Key Takeaways
- Basic accounting assumptions are concepts under which business transactions are recorded and financial statements are prepared. They enhance the understanding of the financial statements.
- The 4 basic accounting assumptions are Economic Entity Assumption, Going Concern Assumption, Time Period Assumption, and Monetary Unit Assumption.
The Basic Accounting Assumptions?
Basic Accounting Assumptions are fundamental concepts and guidelines under which the financial statements are prepared.
When preparing a company’s financial statements, you’ll be guided by applicable accounting standards such as the IFRS and GAAP. These accounting standards are based on the following basic accounting assumptions:
- Economic Entity Assumption
- Going Concern Assumption
- Time Period Assumption
- Monetary Unit Assumption
Basic accounting assumptions serve as the foundation of the accounting process and are derived from the experiences and practices of accountants. These underlying assumptions enhance the understanding of the financial statements by providing guidelines on how business transactions are recorded.
Economic Entity Assumption
The Economic Entity Assumption states that the company or business entity is separate and distinct from its owners, managers and employees. It is also known as Business Entity Assumption, Accounting Entity Assumption and Separate Entity Assumption.
Under the Economic Entity Assumption, the accounting records of a business must be kept separate from the personal financial records of its owner or employees. Mixing personal transactions with the company’s business transactions will negatively affect the fair presentation of information in the financial statements and lead to distorted amounts.
A company, such as a partnership and a corporation, is considered a juridical person, i.e. a separate living entity unto itself. This means that it can own assets, incur liabilities and enter into contracts under its registered name. Therefore, personal assets, personal liabilities and other personal transactions of the owners, managers or employees are not accounted in the financial statements of the business.
In the case of a sole proprietorship, the law considers the business and the proprietor as a single entity wherein the liabilities of the business may extend to the personal properties of its owner. The proprietor also reports the income of the business in his or her personal income tax return rather than on a separate tax return. However, at the viewpoint of accounting, the owner and the proprietorship business are still considered as two separate entities, with their transactions being accounted for separately.
The economic entity assumption also assumes that if an owner owns two or more companies, each company should maintain separate accounting records and financial statements. This also applies to a parent or holding company and its subsidiary.
The Purpose of the Economic Entity Assumption
The economic entity assumption helps:
- To differentiate between the activities of the business and its owners. You can determine with confidence the financial position, financial performance and cash flows of the business without being mixed and confused with that of the owner.
- To properly document the transactions between the owner and the company. You account any transfer of assets by the owner to the business as an investment transaction, which consequently increases the equity of the owner in the company. Likewise, any transfer of assets from the business to the personal use of the owner is considered a withdrawal of resources by the owner, thus decreasing his or her equity in the business.
- To have a fair presentation of the economic activities of the business in the financial statements, regardless of the personal financial activities of the owner. The amounts and items in the financial statements should match the actual effects of the transactions that happened in the business.
Some Illustrative Examples
Example 1
Mr. A opens a laundromat business by investing $50,000 and 10 sets of commercial washers and dryers under the registered name of the business, LaundrySpree. He also has $10,000 remaining in his personal bank account and an unpaid personal loan amounting to $500.
The financial statements of LaundrySpree should only show cash amounting to $30,000 and the value of the washers and dryers. The balance in Mr. A’s personal bank account and his unpaid personal loan should not be included in the financial statements of LaundrySpree because the assets and liabilities of his business is separate from his personal assets and liabilities.
Example 2
Ms. B owns a cleaning services business and another business which is a chemical manufacturer. The chemical manufacturing company supplies detergent and other cleaning chemicals to the cleaning services company.
Although Ms. B is the common owner of the two companies, she shouldn’t record the business transactions of both companies into a single set of books or accounting records. The transactions of each company in this case should be accounted separately. The only time that both companies can report their business transactions together into a single set of financial statements is when both companies merge into a single company.
Example 3
The company owned by Ms. C purchased two vehicles from its own funds. One vehicle was used for the delivery of products to customers while the other vehicle was used by Ms. C solely for her personal trips.
The company should only report the delivery vehicle in its financial statements. The vehicle used by Ms. C for her personal trips should be accounted as a withdrawal of resources by the owner, thus decreasing her equity in the business.
In addition, if the company spends gasoline expenses for her personal trips, then the amount paid for the gasoline should also be treated as a withdrawal of resources by the owner instead of a business expense.
Example 4
Mr. D opened a software start-up business and used the garage of his house as his office. He paid for renovation services and registered the former garage area as a commercial area.
Mr. D can capitalize those expenses in his financial statements but he cannot report the entire value of his house as an asset of the business.
Going Concern Assumption
What is the going concern assumption?
The Going Concern Assumption views the business entity as continuing its operations indefinitely or at least long enough to accomplish its objectives and commitments without any intention to liquidate in the foreseeable future. It is also called the Continuity Assumption.
The Going Concern assumption is the only underlying accounting assumption mentioned in the IFRS Conceptual Framework for Financial Reporting.
Under the going concern assumption, your company is expected to have an indefinite existence and will continue its operations in the foreseeable future, i.e. not less than one year. Assuming that your company might be winding up tomorrow or in the following days or months will significantly affect the valuation and recognition of financial statement items. That’s why in the absence of any evidence to the contrary, a company is assumed to be a going concern.
Below are some instances where the going concern assumption does not apply.
- When your company is unable to pay its short term and long term obligations anymore as in the case of a bankruptcy.
