Four Basic Assumptions of Accounting

Generally Accepted Accounting Principles may be defined as those rules of action or conduct which are derived from experience and practice and when they prove useful, they become accepted principles of accounting.

And four basic assumptions are part of GAAP, accounting principles and the double entry system. The basic assumptions are like the pillars on which the structure of accounting is based. The four basic assumptions are as under:

  1. Business Entity Assumption,
  2. Money Measurement Assumption,
  3. Going Concern Assumption, and
  4. Accounting Period Assumption.

Business Entity Assumption

According to this assumption, the business is treated as a unit or entity apart from its owners, creditors, managers and others.

In other words, the proprietor of an enterprise is always considered to be separate and distinct from the business which he controls.

All the transactions of the business are recorded in the books of the business from the point of view of the business. Even the proprietor is treated as a creditor to the extent of his capital.

Upon investment of money in the business by the proprietor, it is deemed that the proprietor has given money and the business has received money.

The assumption of separate entity is applicable to all forms of business organizations.

For example, from legal point of view a body corporate is a separate entity and the sole trader and his business are regarded as one and the same thing.

But for accounting purposes, they are regarded as different entities. For recording the transactions, it is the business which is the entity and with which we are concerned.

The assumption of the business as a separate legal entity as distinct from its owners has been well accepted in relation to companies all over the world since the legal decision in the case of Salmon vs. Salmon & Co. (1897).

Though this legal assumption has not been extended to sole trader and partnership business firms, for purposes of accounting, all transactions should specifically relate to the business operations of the entity itself.

In a partnership business, the firm is quite separate from the individual partners who are its members and who have agreed to come together in a formal way to attain an agreed objective.

Still, each partner has his own separate life and may have many interests – financial and otherwise, outside the partnership. It is most desirable that the dealings and transactions of the partnership business should be recorded in firm’s books.

If any partner enters into private financial dealings, e.g., to purchase or sell equity shares in a limited, company, it has no relevance to the partnership business and so it should not be recorded in firm’s books. Similarly, a sole proprietor may have many interests apart from or in addition to his business.

But these should not be included in the firm’s books if they are not connected with it.

In brief;

  1. Only the business transactions and not the personal transactions of the proprietor are recorded and reported.
  2. The personal assets of the owners or shareholders are not considered while recording and reporting the assets of the business entity.
  3. Income is the property of the business assets distributed to owners.

Money Measurement Assumption

The money measurement assumption underlines the fact that in accounting every worth-recording event, happening or transaction is recorded in terms of money.

In other words, a factor an event which cannot be expressed in terms of money is not recorded in the account books.

General health condition of the chairman of the company, working conditions in which a worker has to work, sales policy pursued by the enterprise, quality of products introduced by the enterprise, etc., cannot be expressed in terms of money and thus are not recorded in the books.

In view of the above conditions this concept puts a serious handicap on the usefulness of accounting records for management decisions.

In spite of the above limitations of money measurement assumption, it remains indispensable. This assumption increases the understanding of the state of affairs of the business.

For example, if a business has a cash balance of $7,000, a building containing 20 rooms, a piece of land of 2,000 square meters, 40 tables, 20 fans, 2 machines, one tone of raw material and so on then in the absence of money measurement assumption the value of different types of assets cannot be measured by the simple method if addition.

But if they are expressed in monetary terms – $7,000 cash, $50,000 for building, $2,00,000 for land, $8,000 for tables, $6,000 for fans, $1,60,000 for machines, $80,000 for raw material – It is possible to add them and use them for comparison or any other purpose.

This assumption has another serious limitation and is currently attracting the attention of the accountants the entire world over. As per this assumption a transaction is recorded at its money value on the date of occurrence and the subsequent changes in the money value are conveniently ignored.

For example, a building purchased for $ 50,000 in 1960 and another purchased for the same amount in 1992 are recorded at, the same price, although the one purchased in 1960 may be worth four times more than the value recorded in the books, due to rise in land value and construction costs (conversely, because of the fall in the money value). Inflation accounting seeks to deal with this type of problem.

Going Concern Assumption

It is also known as continuity assumption. According to this assumption, the enterprise is normally viewed as a going concern, i.e. continuing in operation for the foreseeable future.

It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations. It is because of the going concern assumption:

  1. That the assets are classified as current assets and fixed assets.
  2. The liabilities are classified as short-term liabilities and long-term liabilities.
  3. The unused resources are shown as unutilized costs (or unexpired costs) as against the break-up values as in case of liquidating enterprise. Accordingly, the earning power and not the break-up value evaluate the continuing enterprise.

According to accounting standards, if this concept is followed, this fact needs not be disclosed in the financial statements since its acceptance and use are assumed. In case this concept is not followed, the fact should be disclosed in the financial statements together with reasons.

Periodic Assumption

It is also known as periodicity assumption or time period assumption.

According to this assumption, the economic life of an enterprise is artificially split into periodic intervals which are known as accounting periods, at the end of which an income statement and financial position statement are prepared to show the performance and financial position, the use of this assumption further requires the allocation of expenses between capital and revenue.

That portion of capital expenditure which is consumed during the current period is charged as an expense to income statement and the unconsumed portion is shown in the balance sheet as an asset for future consumption.

Truly speaking, measuring the income following the concept of accounting period is more an estimate than factual since, actual income can be determined only on the liquidation of the enterprise.