Businesses follow some theoretical accounting assumptions when preparing a company's financial statements. According to the FASB (Financial Accounting Standards Board), accounting assumptions are rules that ensure an organisation's business operations run efficiently. This process ultimately lays out consistent, reliable, and valuable information to the business. Keep reading to learn more about the seven basic accounting assumptions and examples of accounting assumptions.
Did You Know? Going concern, Accrual and Consistency assumptions are the three basic accounting assumptions as per AS - 1 of ICAI.
What are Accounting Assumptions?
A business's organisation and operations are based on accounting assumptions. They structure how to record business transactions. The company may need to alter the business's financial information if any of these assumptions are false. Accounting assumptions underlie GAAP, the foundation of all its concepts and standards. In some cases, accounting assumptions are derived from old accounting practices, while in others, they are derived from regulatory bodies such as the FASB (Financial Accounting Standards Board).
Importance of Accounting Assumptions
Accounting assumptions help in providing basics for reliability that helps business to predict their business financial future and more. It is important in many ways and some are mentioned below:
These assumptions significantly impact the company, its management, and the financial statement readers. The framework facilitates the development of reliable and consistent information.
Doing so makes financial statements more reliable, verifiable, and objective. An organisation's financial records are evaluated and confirmed by such assumptions so that users can assess its economic well-being and evaluate the authenticity of its financial records. These assumptions undoubtedly establish credibility.
Accounting assumptions provide a systematic method for recording and reporting an organisation's accounting transactions for a specific period. Accountants and investors can use accounting assumptions to verify financial statements' accuracy, reliability, authenticity, and comparability over different accounting periods.
You can make investment decisions based on a company's financial statement's genuineness, reliability, and financial results. Management can make necessary decisions by using the results of the financial statements. Doing so reduces or eliminates the possibility of errors and fraud.
Advantages of Accounting Assumptions
Investors benefit from accounting assumptions as well as companies and their management. The following are some of these benefits:
Investors of all kinds can benefit from these, whether they are potential or existing investors.
By assessing the company's financial statements, investors can determine its accurate and fair view of its financial health.
By using their reasoning, investors can make crucial investment-related decisions.
False representations of transactions do not manipulate a company's financial statements.
An organisation's management can also benefit from these. As a result of these results, the direction of an entity can make appropriate decisions and ensure that the entity continues to perform well.
Companies can achieve their long- and short-term business goals and objectives through it.
Types of Accounting Assumptions
Listed below are the four main types of accounting assumptions as per the Indian accounting standards.
Going Concern Assumption
In accounting, a "going concern" assumption is that you can expect a business to continue operating for at least the next 12 months. You can also assume that the company plans to generate income during the following year, meet its obligations, and won't need to liquidate.
It is crucial to make this assumption because it allows for proper accounting of fixed assets and depreciation. We assume the business is not at risk of shutting down in the future since we use the historical cost method for asset valuation. You must determine the value of such assets based on market value if this is the case. The increase or decrease in asset prices is not considered in the case of a going concern.
The Consistency Assumption
In accounting, consistency assumes that the same accounting guidelines are followed from one period to the next. Changes only occur occasionally. Accounting policies are supposed to be consistent from period to period.
According to this assumption, things followed in accounting remain the same unless and until they are specified in accounting policies, procedures, standards, etc. Having uniform financial statements over time allows for consistency in financial reporting years. As a result, potential investors and other external stakeholders can more easily compare financial statements from previous years.
Also Read: What is the List of Accounting Standard
How Consistency Assumption Helps Companies?
Using the same accounting treatments and methodologies over several years allows management to draw accurate conclusions about a company's performance. An essential part of management's decision-making and planning processes is technology. It does not mean you cannot change accounting policies to stay updated with the times. The assumption does not entirely preclude change. Under the following conditions, changes may be necessary.
An entity may have to change its accounting policy due to statutory requirements.
Other times, they can better represent their accounts with a policy change.
The ICAI Accounting Standards have been amended so that books of accounts comply.
The Accrual Assumption
'Accrual' accounting recognises transactions as soon as they occur, regardless of whether cash or cash equivalents are received/paid. Using an accrual basis makes it easier to match revenue and costs. Instead of operating cash flow to calculate profits and losses, enterprises use accruals. A book of accounts is filled with accounting transactions as soon as they occur according to this assumption. It is known as the Mercantile System. Contrary to the cash system, it would help if you recognised revenue and expenditure in the year of incurring in the accrual concept.
As a result, you should recognise the revenue in the year of realising it. Imagine that XYZ and Co. made ₹10,000/- in credit sales in January 2008. Those funds had received only ₹7,000/- by 31st March, while ₹3,000/- was still outstanding. Regardless of how much money was received, the entire ₹10,000/- will be recognised in 2007-2008.
The Reliability Assumption
The reliability assumption states that companies record accounting practices should only record transactions based on reliability. As a result, businesses must provide evidence of transactions, such as receipts, billing statements, invoices, and bank statements. According to this assumption, companies can record transactions that they can prove. Business receipts, bills, invoices, and bank statements are examples of proofs of transactions that need to be provided by businesses. There must be some objective evidence for a transaction to be reported in an accounting record. The objectivity assumption is often referred to as this assumption.
The Time Period Assumption
According to the Financial Accounting Standards Board, the time period assumption is another fundamental accounting assumption. In other words, this assumption implies that a company should maintain and report on its accounting methods and practices for a specific period. Additionally, these periods should be consistent throughout the business's existence. Records should be compared over a consistent period, whether monthly, quarterly, biannual, or annual.
The Economic Entity Assumption
A business's transactions are separate from its owner's under the economic entity assumption. An organisation's divisions can also be separated. Depending on the business operations, each unit maintains its accounting records. In particular, small businesses should make use of the economic entity assumption. Assume that a business's accounting records will be kept separate from the owner's accounts. Accounting practices should never mix business transactions with confidential transactions of business owners. Small, family-owned businesses are particularly vulnerable to this problem.
The Monetary Unit Assumption
The monetary unit principle allows companies to express and measure all transactions or economic events in their accounts in monetary terms. Following the monetary unit assumption, you must record the financial activity in the same currency. Your business bookkeeping for foreign transactions is required for this reason. The purchasing power of money is also assumed to remain static over time under this basic accounting principle. Therefore, businesses that have existed for decades do not consider inflation in their financial reports. An organisation's financial reports do not consider inflation, even if it has existed for decades.
Although these assumptions may seem obvious, they are easily violated and can result in unsound financial statements. If these accounting assumptions are violated, the auditors will give a negative opinion on a company's financial statements until any issues are corrected. The new financial statements will need to reflect the adjusted assumptions.
Also Read: All You Need To Know About Cash Deposit Slip
For an organisation to be successful, these factors are essential. As a result of these assumptions, companies must ensure that all statutory requirements are followed in reporting financial transactions in their financial statements. In addition, it highlights the authenticity, reliability, and validity of an organisation's financial statements. In addition to being beneficial to the company and its management, they also benefit the readers of the financial statements.
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