for the business to meet its objectives and to fulfil its commitments. It is important to note that the 'going concern' concept does not imply or guarantee that the business is profitable and will remain so for the foreseeable future.

Example A bank is in serious financial troubles and the

government is not willing to bail it out. The Board of Directors has passed a resolution to liquidate the business. The bank is not a going concern.

Accrual AssumptionUnder the accrual basis accounting, business transactions

specifically those relating to income and expenses are recognized and recorded in the books the moment the substance of the transaction has been perfected.

Generally Accepted Accounting Principles (GAAP) prefers that financial statements are based entirely on the accrual basis accounting instead of the cash basis accounting.

In its simplest terms, the accrual basis accounting assumes that income is recognized when earned regardless of the date of payment. On the other hand, expenses are recorded when incurred regardless of whether it was paid in cash or in credit terms.

Accounting Principles

Business Entity ConceptIn accounting, business is treated as separate entity from its

owners. Accounts are prepare to give information about the business and not about those who own it. a distinction is made between business transactions and personal transactions. Without such a distinction, the affairs of the business will be mixed up with the private affairs of the proprietor and the true picture of the firm will not be available. The 'Business' and 'owner' are taken as two separate entities. The accountant is interested to record transactions relating to business only. The private transactions of the owner will be recorded separately and will have no bearing on the business transactions. All the transactions of the business are recorded in the books of the business from the point of view of the business as an entity and even the proprietor is treated as a creditor to the extent of his capital.

The concept of separate entity is applicable to all of business organizations. For example, in case of a sole proprietorship business or partnership business, though the sole proprietor or partners are not considered as separate entities in the eyes of law, but for accounting purposes they will be considered as separate entities. In the case of joint stock company, the business has a separate legal entity than the shareholders. The coming and going shareholders don not affect the entity of the business. Thus, the distinction between owner and the business unit has helped accounting in reporting profitability more objectively and fairly. It has also led to the development of 'responsibility accounting' which enables us to find out the profitability of even the different sub-units of the main business

Money Measurement Concept:The money measurement concept underlines the fact that

in accounting, every recorded event or transaction is measured in terms of money. Using this principle, a fact or a happening which cannot be expressed in terms of money is not recorded in the accounting books. Thus, it is not acceptable to record such non-quantifiable items as employee skill levels or the quality of customer service.

One of the basic principles in accounting is "The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency.

This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements. The inflation which occurs over the passage of time is not considered."[2]

ExampleFor example, if a business has got a team of

dedicated and trusted employees, it is definitely an asset to the business, but since their monetary measurement is not possible, they are not shown in the books of business. It should be remembered that money enables various things of diverse nature to be added up together and dealt with. The use of a building and the use of clerical service can be aggregated only through money values and not otherwise.

Accounting period concept:According to this concept, the life of the business is

divided into appropriate segments for studying the results shown by the business after each segment. Since the life of the business is considered to be indefinite (according to going concern concept) the measurement of income and studying financial position of the business according to the above concept, after a very long period would not be helpful in taking proper corrective steps at the appropriate time. It is, therefore, absolutely necessary that after each segment or time interval the businessman must stop and see, how things are going on. In accounting such a segment or time interval is called accounting period. It is usually of a year.

 

At the end of each accounting period and Income Statement/Profit & Loss Account and a Balance Sheet are prepared. The income statement discloses the profit or loss made by the business during the accounting period while Balance Sheet discloses the financial position of the business as on the last day of the accounting period. While preparing these statements a proper distinction has to be made between capital and revenue expenditure.

Full Disclosure PrincipleThe full disclosure principle states that you

should include in an entity's financial statements all information that would affect a reader's understanding of those statements. Your interpretation of this principle is highly judgmental, since the amount of information that can be provided is potentially massive. To reduce the amount of disclosure, it is customary to only disclose information about events that are likely to have a material impact on the entity's financial position or financial results.

ExampleThe nature and justification of a change in

accounting principleThe nature of a non-monetary transactionThe nature of a relationship with a related

party with which the business has significant transaction volume

Prudence or Conservatism PrincipleThe conservatism principle is the general concept of

recognizing expenses and liabilities as soon as possible when there is uncertainty about the outcome, but to only recognize revenues and assets when they are assured of being received. Thus, when given a choice between several outcomes where the probabilities of occurrence are equally likely, you should recognize that transaction resulting in the lower amount of profit, or at least the deferral of a profit. Similarly, if a choice of outcomes with similar probabilities of occurrence will impact the value of an asset, recognize the transaction resulting in a lower recorded asset valuation.

ExampleAlso, for example, if a loss is foreseen, it

should be taken into account immediately: If a business purchases stock for £1,200 but then because of a sudden slump in the market, it can only be sold for £900, then the stock should be valued at £900 in the accounts,

Matching concept principleThe aim of business is to earn profit. In order to ascertain

the profit the costs (expenses) are matched to revenue. The difference between income from sales and costs of producing the goods will be the profit. When business is taken as a going concern then it becomes necessary to evaluate the performance periodically.A correct statement of income requires a distinction between past, present and future expenditures. A distinction between capital and revenue expenditure is also necessary. The revenues and costs of same period are matched. In other words, income made by the business during a period can be measured only when the revenue earned during a period is compared with the expenditure incurred for earning that revenue. The question when the payment was received or made is irrelevant.

Example

Accrued expense allows one to match future costs of products with the proceeds from their sales prior to paying out such costs.

Deferred expense (prepaid expense) allows one to match costs of products paid out and not received yet.

Depreciation matches the cost of purchasing fixed assets with revenues generated by them by spreading such costs over their expected life.

Dual Aspect Concept:

This is the basic concept of accounting. Modern accounting system is based on dual aspect concept. Dual aspect concept may be stated as "for every debit, there is a credit". Every transaction should have two sided effect to the extent of same amount. For example, if A starts a business with a capital of $10,000. There are two aspects of the transaction. On the one hand the business has assets of $10,000 while on the other hand the business has to pay to the proprietor a sum of $10,000 which is taken as proprietor's capital. This expression can be shown in the form of following equation: 

Capital (Equities)=Costs (Assets) 10,000=10,000

The term 'assets' denotes the resources owned by a business while the term 'equities' denotes the claims of various parties against the assets. Equities are of two types. They are owners equity and outsiders equity. Owner's equity (or capital) is the claim of the owner's against the assets of the business while outsiders equity (liabilities) is the claim of outside parties against the assets of the business. Since all assets of the business are claimed by someone (either owners or outsiders), the total of assets will be equal to total of liabilities. Thus:  Equities=Assets  OR Liabilities+Capital=Assets

Suppose if the business borrows $5000 from a bank, dual aspect of this transaction will be   Capital + Liabilities=Assets

 5,000=5,000Thus the accounting Equation states that at any point of time

the assets of any entity must be equal (in monetary terms) to the total of owner's equity and outsider's liabilities. As a mater of fact the entire system of double entry accounting is based on this concept.

Revenue recognition Concept

The revenue recognition principle states that, under the accrual basis of accounting, you should only record revenue when an entity has substantially completed a revenue generation process; thus, you record revenue when it has been earned. For example, a snow ploughing service completes the ploughing of a company's parking lot for its standard fee of $100. It can recognize the revenue immediately upon completion of the ploughing, even if it does not expect payment from thecustomer for several weeks.

Also under the accrual basis of accounting, if an entity receives payment in advance from a customer, then the entity records this payment as a liability, not as revenue. Only after it has completed all work under the arrangement with the customer can it recognize the payment as revenue.

THE END