What are the 5 underlying assumptions in accounting?

Underlying assumptions or accounting concept also referred as accounting conventions are those accounting principles (more on this later in this article) that all accountants must abide with to produce a set of reasonably acceptable accounting output.

Accountants deal on business whose currency revolves around credibility and accountability. It is the accountability aspect of accountant’s functions that creates the necessity and need for accounting principles. You will agree with me that unless there is some sort of generally guiding principles that must be followed by all accountants, users of accounting information will find it a bit difficult to fully accept information contained in the financial statements of organizations.

The contentious areas like ‘recognition’, ‘measurement’, ‘derecognition’, and ‘disclosure requirements’ of ‘assets’, ‘liabilities’, ‘revenue’, and ‘expenses’ would be causing accountants nightmare if not for the availability of accounting standards that is in turn deeply rooted into conceptual framework which also is rooted in underlying assumptions or concepts of accounting.

Accountants globally while recording business transactions make certain assumptions about the organizations involved in the business transactions that they are recording.

What is accounting principles?

In general term, accounting principles are rules, conventions, practices and procedures that have been fully adopted as a general guide in relation to the acts of accounting professionals. These principles are what is commonly referred to as Generally Accepted Accounting Principles (GAAP).

These GAAP vary from country to country but there is a slow but steady progress towards convergence where all countries of the world be using the IFRS’s (International Financial Reporting Standard) based GAAP.

What is accounting bases?

Accounting bases are amongst those ingredients that all come together to make accounting principle what it is. Accounting bases are methods which have been developed to provide an orderly, harmonious and consistent framework for expressing or applying fundamental accounting concepts to business transactions.

Example of methods include things like; method of valuation of inventories (stocks) and work in progress. This is very reasonable as they encourage fairness in financial reporting.

What is accounting policies

Accounting policies are collection of bases chosen by an entity and applied consistently from period to period across all assets, liabilities, expense and income items. Accounting policies of an entity must be disclosed as notes in the financial statements.

Organizations are free to choose their accounting policies to meet their specific, unique needs that fosters attainment of her objectives and long-term goals. Accounting policies are not to be easily changed from period to period.

What is an accounting concept?

Accounting concepts determine the rules which are applied to accounting procedures. Accounting concepts can be said to be the soul and spirit of accounting basis. Accounting concepts are many and more are still coming out especially in this disruptive accounting era. Some of the popular accounting concepts are discussed later in this article.

Both users of financial statements and the preparers must have a working understanding of these assumptions, hence, the reason why I am writing this article on the underlying assumptions or concepts of accounting.

List the underlying assumptions or concepts of accounting

Below are the list and explanations of twelve (12) most common underlying assumptions or accounting concepts:

Going concern or business continuity concept: accountants prepare financial statement on the assumption that a business will still be in business for the foreseeable future which is taken to be 12 months into the future. It is believed that businesses are on a journey without a definite destination.

Money unit measurement concept: there must be an agreed measurement yardstick for business transactions. Money as we are aware of serves as a unit of measure and a means of legal tender. The money measurement concept sets an absolute limit to the type of information that can be selected and measured by accountants.

Periodicity concept: it will not be nice for owners of business to be left in the dark for too long without having a glimpse of what is going on in their business. For this reason, wealthy business owners influenced the government to make it mandatory for stewards (business managers) to prepare regular stewardship statements to the owners of businesses.

Periodicity essentially means the financial communication obligation that accountants perform periodically in a bid to satisfy their contractual task to business owners – usually annually

Accrual concept: accrual concept makes it clear that the receipt of cash and the right to receive cash are two separate valid activities and must treated as such. The substance of the business transaction is what determines when the activity is recognized in the financial statement.

Simply put, accrual concept states that all incurred expenses and all due or mature gains or incomes that yet to be paid for or received at the end of accounting periods are recognized in the period in which the transaction took place.

Matching concept: accrual concept guides the accountant to properly record revenues and expenses. Realization concept allows the accountant to correctly identify the timing of gains. But, none of these two concepts provides guidelines to the accountant on how to calculate profit; that is the gap that matching concept fills. It links revenue with their relevant expenses.

We all know that one of the main purposes of accounting is to deduce profit from transaction. Therefore, through matching concept, accountants are able to identify gains resulting from transactions and setting same off against their associated expenses. This is rather intuitive from the name ‘matching’.

Prudence concept: it is believed that business owners are happier when a forecasted loss turns into an actual profit than the other way around. The idea of recognizing expenses immediately and deferring income until all conditions are met is all dancing to the tune of prudence concept in accounting. Prudence is a specific type of conservatism. See explanation of conservatism below.

Conservatism: conservatism is all about anticipating future losses and not future gains. It is better to understate assets rather than overstating the assets. Most people the prudence and conservatism to mean the same – I don’t see anything wrong with that idea.

Realization concept: historical cost concept and realization concept are related to some extent on the basis that they both agree that the recorded value of an asset to the firm is determined by the transaction which was necessary to acquire an asset.

Changes in price of an asset under the realization concept is not a factor to determine the current value of an asset. There is no certainty of profit until sales in concluded as far as the accountant is concerned.

Historic Cost concept: accountants world over agrees that cost of purchasing an asset can be used to determine the value of an asset. A lot of arguments exist around this but beyond the scope of this article.

Entity concept:  the idea that businesses are different from their owner is required by law in order to ensure that a clear line is drawn between personal and business assets and liabilities. Entity concepts is an ancient accounting concept that is still very much relevant in our modern world where the divide between ownership and management is continuing to widen.

Materiality concept: there are times when it is simply not worth the time and efforts put into finetuning the records. Accountants tend to generally ignore some extra polishing when the perceived benefits from the extra task will not be up to the level of resources that engaging in the extra activity will consume.

Consistency concept: this is a concept that ensures that identical items are treated same way within each accounting period and from one period to another. Consistency also ensures that accounting policies are consistently applied.

Methods of accounting or style of accounting

There are three methods of accounting namely; Cash basis method of accounting, Accrual basis method of accounting and hybrid method of accounting.

The accrual basis is widely used as it follows matching concept and is strongly recommended by the accounting standards except for some specialized businesses (usually small in nature) that can use the cash basis method of accounting. Accounting adjustments are sometimes needed to make journal entries comply with matching concept. Please note the underlying assumptions in accounting and accounting concepts are put in place as a quality management mechanism that ensures that high quality accounting information that meets the demands of consumers of this accounting information are consistently produced.

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