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Accounting assumptions provide a level of foundation to help prevent misunderstandings between and among accountants who prepare financial statements and users of such reports.

Underlying assumptions in accounting provide the basis in preparing, presenting and interpreting the financial statements. These assumptions are held true when accountants prepare the financial statements and when users read them. In effect, accounting assumptions provide a level of foundation to help prevent misunderstandings between and among accountants and users.

The two major assumptions are: accrual and going concern. In addition, the accounting entity assumption, monetary unit assumption, and time period assumption are also important concepts in preparing and interpreting financial statements.

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, 2011. The client paid after 30 days – January 8, 2012. When should the income be recognized? – On the date it is considered earned (when the service has been fully rendered). Hence, the income should be recognized on December 9, 2011 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, 2012 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 it was paid in April.

Cash Vs. Accrual Accounting

Cash basis accounting is the exact opposite of accrual accounting. Under this method, income is recorded when received and expenses are recorded when paid. Cash basis results in mere records of cash receipts, cash payments, and major accounts such as receivables and payables.

Because of reliability issues, cash basis does not comply with acceptable accounting standards. Accrual accounting provides a more reliable measurement of income and expenses. Cash basis accounting produces incomplete information because it does not record important accounts:

• Accrued income - income earned but not yet received (an asset)
• Accrued expense - expense incurred but not yet paid (a liability)
• Deferred income - income received but not yet earned (a liability)
• Prepaid expense - expense paid but not yet incurred (an asset)

Going Concern Principle

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 to be carried in the books until they are fully utilized and retired.

The Major Assumptions

To sum up what we have so far, here are some of the notable points:

• Accrual means that income is recorded when earned regardless of when received, and expense is recorded when paid regardless of when paid. This assumption is much applicable to accounts in the income statement.
• Going concern means that an entity will continue to exist in the future when no stateemnt to the contrary is given in the financial statements. This is the major assumption in preparing and reading the balance sheet.

So again, accrual and going concern are the two major assumptions in accounting. Learn about the three other assumptions and a summary of principles derived from them all on the next page.

Fundamental Accounting Concepts: Table of Contents

Elements of Accounting: Assets, Liabilites, Capital (incl. Income and Expense)