Accounting assumptions are defined as rules of action or conduct which are derived from experience and practice, and when they prove useful, they become accepted principles of accounting.
4 basic assumptions of accounting are the pillars on which the structure of accounting is based. They are part of GAAP (Generally Accepted Accounting Principles).
4 Accounting Assumptions are;
- Business Entity Assumption.
- Money Measurement Assumption.
- Going Concern Assumption.
- Accounting Period Assumption.
And 4 basic accounting assumptions are part of GAAP, accounting principles, and the double-entry system.
The basic accounting assumptions are like the pillars on which the structure of accounting is based.
Business Entity Assumption
According to this assumption, the business is treated as a unit or entity apart from its owners, creditors, managers, and others.
In other words, the proprietor of an enterprise is always considered to be separate and distinct from the business which he controls.
All the transactions of the business are recorded in the books of the business from the business. Even the proprietor is treated as a creditor to the extent of his capital.
Upon investment of money in the business by the proprietor, it is deemed that the proprietor has given money, and the business has received the money.
The assumption of the separate entity applies to all forms of business organizations.
For example, from a legal point of view, a body corporate is a separate entity, and the sole trader and his business are regarded as the same thing.
But for accounting purposes, they are regarded as different entities. For recording the transactions, it is the business that is the entity and with which we are concerned.
The assumption of the business as a separate legal entity as distinct from its owners has been well accepted about companies all over the world since the legal decision in the case of Salmon vs. Salmon & Co. (1897).
Though this legal assumption has not been extended to the sole trader and partnership business firms, for purposes of accounting, all transactions should specifically relate to the business operations of the entity itself.
In a partnership business, the firm is quite separate from the individual partners who are its members and who have agreed to come together in a formal way to attain an agreed objective.
Still, each partner has his own separate life and may have many interests – financial and otherwise, outside the partnership.
It is most desirable that the dealings and transactions of the partnership business should be recorded in a firm’s books.
If any partner enters into private financial dealings, e.g., to purchase or sell equity shares in a limited company, it has no relevance to the partnership business, and so it should not be recorded in a firm’s books.
Similarly, a sole proprietor may have many interests apart from or in addition to his business.
But these should not be included in the firm’s books if they are not connected with it.
- Only the business transactions and not the personal transactions of the proprietor are recorded and reported.
- The personal assets of the owners or shareholders are not considered while recording and reporting the assets of the business entity.
- Income is the property of the business assets distributed to owners.
The economic entity assumption means that economic activity can be identified with a particular unit of accountability.
In other words, a company keeps its activity separate and distinct from its owners and any other business unit.
An individual, department, division, or an entire industry could be considered a separate entity if we choose to define it in this manner.
Thus, the entity concept does not necessarily refer to a legal entity.
A parent and its subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes does not violate the economic entity assumption.
Money Measurement Assumption
The monetary unit assumption means that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis.
That is, the monetary unit is the most effective means of expressing to interested parties changes in capital and exchanges of goods and services.
The monetary unit is relevant, simple, universally available, understandable, and useful.’
The application of this assumption depends on the even more basic assumption that quantitative data are useful in communicating economic information and in making rational economic decisions.
The money measurement assumption underlines the fact that in accounting, every worth-recording event, happening, or transaction is recorded in terms of money.
The general health condition of the chairman of the company, working conditions in which a worker has to work, sales policy pursued by the enterprise, quality of products introduced by the enterprise, etc., cannot be expressed in terms of money and thus are not recorded in the books.
Because of the above conditions, this concept puts a serious handicap on the usefulness of accounting records for management decisions.
In spite of the above limitations of the money measurement assumption, it remains indispensable.
This assumption increases the understanding of the state of affairs of the business.
For example, if a business has a cash balance of $7,000, a building containing 20 rooms, a piece of land of 2,000 square meters, 40 tables, 20 fans, 2 machines, one tone of raw material, and so on, then in the absence of money measurement assumption the value of different types of assets cannot be measured by the simple method if addition.
But if they are expressed in monetary terms – $7,000 cash, $50,000 for building, $2,00,000 for land, $8,000 for tables, $6,000 for fans, $1,60,000 for machines, $80,000 for raw material.
It is possible to add them and use them for comparison or any other purpose.
This assumption has another serious limitation and is currently attracting the attention of accountants the entire world over.
As per this assumption, a transaction is recorded at its money value on the date of occurrence, and the subsequent changes in the money value are conveniently ignored.
