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    Friday
    Dec142012

    What are the key accounting assumptions?

    Any accounting system is based on the set of key accounting assumptions concerning how a business is organized and operates. 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. These key assumptions are:

    • Accrual assumption. Transactions are recorded using the accrual basis of accounting, where the recognition of revenues and expenses arises when earned or used, respectively. If this assumption is not true, a business should instead use the cash basis of accounting to develop financial statements that are based on cash flows.
    • Conservatism assumption. Revenues and expenses should be recognized when earned, but there is a bias toward earlier recognition of expenses. If this assumption is not true, a business may be issuing overly optimistic financial results.

    • Consistency assumption. The same method of accounting will be used from period to period, unless it can be replaced by a more relevant method. If this assumption is not true, the financial statements produced over multiple periods are probably not comparable.
    • Economic entity assumption. The transactions of a business and those of its owners are not intermingled. If this assumption is not true, it is impossible to develop accurate financial statements. This assumption is a particular problem for small, family-owned businesses.
    • Going concern assumption. A business will continue to operate for the foreseeable future. If this assumption is not true (such as when bankruptcy appears probable), deferred expenses should be recognized at once.
    • Reliability assumption. Only those transactions that can be adequately proven should be recorded. If this assumption is not true, a business is probably artificially accelerating the recognition of revenue to bolster its short-term results.
    • Time period assumption. The financial results reported by a business should cover a uniform and consistent period of time. If this is not the case, financial statements will not be comparable across reporting periods.

    Though the preceding assumptions may appear obvious, they are easily violated, and can lead to the production of financial statements that are fundamentally unsound.

    When a company's financial statements are audited, the auditors will be looking for violations of these accounting assumptions, and will refuse to render a favorable opinion on the statements until any issues found are corrected. Doing so will require that new financial statements be produced that reflect the corrected assumptions.

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