- When there are legal proceedings against your company which may result with the shutting down of its operations.
- When your company’s situation dictates that it may not be able to continue its operations or remain in business for the foreseeable future.
In any of these scenarios, liquidation or winding up procedures will take place in your business. Proper disclosure in the financial statements together with the reasons and different measurement basis to be used should be made when the going concern assumption ceases to apply.
Financial statements are prepared under the going concern assumption. Some of the effects of this assumption are as follows:
- Recognition of accounting transactions such as deferrals, accruals, depreciation, and amortization. These concepts are forward-looking and are necessary to an entity that is continuing its operations in the foreseeable future. They don’t apply anymore when a company is undergoing a liquidation process.
- Assets and liabilities are classified as either current or non-current. In case of liquidation, using a current or non-current classification is insignificant and hard to justify.
- The use of historical cost as the initial measurement basis for most financial statement elements. In case of liquidation, the net realizable value will be applied rather than the historical cost.
Time Period Assumption
The Time Period Assumption requires that the company divides its business activities into equally measured time intervals which are called accounting periods. It is also known as Periodicity Assumption and Accounting Period Assumption.
While the going concern assumption views the business entity as having an indefinite life, the Time Period assumption requires that it should be subdivided into time periods, called Accounting Periods, for the purpose of preparing financial statements. An Accounting Period is the time frame covered by a company’s financial statements. All financial transactions that occurred within this period undergo an accounting process which results to information reported in the financial statements.
If you look at the header portion of the income statement, cash flow Statement and statement of changes in equity, you’ll notice that the accounting period is indicated below the financial statement names. It is usually written as “For the year ended December 31, 20xx” or “For the quarter ending March 31, 20xx”. This indicates the period covered in the financial statements and is useful when analyzing the financial statements across different periods.
An accounting period is usually one year or twelve months beginning from the end of the previous accounting period. This is also in line with the annual government requirements for financial reports. Furthermore, this one year period can be subdivided into interim periods where financial statements are prepared in a monthly, quarterly or semi-annual basis.
The two accounting periods usually followed are the Calendar Accounting Period and the Fiscal Accounting Period.
Calendar Accounting Period
A Calendar Accounting Period can be:
- A twelve-month calendar year that begins on January 1 and ends on December 31. An example is a period that begins on January 1, 2023 and ends on December 31, 2023.
- A three-month calendar quarter that covers any of the following period: January to March, April to June, July to September, or October to December. An example is a period covering April 1, 2023 to June 30, 2023.
- A calendar month that covers one of the months in a calendar year. An example include the calendar month of September 1, 2023 to September 30, 2023. Another example is a one-month calendar period covering October 1, 2023 through October 31, 2023.
Fiscal Accounting Period
A Fiscal Accounting Period can be:
- A twelve-month fiscal year or natural business year that does not end on December 31, as opposed to a calendar year. An example is a 12-month period covering April 1, 2023 to March 31, 2024.
- A 52-week or 53-week fiscal period that ends on the same day of the week each year such as the last Saturday of a fiscal year end month. An example is a 52-week period that ends on the last Saturday of August 2023 which is August 26, 2023.
- A 52-week or 53-week fiscal period that ends on a certain day such as a Saturday that falls nearest to the last day of a fiscal year end month. An example is a 53-week period that ends on a Saturday nearest to August 31, 2023 which is September 2, 2023.
- A three-month fiscal quarter that does not cover any quarterly calendar period. An example is a fiscal quarter covering February 1, 2023 to April 30, 2023.
The Purpose of the Time Period Assumption
The time period assumption allows you to acquire timely information on a regular basis about the results of operations of the business in a particular period. Timely information is very important when making investment decisions and predicting possible outcomes of business operations in the succeeding accounting periods.
Monetary Unit Assumption
The Monetary Unit Assumption states that all business transactions must be measured and recorded only in terms of a common unit of measurement which is money. This means that all financial statement items should be expressed in terms of monetary units. It is also called Unit of Measurement Assumption and Stable Monetary Unit Assumption.
When you observe a company’s financial statements, you’ll notice that the amounts are expressed in a certain currency, e.g. dollars, euros, pesos, and yen. The purpose is to express diverse economic transactions of a business using a common denominator for uniformity. In addition, it also allows the financial statements to be comparable with those from other companies.
One limitation of this assumption is that only quantifiable information are recorded in the accounting books and reflected in the financial statements. In other words, events and transactions that could not be assigned with a monetary value is not recorded in the financial statements. Some examples of these transactions are the improvement in the quality of the products and the efficiency produced after investing in trainings to improve employee skills and knowledge.
Although some transactions cannot be expressed in money, they could still have an impact on the performance of the business. In this case, important information which can be qualified can be disclosed in separate notes that support and accompany the financial statements.
The monetary unit assumption also assumes that the currency used in the financial statement remains stable over time. This means that the purchasing power of the currency is constant and any changes or fluctuations are insignificant.
However, this leads us to another limitation of this assumption which is its applicability only in regions that enjoy low inflation rates. If a company is operating in a hyperinflationary economy, then its financial statements should be restated to reflect the changes in the general purchasing power of the functional currency.
Review Questions
- What are basic accounting assumptions and why do we need them when preparing financial statements?
- What is the purpose of the Going Concern Assumption?
- What’s the difference between Calendar Accounting Period and Fiscal Accounting Period?
- Why is there a need to separate the financial records of a business and of its owners?
- What is a limitation of the Monetary Unit Assumption?