For example, a building purchased for $50,000 in 1960 and another purchased for the same amount in 1992 are recorded at the same price, although the one purchased in 1960 may be worth four times more than the value recorded in the books, due to rising in land value and construction costs (conversely, because of the fall in the money value).
Inflation accounting seeks to deal with this type of problem.
Going Concern Assumption
It is also known as continuity assumption.
Most accounting methods rely on the going concern assumption—that the company will have a long life. Despite numerous business failures, most companies have a fairly high continuance rate.
As a rule, we expect companies to last long enough to fulfill their objectives and commitments.
This assumption has significant implications. The historical cost principle will be of limited usefulness if we assume eventual liquidation.
Under a liquidation approach, for example, a company would better state asset values at net realizable value (sales price fewer costs of disposal) than at acquisition cost.
Depreciation and amortization policies are justifiable and appropriate only if we assume some permanence to the company.
If a company adopts the liquidation approach, the current/non-current classification of assets and liabilities loses much of its significance.
Labeling anything a fixed or long-term asset would be difficult to justify. Indeed, listing liabilities on the basis of priority in liquidation would be more reasonable.
The going concern assumption applies in most business situations.
Only where liquidation appears imminent is the assumption inapplicable.
In these cases, a total revaluation of assets and liabilities can provide information that closely approximates the company’s net realizable value.
According to the going concern assumption, the enterprise is normally viewed as a going concern, i.e., continuing in operation for the foreseeable future.
It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing the scale of its operations materially. It is because of the going concern assumption:
- That the assets are classified as current assets and fixed assets.
- The liabilities are classified as short-term liabilities and long-term liabilities.
- The unused resources are shown as unutilized costs (or unexpired costs) as against the break-up values, as in the case of a liquidating enterprise. Accordingly, the earning power and not the break-up value evaluate the continuing enterprise.
According to accounting standards, if this concept is followed, this fact needs not be disclosed in the financial statements since its acceptance and use are assumed.
In case this concept is not followed, the fact should be disclosed in the financial statements together with reasons.
Why is the going concern assumption important in the preparation of financial statements?
Going concern assumption is one of the fundamental assumptions in accounting on the basis of which financial statements are prepared.
Financial statements are prepared to assume that a business entity will continue to operate in the foreseeable future without the need or intention on the part of management to liquidate the entity or to curtail its operational activities significantly.
Therefore, it is assumed that the entity will realize its assets and settle its obligations in the normal course of the business.
It is the responsibility of the management of a company to determine whether going a concern assumption is appropriate in the preparation of financial statements.
If the going concern assumption is considered by the management to be invalid, the financial statements of the entity would need to be prepared on a break-up basis.
This means that assets will be recognized at an amount that is expected to be realized from its sale (net of selling costs) rather than from its continuing use in the ordinary course of the business.
Assets are valued for their individual worth rather than their value as a combined unit. Liabilities shall be recognized at amounts that are likely to be settled.
It is also known as the periodicity assumption or period assumption.
To measure the results of a company’s activity accurately, we would need to wait until it liquidates. Decision-makers, however, cannot wait that long for such information.
Users need to know a company’s performance and economic status on a timely basis so that they can evaluate and compare firms and take appropriate actions.
Therefore, companies must report information periodically.
The periodicity (or time period) assumption implies that a company can divide its economic activities into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly.
The shorter the time period, the more difficult it is to determine the proper net income for the period.
A month’s results usually prove less reliable than a quarter’s results, and a quarter’s results are likely to be less reliable than a year’s results.
Investors desire and demand that a company quickly process and disseminate information.
Yet, the quicker a company releases the information, the more likely the information will include errors.
This phenomenon provides an interesting example of the trade-off between relevance and reliability in preparing financial data.
The problem of defining the time period becomes more severe as product cycles shorten and products become obsolete more quickly. Many believe that, given technology.
According to this assumption, the economic life of an enterprise is artificially split into periodic intervals, which are known as accounting periods, at the end of which an income statement and financial position statement are prepared to show the performance and financial position, the use of this assumption further requires the allocation of expenses between capital and revenue.
That portion of capital expenditure, which is consumed during the current period, is charged as an expense to the income statement, and the unconsumed portion is shown in the balance sheet as an asset for future consumption.
Truly speaking, measuring the income following the concept of the accounting period is more an estimate than factual since actual income can be determined only on the liquidation of the enterprise.