What are the principles and assumptions of financial statements?

Key accounting assumptions state how a business is organized and operates. They provide structure to how business transactions are recorded. If any of these assumptions are not true, it may be necessary to alter the financial information produced by a business and reported in its financial statements. Accounting principles are the building blocks for GAAP. All of the concepts and standards in GAAP can be traced back to the underlying accounting principles. Some accounting principles come from long-used accounting practices whereas others come from ruling making bodies like the FASB.

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What are the 10 basic accounting principles?
Understanding 10 of the most important accounting principles
List of Accounting Assumptions
Importance of Accounting Assumptions
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It’s important to have a basic understanding of these main accounting principles as you learn accounting. This isn’t just memorizing some accounting information for a test and then forgetting it two days later. These principles show up all over the place in the study of accounting.

What are the 10 basic accounting principles?

Here’s a list of 10 accounting principles that make up GAAP.

Economic entity assumption: The economic entity assumption is an accounting principle that separates the transactions carried out by the business from its owner.
Monetary unit assumption: All financial transactions should be recorded in the same currency.
Specific time period assumption: Financial reports should show results over a distinct period of time.
Cost principle: The cost of an item doesn’t change in financial reporting.
Full disclosure principle: All information that relates to the function of a business’s financial statements must be disclosed in notes accompanying the statements.
Going concern principle: A business will continue to exist and function with no defined end date.
Matching principle: Businesses should use the accrual basis of accounting and report all financial information using this method.
Revenue recognition principle: Revenue is reported when it’s earned, regardless of when payment is actually received.
Materiality principle: When an accountant finds a transactional error, they can use their professional judgment to determine if the error is immaterial to the business.
Conservatism principle: When there is more than one acceptable way to record a transaction, expenses and liabilities should be recorded as soon as possible, and revenues and gains should only be recorded when they occur.

Understanding 10 of the most important accounting principles

It refers to the separation between various divisions in a company. Each unit maintains its own accounting records specific to the business operations. External stakeholders like; Governments and investors use a company’s financial records to assess its performance. Hence, it is important that the transactions reflect the activities of the entity accurately. According to the economic entity assumption, a person evaluating a company’s records assumes all the transactions pertaining to the business are being reviewed.

The monetary unit assumption principle dictates that all financial activity be recorded in the same currency. It is the reasoning behind why you have to complete your business bookkeeping for foreign transactions. Moreover, another assumption under this basic accounting principle is that the purchasing power of currency remains static over time. In other words, inflation is not considered in the financial reports of a business, even if that business has existed for decades.

The specific time period assumption requires that a business’ financial reports show results over a distinct period for comparisons. Additionally, this accounting principle specifies that all financial statements must indicate the specific time period that they’re considering for review, on the actual document. It is because of this principle that your balance sheet always reports information as of a certain date and your profit and loss statement encompasses a date range.

Cost Benefit Principle – limits the required amount of research and time to record or report financial information if the cost outweighs the benefit. Thus, if recording an immaterial event would cost the company a material amount of money, it should be forgone. This basic accounting principle is important because it reminds business owners not to confuse cost with value. Although the value of items and assets changes over time, the gain or loss of your assets is only reflected in their sale or in depreciation entries. If you need a true valuation of your business without selling your assets, then you’ll need to work with an appraiser, as opposed to relying on your financial statements.

This principle requires that any knowledge that would materially affect a financial statement user’s decision about the company must be disclosed in the footnotes of the financial statements. This prevents companies from hiding material facts about accounting practices or known contingencies in the future. Basically, this principle states that all financial activities related to the company must be presented accurately, without any hidden numbers to the business owner/accountant, to ensure full transparency to business’ finances.

Also referred to as the “non-death principle,” the going concern principle assumes the business will continue to exist and function with no defined end date—meaning the business will not liquidate in the foreseeable future. It is because of this basic accounting principle, why you defer the recognition of expenses to a later accounting period.

This principle states that all expenses must be matched and recorded with their respective revenues in the period that they were incurred and not when they are paid. This principle works with the revenue recognition principle ensuring all revenue and expenses are recorded on an accrual basis. These expenses can include wages, sales commissions, certain overhead costs, etc. That being said, even if your tax return is based on the cash method of accounting, your accountant may prepare your financial reports using the accrual basis of accounting. Ultimately, accrual-based reports not only reflect the matching principle but also provide a better analysis of your business’ performance and profitability than cash-based statements.

This principle requires companies to record revenue when it is earned instead of when it is collected. This accrual basis of accounting gives a more accurate picture of financial events during the period. The purpose of this principle is to accurately report an income or revenue when the sale is made, even the payment is received at a later stage. With this basic accounting principle, your business could earn a monthly revenue even if you haven’t received any actual cash that month.

This principle highlights an accountant’s ability to exercise judgment and use their professional opinion—since businesses come in all sizes, an amount that might be material for one business may be immaterial for another—and it’s up to the accountant to make this decision. When an accountant is reconciling a set of books or completing a business tax return, if, during that time the accountant finds any misses or discrepancy, they may deem it as immaterial. In such a scenario, it’s up to the accountant to use their professional judgment to determine if the amount is immaterial.

