Basic assumptions or postulates guide the recording of transactions in the books of account. These are the foundation of accounting records.
Basic Assumptions
Thus the basic assumptions may be defined as, “Basic postulates or assumptions which serve the basis of actual recording.” They are referred to as generally accepted accounting principles.
These assumptions are :
Accounting Entity/Business Entity Assumptions : In accounting, the business and its proprietor have separate entities. Although the proprietor of the enterprise invest capital and does every activity but for accounting purpose, business and its owner are regarded as distinct and have separate entities.
All the transactions are recorded from the point of view of the business, such as capital invested by the proprietor is recorded on the liabilities side of the balance sheet. He is treated as creditor because business owes the amount of the capital to the owners. Personal incomes and personal expenses assumption applied to all forms organisation.
Money Measurement Assumption: This assumption requires use of monetary unit as a basis of measurement. This implies that those transactions which cannot be measured by monetary unit will not be recorded in the books of accounts. It also indicates that certain information, however important it may be to state the true and fair picture of the entity will not be recorded in the financial accounting book if it cannot be expressed in terms of money.
Going Concern Assumption : The financial statements are prepared assuming that the business will continue for an indefinite period. The going concern assumption facilitates the distinction made between—(i) fixed assets and current assets, (ii) short term and long term liabilities, and (iii) capital and revenue expenditure.
Accounting Period Assumption: This assumption is also known as periodity assumption or periodic assumption. The main objective of an enterprise is to earn profits and the results of business operation are to be recorded regularly. Therefore, the whole life of business is divided into intervals of one year.
Most of the firms start on January 1 and close on December 31 each year i.e., 12 months. Government of India’s financial year commences on April 1 and ends on 31st March. Accounting year is also known as financial year. Therefore, profits are calculated on yearly basis.
Basic accounting principles
On the basis of assumption of accounting discussed above, certain principles have been developed that guide how transactions should be recorded and reported. These basic assumptions are as fallows :
Duality Principle : According to this principle, every business transaction is recorded as having a dual aspect. In other words, every transaction affects at least two accounts. If one account is debited, the other account must be credited. The system of recording transactions based on this principle is called as ‘Double Entry System.’ It is because of the principle that the two sides of the balance sheet are always equal and the following accounting equation will always hold good at any point of time :
Assets = Liabilities + Capital
or
Capital = Assets – Liabilities
The business can acquire an asset by sacrificing another asset, incurring the liability or receiving it from owner (resulting in the increase in the owner’s equity).
Historical Cost Principle : Historical principle says that assets are entered in the books of account at the price paid to acquire them, irrespective of any increase or decrease in their market value later on. It is why it is called the historical cost principle.
Every asset has a limited life and should be written off over its effective life. Expired cost is an expense and unexpired cost in an asset.
Revenue Recognition Principle: Revenue means the amount which is added to the capital as a result of business operations. Revenue is earned by sale of goods or services provided. Principle of revenue recognition determines the time or the particular period in which the revenue is realized. Following basis may be used for determining the period in which revenue is realized :
(a) On the Basis of Cash : According to it, the revenue should be recognized when it is actually received in cash. This basis is adopted when the goods have been sold on credit and there is doubt about the collection of the proceeds. This basis is also adopted in case of sales on installment basis. Installments received in respect of these goods are treated as revenue.
(b) On the Basis of Production : This basis is used when sales basis and cash basis fail to identify revenue. In case of long term construction-projects, it is difficult to postpone the revenue till the completion of full contract. In such cases, that proportionate part of revenue which is equal to the part of contract by the end of the year is recognised as realized.
(c) On the Basis of Sale : According to it, the revenue in deemed to be realized when the title or the ownership of the goods has been transferred to the purchaser and when he has legally become liable to pay the amount. It should be remembered that revenue recognition is not related with the receipt of cash. For example, if a firm gets an order of goods on 15th March, supplies the goods in 1st March and receives cash on 10th March, the revenue will be deemed to have been earned on 1st March, as the ownership of the goods was transferred on that day.
Verifiability and Objectivity of Evidence Principle : The principle of verifiable objectives means that every transaction must be supported by vouchers or documents i.e., supported by documentary evidence. Objectivity is the essential characteristics which may be measured and verified without any personal feeling and prejudice.
No entry can be passed or posted in subsidiary books unless there is a voucher for it. Receipts, bills, invoices, cash memos are the vouchers used as documents for recording business transactions.
Full Disclosure Principle: According to this principle, all the information significant to the users of financial statements should be disclosed. Accounts should be prepared truly and all material information must be disclosed. Any claim pending in the court of law against the business organization should be written as a footnote at the end of the balance sheet.
Disclosing of material facts does not imply the disclosure of business secrets. Certain important items can be left and some of them are merged with other items. It increases the reputation and reliability of the financial statements.
Match Cost and Revenue Principle: This principle requires that the expenses should be matched with the revenue generated in the relevant period. The simple rule that followed in this context is ‘Let expenses follow revenues’.
