What Are the Five Basic Accounting Assumptions? (Top 5 Accounting Principles)

Definition:

An accounting assumption is a set of rules that helps to ensure financial reports of the business are prepared in line with applicable accounting standards. It lays a strong foundation for consistent, reliable, objective, and valuable financial information. Accounting assumptions provide a basis for consistency and reliability that helps readers of financial statements compare financial performance and make a decision based on it.

Let’s discuss five basic accounting assumptions to be considered while preparing a financial statement.

Going concern assumption

The concept of going concern is one of the underlying assumptions applied in the preparation and presentation of the financial statements. The theme of this assumption is that business does not seem to curtail major operations during the foreseeable future. It means the business can and intends to keep the major operations of the company operational.

That’s an assumption of the going concern that validates recording the deferred revenue, deferred expenses, prepaid, accruals, etc. So, if management concludes that they won’t be able to remain in the business, the accounting standards do not allow going concern assumptions. So, in this case, financial statements have to be prepared on a different basis, like a break-up basis.

 The going concept has great significance for the stakeholders like shareholders, suppliers, customers, employees, and others as their return depends on its financial stability. However, concluding on the going concern status is a judgmental matter. Still, the following are some warnings/signs that help to assessability of the business to remain a going concern.

  1. The business finds it difficult to pay dividends.
  2. The business is facing massive financial losses.
  3. Negative retained earnings.
  4. The business is missing installments for the repayment of the debt.
  5. The operating cash flow of the company is negative.
  6. Pending regulatory proceeds are expected to have a massive impact on the stability of the company.

It’s important to note that the given list of signs/warnings is not exhaustive; there may be several other factors that impact the going concern status of the business.

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Consistency assumption

The consistency principle states that an accounting policy/method, once adopted, should be consistently practiced. The adoption of this accounting policy brings an element of comparability. In other words, the set of financial statements can only be compared when accounting treatment and presentation of both financial statements are the same; otherwise, there will be a need to make adjustments.

However, it’s not like this that accounting policy, once selected, can never be changed. However, there is a need for strong logic that reflects enhancement in the quality of financial reporting if accounting policy/method is to be changed.  In addition to this, the impact of changing accounting policy/method has to be disclosed in the financial statements. Further, consistent accounting policies bring comparability and familiarization that helps to bring efficiency in time and cost management for the financial reporting.

Economic entity concept

An economic entity concept states that a business is a separate entity from its owners or other businesses. Hence, the record of business must be separate from the personal expenses of the owner. If there is no separation of accounting records, it will not be possible for the reader to assess the business’s financial performance.

In simple words, the business only needs to record transactions that are related to it. For instance, if a personal house of the owner is recorded in the financial statements, it will violate an economic entity concept because the personal house of the owner has nothing to do with the business.

The application of the economic entity concept has significant importance because of the following reasons.

  1. Each business is taxed separately. Hence, their income, expenses, assets, and liabilities should be kept separately.
  2. If the economic entity concept is not followed, it will be difficult for an auditor to perform audit procedures and formulate their opinion on the financial statements.
  3. Business performance can only be assessed if the record of the business has been kept separately.

Reliability assumption

The reliability assumption means the company has objective evidence of its recorded information in the financial statements. It means management must have some form of evidence to prove ownership of the assets and obligation for paying liabilities recorded in the financial statement.

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The evidence may be in bills, bank statements, invoices, and some other documents. The assumption of reliability is more relevant when we speak about an audit of the financial statements. Since auditors do perform procedures to assess authorization, support, and approval of the transactions. Further, an external document as evidence is considered to be more reliable than the documents generated internally.

Application of reliability assumption is not always straightforward as some account balances require judgment in finalizing their amount. For instance, reserves for the sales return, inventory obsolesce, allowance for doubtful receivables, and amount of depreciation, etc. The company’s management is expected to have reliable regulatory measures to calculate these balances.

Element of reliability on the financial statements is essential for the external stakeholders like shareholders, suppliers, tax authorities, and other business partners as they rely on that.

Assumption of a time period

Time period assumption requires companies to report their financial statement at specific and appropriate time periods.  The reporting period may be monthly, quarterly, half-yearly, annual, and any other period an owner wants to get financial information for.

Application of time period assumption enables companies to divide their financial information into specific periods. This helps them to study the pattern of financial performance and to set an appropriate action if required. Further, it helps the financial statement reader to ascertain the period for which they are reading the financial statements.

An assumption behind the time period assumption is that businesses can accurately allocate revenues and expenses to specific periods. However, it’s not always straightforward to ensure accurate allocation. For instance, a depreciable amount is charged in different periods based on the estimate.

Hence, there is the significant importance of the specific reporting periods. Otherwise, the financial statement reader may not compare business performance with different periods or get a trend of performance.

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Frequently asked questions

What is the role of accounting assumptions in the process of financial reporting?

Accounting assumptions are essential because they facilitate financial statement usage in terms of forecasting, performance comparison, enhanced reliability, and availability of structured financial data.

What’s the responsibility of the auditor for going concern status of the company?

An auditor is responsible for assessing the appropriateness of the management’s assumption that the company is going concerned. It can be done by collecting sufficient and appropriate audit evidence and observing if there is something to believe the company is not concerned about.

There is no set of rules to indicate if the company is going concerned or no. However, certain warnings or signs need to be considered while concluding the company’s going concern status.

What’s the role of financial analysis in assessing the going concern status of the company?

Financial analysis is one of the key aspects for assessing the company’s going concern status because it helps to understand its financial position deeply. For instance, if the company has accumulated losses/negative retained earnings, negative operating cash flow, meager current ratio, and a higher proportion of debt. It raises questions on the going concern status of the company.

What’s the role of auditors in verifying reliability assumptions?

Verifying the accuracy of the accounting record is one of the essential purposes of audit activity. So, auditors not only need to collect audit evidence but need to verify its appropriateness. Hence, the assessment of reliability for the accounting record is one of the essential objectives of the auditor.

Who is primarily responsible for assessing the going concern concept?

Management of the company is primarily responsible for assessing the company’s going concern status, and auditors need to assess if it’s appropriate for the management to use this assumption.

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