They provide a foundation to prevent misunderstandings between and among the preparers and users.
The Conceptual Framework of Accounting mentions the underlying assumption of going concern.
In addition, the concepts of accrual, accounting entity, monetary unit, and time period are also important in preparing and interpreting financial statements.
Going Concern Assumption
The going concern principle, also known as continuing concern concept or continuity assumption, means that a business entity will continue to operate indefinitely, or at least for another twelve months.
Financial statements are prepared with the assumption that the entity will continue to exist in the future, unless otherwise stated.
The going concern assumption is the reason assets are generally presented in the balance sheet at cost rather that at fair market value. Long-term assets are included in the books until they are fully utilized and retired.
Accrual Basis of Accounting
The accrual method of accounting means that "revenue or income is recognized when earned regardless of when received and expenses are recognized when incurred regardless of when paid".
Hence, income is not the same as cash collections and expense is different from cash payments. Under accrual basis, revenues and expenses are recognized when they occur regardless of when the amounts are received or paid.
For example, ABC Company rendered repair services to a client on December 9, 2014. The client paid after 30 days – January 8, 2015.
When should the income be recognized? – On the date it is considered earned (when the service has been rendered). Hence, the income should be recognized on December 9, 2014 even if it has not yet been collected as of that date.
Another example, suppose ABC Company received its electricity bill for March on April 5, 2014 and paid it on April 10. When should the electricity expense be recorded?
Correct! – March. Why? Because, the electricity expense was for the month of March even if the bill has been received and paid in April. In other words, the "electricity" was used/consumed in March.
Accounting Entity Concept
The accounting entity concept recognizes a specific business enterprise as one accounting entity, separate and distinct from the owners, managers, and employees of that business.
In other words, it means that a company has its own identity set apart from its owners or anyone else. Personal transactions of the owners, managers, and employees must not be mixed with transactions of the company.
For example, if ABC Company buys a vehicle to be used as delivery equipment, then it is considered a transaction of the business entity.
However, if Mr. A, owner of ABC Company, buys a car for personal use using his own money, that transaction is not recorded in the company's accounting system because it clearly is not a transaction of the company.
Time Period (Periodicity)
The time period assumption, also known as periodicity assumption, means that the indefinite life of an enterprise is subdivided into time periods (accounting periods) which are usually of equal length for the purpose of preparing financial reports on financial position, performance and cash flows.
An accounting period is usually a 12-month period – either calendar or fiscal.
A calendar year refers to a 12-month period ending December 31. A fiscal year is a 12-month period ending in any day throughout the year, for example, April 1 to March 31 of the following year.
The need for timely reports has led to the preparation of more frequent reports, such as monthly or quarterly statements.
Monetary Unit Assumption
The monetary unit assumption has two characteristics – quantifiability and stability of the currency.
Quantifiability means that records should be stated in terms of money, usually in the currency of the country where the financial statements are prepared.
Stability of the dollar (or euro, pound, peso, etc.), a.k.a. stable dollar concept means that the purchasing power of the said currency is stable or constant and that any insignificant effect of inflation is ignored.
It is to be noted however that financial statements of a company reporting in the currency of a hyperinflationary economy (an economy with very high inflation rate) must be restated, in accordance with applicable accounting standards.
Other Principles Derived from the Above Concepts
Some of the other principles followed in accounting include:
- Matching Principle – The matching concept means that expenses are recognized in the period the related income is earned, and income is recognized in the period the related expenses are incurred. In essence, income is matched with expenses and vice versa.
Through the accrual basis of accounting, better matching of income and expenses is achieved.
- Revenue Recognition Principle – In accrual basis accounting, revenue or income is recognized when earned regardless of when received. It means that income is recorded when the service is fully performed or when sale occurs, even if the amount is not yet collected.
- Expense Recognition Principle – Also under accrual basis accounting, expenses are recognized when incurred regardless of when they are paid. In other words, expenses are recorded when used (incurred), even if they are not yet paid.
- Historical Cost Principle – Items in the balance sheet are generally presented at historical cost. Nonetheless, some accounts are measured using other bases such as fair market value, current cost, and discounted amount. You will learn more about them in intermediate accounting studies.