Question

Discuss how the following underlying accounting assumptions influence the way financial statements are prepared:

•   the accounting entity assumption
•   the accrual basis assumption
•   the going concern assumption
•   the period assumption.

Answer 1

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Discuss how the following underlying accounting assumptions influence the way financial statements are prepared:

It would be very difficult if every entity will prepare financial statements as per their convenience. It would be impossible to get any meaningful information from the statements.

This is why professional accounting associations have established accounting assumptions to use when preparing financial statements. The purpose is to create a consistent basis that managers, stockholders and analysts can use to evaluate a company's financial statements and performance.

•   the accounting entity assumption

The economic data in financial reports is restricted to the operations of the company. The activities of the business are not intermingled with the personal transactions of the owner. This principle allows the accountant to keep the sole proprietor's business transactions separate from the owner's personal transactions even though a sole proprietorship is not legally separate from the owner.

•   the accrual basis assumption

Accrual principles require that activities are recorded as they occur and revenue and expenses are related. Revenues are earned and recorded at the time of sale. This means that revenue from a sale is valid when the buyer takes possession of the product or the service has been performed. However, it is not the moment when cash is transferred from the buyer to the seller. Expenses are recorded when the business accepts the goods or services from another company, not when payment is made for the goods or services. Accrual principles require the recording of revenues along with their related expenses. For example, if your company manufactures and sells a bicycle, the expenses (invoices) for the steel, wheels, cables and chains would be recorded when the bicycle is sold. The accrual-basis method of accounting matches revenues and expenses, and presents an accurate picture of the company's profit.

•   the going concern assumption

Accountants present the value of the information as if the business were going to remain a "going concern" and will continue to operate indefinitely in the future. The company does not have the necessity nor the intention to cease operations. The numbers would be different if it looked like the company was going out of business and cease to exist. Accordingly, the depreciation expenses for fixed assets are spread over their useful life. If the firm were not expected to continue, the cost of a fixed asset would be expensed in full in the year of acquisition. Accountants are required to express an opinion as to the long-term survivability of the company. If the accountant determines that the business will not be able to continue operating, the accountant must disclose this viewpoint.

•   the period assumption.

Financial reports should cover a uniform and consistent time period. The reporting periods could be monthly, quarterly or annually. If this approach is not followed, financial reports across different periods will not be comparable.