The matching principle by relating expenses to the associated revenues helps in measuring income (profit) for the given period. It is of great significance since the performance of an entity is usually measured in terms of income earned by the entity.
We don’t recognize the expense when cost is paid or when a product is produced. It is recognized when the service or the product actually contributes to the revenue. Therefore, expenses are not related to the period of cash outflow but to the period in which the revenues are generated. The matching principle requires that part of the cost of fixed assets used in the operations of business, known as depreciation, is treated as expense of the period. Similarly, in case revenues received in advance for which the services have not been rendered, will be treated as unearned income, and hence, it will be carried forward to the following accounting period.
Modifying principles
These are certain accounting principles which can be slightly modified by different accountants according to the situation and requirements of the business. This is done in order to make the financial statements more relevant and reliable. These principles are as follows :
Consistency : In order to make the results of one year comparable with those of other years, the basis should not be changed, otherwise the profit of one year cannot be compared with the profit of other years. This principle is particularly important when alternative accounting is equally acceptable.
Materiality : This principle is an exception to the principle of full disclosure. As such, it is termed as modifying principle. According to this principle, items having an insignificant effect or being irrelevant to the user need not be disclosed. These important items are either left out or merged with other items, otherwise accounting statement will be unnecessarily overburdened. According to the American Accounting Association, “An item should be regarded as material if there is reason to believe that knowledge of it would influence decision of informed investor.”
Prudence (Conservatism) : According to this principle, all anticipated losses should be recorded into the books of accounts but all anticipated or unrealized gains should be ignored. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty. The examples of principle of conservatism are as follows :
(a) Provision for a pending law suit against the firm, which may either be decided in its favour.
(b) Joint Life Policy is shown only at surrender value as against the amount paid.
(c) Provision for a doubtful debt is created in anticipation of actual bad-debts.
(d) Closing stock is valued at cost price or market price, whichever is less.
Effects of conservatism
(a) Balance sheet will disclose understatement of assets and over-statement of liabilities in comparison to actual values.
(b) Profit and loss account will disclose lower profits in comparison to the actual profits.
These facts will be in contravention of the principle of full disclosure.
Timeliness : An information is useful for a decision maker if it is relevant and reliable. Information loses its relevance if it is not available in time. Timeliness refers to the fact that information must be available to the users before it loses its effects. The Company Act, therefore requires that the annual reports must be submitted to the Registrar and made available to users within a specified period of time after the close of the financial year. It also requires companies to publish unaudited quarterly reports in the national newspapers.
Industry Practice : The G.A.A.P. are followed by the enterprise but sometimes practical considerations requires that the enterprise in a given industry form G.A.A.P. The unique characteristics of some industries may require varied applications of the principle, such as banks are governed by the Banking Companies (Regulation) Act. In such cases the reporting format for banks is strikingly different from other companies governed by the Company Act 1956. Banks and insurance companies are require to report certain investment securities at cost rather than lower cost on market value.
Substance over Legal Form : It is an important modifying principle of financial accounting. It means accounting should communicate the material useful, real and actual information to all those who are directly or indirectly interested in their information. It means that the accountants should not conceal substantial information. They should be presented in legal form. The accountants should describe the transactions in terms of substance rather than the form.
Vertical form of information of financial statement was introduced against Horizontal form. Recently substance form of presenting financial information was also introduced. It is divided into nine schedules. Substance of importance should not be lost in the maintenance of form and format presentation.
Variation in Accounting : Variation in accounting practices may be variation in accounting principle, in accounting estimate or variation in reporting.
Every industry or firm has its own requirements, specialities, peculiarities and nature of work. It means that they have to adopt accounting practice prevailing in the business or industry. Non-profit institutions, such as charitable institutions, clubs, prepare receipts and payments account and income and expenditure account. Small business houses use single entry system. Hotels prepare analytical cash book. Insurance companies prepare revenue accounts and electrical companies have their own set of accounts.
The nature and variation and jurisdiction for each variation must be disclosed.
Accounting standards
Meaning : Accounting standards are accounting rules which are related to measurement, valuation and disclosure of financial statements.
The uniform, definite and universally accepted accounting rules were developed by the International Accounting Standard Committee (IASC) are known as accounting standards. They are the norms of accounting policies and practices by way of guidelines that should be followed while preparing accounts.
Need : There should be uniformity in preparing financial statements so that accounting information may be comparable for better analysis and performance. The need for the uses of accounting standards is as follows :
(a) Removal of ambiguity.
(b) Globalisation of business.
(c) Prevention of accounting scandals.
(d) Uniform standard presentation.
(e) Internationalisation of financial institutions.
Nature : Accounting standards are mandatory in nature. It means they are mainly applicable to the published accounts of limited companies.
The accounting standard apply to the preparation of general purpose financial statements, balance sheet, profit and loss account and statutory notes which are essential for financial statements.
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