When there’s more than one acceptable way to record a transaction, the principle of conservatism instructs the accountant to record expenses and liabilities as soon as possible, but to only record revenues and gains when they occur. Using this accounting principle, then, your accountant will be more likely to anticipate losses in your reports, but not revenues or profits—hence they’re being more conservative with the business’s financial success. It’s important to understand, however, that this basic accounting principle is only invoked when there are multiple acceptable ways for the accountant to record the transaction. The principle of conservatism does not allow a business accountant to completely disregard other accounting principles.

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Accounting assumptions can be defined as a set of rules that ensures the business operations of an organization are conducted efficiently and as per the standards defined by the FASB (Financial Accounting Standards Board), which ultimately helps in laying the groundwork for consistent, reliable, and valuable information and it is based entirely on the fundamentals like accrual, consistency, reliability and objectivity, monetary unit assumption, business entity assumption, period, going concern, historical costs, full disclosures, and conservatism.

It defines the mechanism for reporting financial transactions in the financial statementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more. These are rules that make it mandatory for the companies to conduct their business operations and reporting mechanism as per the standards laid out by the FASB. The purpose of accounting assumptions is to provide a basis of consistency that the readers of the financial statements can use to evaluate the genuineness of a company’s financials and confirm its financial well-being depicted in the same.

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List of Accounting Assumptions

#1 – The Reliability Assumption

This assumption makes it mandatory for the companies to record only such accounting transactionsAccounting Transactions are business activities which have a direct monetary effect on the finances of a Company. For example, Apple representing nearly $200 billion in cash & cash equivalents in its balance sheet is an accounting transaction. read more that can be easily proven. In other words, financial transactions that can be verified through invoices, billing statementsBilling statement template makes it easy to generate the transaction receipts which can be easily printed, emailed to the customer any time. These could be implemented for billing invoices, customer account relationship management including general invoicing.read more, receipts, and bank statements must only be recorded in the financial statements.

#2 – The Consistency Assumption

This assumption makes it substantial for the companies to use a consistent method of accounting for all the accounting periods. Having a consistent method of accountingAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods.read more will ensure an easy comparison between the company’s financial statements for different financial periods.

#3 – The Time Period Assumption

This assumption states that the accounting practices and methods used by an entity must be reported and maintained for a particular period. The companies must ensure that these periods remain consistent for each year. It becomes easy for the readers of the financial statements to compare the same for different periods. This assumption is also known as periodic or accounting period assumptionAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more.

#4 – The Going Concern Assumption

Going ConcernAny analyst analyzing a company will be left to a basic assumption that the company does not go bankrupt or file a chapter 11 bankruptcy. This basic assumption allows the analyst to think that there is no immediate danger to the company. The company can operate until infinity is called the principle of going concern. is also termed a continuity assumption. Per this assumption, a company will continue to deliver its business operationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.read more and continue to exist for an unforeseeable future. This assumption is based on the fact that a company will never go bankrupt, and it shall be able to perform its business operations for a more extended period.

#5 – The Economic Entity Assumption

This assumption separates the owner of the company from the company itself. It means that the economic entity assumption separates the company’s financial records from that of the personal financial records of the company’s owner. In all probabilities, the commercial business transactionsA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements.read more must not mix with the individual transactions of the company’s owner. This assumption is also known as the business entity assumption.

#6 – The Money Measurement Assumption

Money Measurement concept states that every worth transaction recording must be recorded and expressed in monetary terms. The money measurement assumption enhances the understanding of a business concern’s financial state of affairs.

Importance of Accounting Assumptions

These assumptions are huge for the organization, its management, and the readers of the financial statements. It helps establish a robust framework for reliable and consistent information.
It enhances the reliability, verifiability, and objectivity of financial statements. The purpose of such assumptions is to enable the users of the financial statements to evaluate and confirm the genuineness of an organization’s financial records and assess economic well-being. There is no doubt that these assumptions help in the establishment of credibility.
It offers a systematic structure concerning how the accounting transactions of an organization for a particular financial period must be recorded and reported in the financial statements. The analyst and potential and existing investors can verify the accuracy, reliability, authenticity, and comparability of the financial statements for different accounting periods with the help of accounting assumptions.
The users of the financial statementsFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers.read morecan even make significant investment-related decisions based on the genuineness, reliability, and financial results depicted in a company’s financial statements. It enables the management to make necessary decisions based on the results of the financial statements. It helps minimize or eliminate the presence of potential errors and frauds in the same.

Benefits

The benefits of accounting assumptions are reaped not just by the companies and their management but also by the investors. These benefits are as follows-

These are beneficial for all kinds of investors, whether they are potential or existing ones. The investors can assess the genuineness of the company’s financial statements and accordingly determine the true and fair view of a company’s financial wellbeing. It enables the investors to make crucial investment-related decisions based on their reasoning. It saves them from being manipulated by false representations of the transactions in a company’s financial statements.
These are beneficial for the management of an organization too. The management of an entity gets to know its actual wellbeing, and based on these results, the former can make appropriate decisions and ensure that the latter does better the next time.
It helps the companies attain their long-term and short-term business goals and objectives.

Conclusion

These are fundamental to the well-being of an organization. These assumptions lay the groundwork for how a financial transaction must be reported in the financial statements and make it mandatory for the companies to ensure complete adherence to all the statutory requirements.
It highlights the reliability, authenticity, and reliability of an organization’s financial statements. These are beneficial for the company, its management, and the readers of the financial statements.