Assumptions and principles used in accounting
Amanda White; CDU Business School; Mitchell Franklin; Patty Graybeal; and Dixon Cooper
The people and entities interacting with businesses all around the world use accounting information to make decisions every single day. But how can businesses be compared and evaluated against each other with any level of reliability? That comes from having a common set of accounting principles, assumptions and concepts that are the same worldwide.
The International Accounting Standards Board (IASB) is the global body responsible for setting consistent standards and requirements to allow users of accounting information to make decisions with confidence in that information. That is, revenue in Country A means the same thing in Country B. The IASB documents these standards in the International Financial Reporting Standards – usually referred to as IFRS. In Australia, the Australian Accounting Standards Board (AASB) implements the IFRS with a few small tweaks for Australian regulatory requirements – but overall it can be said that we are following IFRS.
The majority of the world’s accounting is conducted in accordance IFRS with the main exception being the USA. The United States has the Financial Accounting Standards Board which acts in a similar role as the IASB and they issue the GAAP – General Accepted Accounting Principles. At the introductory level, the main principles, assumptions and concepts of accounting are very similar between IFRS and GAAP.
Want more details on the difference between IFRS and GAAP? Check out this piece from Harvard Business School.
In the following paragraphs we will discuss the assumptions and principles of accounting. These are the same regardless of whether you are following IFRS or US GAAP – things do get more complicated when you get into some specific accounting transactions – but that is something to worry about only if you head into an accounting major or specialisation 😊
Assumptions of accounting
In some textbooks and online sources you may see references to accounting concepts. Accounting concepts is an interchangeable term for the assumptions of accounting. These assumptions are made by accountants and users of accounting information. Accountants make four assumptions in the preparation of financial statements
The economic entity
The financial statements are prepared under the economic entity assumption, meaning that the business itself (or ‘entity’) is separate from the owners of the business and any other businesses. The entity may only report activities on financial statements that are specifically related to their operations.
For example, Felix’s Fancy Flowers (FFF) is a business that sells blooms. When preparing their financial information, Felix only includes transactions related to FFF and not any personal transactions like the holiday he took to Japan.
Monetary measurement or measurability
The financial statements only include transactions that can be measured reliably in accurately using a monetary unit of measurement. In Australia, that monetary unit of measurement is the Australian dollar and every country will have central bank that determines the monetary unit of measurement. Something within a business that cannot be accurately and reliably measured (such as the value of Instagram influencers who promote a business’s products) cannot be included in the financial statements. However, if an influencer is given products in exchange for a social media post – the retail value of those products can be used as the value of that transaction when preparing the accounting records.
Accrual basis
The financial statements are prepared under the accrual basis, which is a method of financial reporting that measures all business transactions in accordance with when they occur, whether that may involve cash or not. Recording business transactions when only cash enters or leaves the business is called the ‘cash basis’. The majority of businesses are required to use the accrual basis of accounting.
Going concern
The going concern assumption assumes a business will continue to operate as normal in the foreseeable future. ‘Operate as normal’ means that the business will have sufficient funds from revenue to pay their expenses and debts as they fall due. The ‘foreseeable future’ is quite an uncertain time period, but in most countries – this is prescribed to be twelve months.
A company that is failing to repay bank loans and experiencing declining sales is likely to NOT be a going concern. This can be worded in the business press in many different ways that can cause confusion – examples include ‘the business is experiencing difficulties in continuing as a going concern’, the business is ‘not a going concern’.
The period assumption
This assumption describes the time interval between financial statement reports. The period assumption states that a company can present useful information in shorter time periods, such as years, quarters, or months. The information is broken into time frames to make comparisons and evaluations easier. The information will be timely and current and will give a meaningful picture of how the company is operating. In Australia, readers of the annual financial statements for publicly listed companies can assume that the information contained within that statement pertain just to that specific financial year, and no other. Australian listed companies also produce half-year financial statements. In the USA, publicly listed firms are required to produce quarterly and annual financial statements.
The period concept also means that businesses cannot arbitrarily choose their own reporting period – for example, you can’t choose to make your financial year 13 months in one year, and then 9 months in another.
Finally – the period concept also means that businesses should only include transactions from that period when preparing the financial statements. You can’t include any transactions from a future period, or one in the past that has already been reported on (otherwise you’d have double counting).
Principles of accounting
The following principles of accounting are used by accountants to help guide their recording of business transactions.
Revenue recognition principle
The revenue recognition principle directs a company to recognise revenue in the period in which it is earned; revenue is not considered earned until a product or service has been provided. This means the period of time in which you performed the service or gave the customer the product is the period in which revenue is recognised.
There also does not have to be a correlation between when cash is collected and when revenue is recognised. A customer may not pay for the service on the day it was provided. Even though the customer has not yet paid cash, there is a reasonable expectation that the customer will pay in the future. Since the company has provided the service, it would recognise the revenue as earned, even though cash has yet to be collected.
Try the drag and drop exercise below to test your understanding.
Matching principle
The expense recognition principle (also referred to as the matching principle) states that we must match expenses with associated revenues in the period in which the revenues were earned. A mismatch in expenses and revenues could be an understated net income in one period with an overstated net income in another period. There would be no reliability in statements if expenses were recorded separately from the revenues generated.
For example, if Lynn earned printing revenue in April, then any associated expenses to the revenue generation (such as paying an employee) should be recorded on the same income statement. The employee worked for Lynn in April, helping her earn revenue in April, so Lynn must match the expense with the revenue by showing both on the April income statement.
Test your understanding with this short multiple choice question.
Historical cost principle
The historical cost principle states that virtually everything the company owns or controls (assets) must be recorded at its value at the date of acquisition. For most assets, this value is easy to determine as it is the price agreed to when buying the asset from the vendor. There are some exceptions to this rule, but always apply the cost principle unless the IFRS has specifically stated that a different valuation method should be used in a given circumstance.
The primary exceptions to this historical cost treatment, at this time, are financial instruments, such as stocks and bonds, which might be recorded at their fair market value. This is called mark-to-market accounting or fair value accounting and is more advanced than the general basic concepts underlying the introduction to basic accounting concepts; therefore, it is addressed in more advanced accounting courses.
Conservatism principle
This concept is important when valuing a transaction for which the dollar value cannot be as clearly determined, as when using the cost principle. Conservatism states that if there is uncertainty in a potential financial estimate, a company should err on the side of caution and report the most conservative amount. This would mean that any uncertain or estimated expenses/losses should be recorded, but uncertain or estimated revenues/gains should not. This understates net income, therefore reducing profit. This gives stakeholders a more reliable view of the company’s financial position and does not overstate income.
Test your understanding
