Chapter: 8 Understanding Financial Statements

Section: 9 Accounting Concepts

Accounting concepts are operational guidelines developed to assist the accounting of various transactions taking place in organizations. These concepts guide in developing rational responses to complicated issues in financial accounting and reporting. There are basic assumptions that are the base for the structure of financial accounting.

Basic Assumptions
Basic assumptions help to establish the framework of accounting in a firm and structural form. There are four basic assumptions that underlie the financial accounting discipline.

Going Concern Assumption: Continuity of business is a basic assumption underlying all accounting treatments. Most accounting methods are based on the assumption that the business enterprise will have a long life. This assumption helps accountants to treat transactions in a meaningful manner as most business transactions are related to the future. Depreciation and amortization principles, for instance are based on the assumption that enterprises will be operative over the life of assets. Further, classification of assets and liabilities into long-term and short-term will be of no relevance unless it is assumed that enterprises have a reasonable life.

Money Measurement Assumption: All accounting transactions are quantified using a monetary measurement in one of the currencies. Accounting is based on the assumption that money is the common denominator by which economic activity is measured, and that the monetary unit provides an appropriate basis for accounting measurement and analysis.

Business Entity Assumption: This is a very important and fundamental assumption that clearly separates the owner and the business from an economic point of view. The activities of the business enterprises are kept separate from the owners and that of any other business unit. This clear distinction forms the base for accounting of the transactions and determines the performance and financial position of a particular entity without confusing with the owners personal transactions. The entity assumption does not mean legal status, for instance, a group of companies may have cited a number of legal entities from a law perspective, however from accounting point of view the consolidated accounts are prepared on the assumption that the group is one business entity.

Periodic Reporting Assumption: Accounts are prepared for a defined period and all transactions during that time span will be taken into account in determining income and financial position. The most accurate way to measure results of business enterprises would be to measure them at the time of eventual liquidation. Business, government, investors, and various other user groups, however, cannot wait indefinitely for such information. Therefore it is practical and convenient to report performance on a periodical basis that could be yearly, quarterly, monthly or even weekly. It is interesting to note that short period results are less reliable than longer period results i.e. weekly or monthly performance of an enterprise is vulnerable due to seasonality and market fluctuations whereas yearly performance of an organization is more dependable as it covers all seasons in a year.