Accounting Concepts Are Basic Assumptions Accounting Essay


Accounting concepts are basic assumptions, which underlie the periodic financial accounts of business enterprises. These concepts are sometimes referred to as rules, principles, procedures, conventions and postulates.

Historical Cost Convention

This concept requires accounting transactions to be recorded at their historical cost. This means that the assets acquired by a business are recorded in the books at their historical costs and subsequent changes in the values are ignored. All transactions are recorded in the books at cost and not at its market value. The underlying ideas of this concept are two forms.

An asset is recorded at the price paid to acquire it i.e. at cost and

This cost is the basis of all the subsequent treatment of the assets. E.g. depreciation, stock valuation, etc.,

Majority of the accounting underlying today's financial reporting is basing on historical cost in completing the transactions. The prices in the transactions acquired the assets or incurring the liabilities is the basis for recording it. Assets wear out or become obsolete, and the accountants establishing conventional depreciations or amortizations procedures to expense the costing of assets over the expected service life. For assets that loses there worth sooner than expected, impairment write-downs are used to reflect the decreases its value. However, the fact that the value of some assets goes up, rather than down, over time was, and still remains, largely unrecognized in US financial reporting. Furthermore, under US GAAP, internally developed intellectual assets are generally not recognized as assets, even though as some point they meet the definition of an asset. Instead, the costs incurred to develop and maintain them are expensed as incurred. Those internally developed intellectual assets that are recognized, for example, patents, are recognized and recorded at the cost to register and protect the asset, not the value of the asset itself.

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The advantages accounting based on historical transactions and lie in the verifiability of the recorded transaction values. In addition, advocates of the historical cost model argue that it is cost efficient.

The disadvantage is that without a well-defined economic event or transaction, some assets and some liabilities escape the financial reports.

Additionally, the historical cost system is better at recognizing when an asset's utility to the company has decreased rather than when it has increased or when a new asset has materialized within the company. In terms of management accountability, historical cost accounting can often result in a conservative view on the value maintained or added over time.

While historical cost convention may not represent the most relevant information regarding the economic conditions at a point in time, this convention is built on verifiability and cost-benefit considerations.


Going Concern Concept

The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.

Suppose, however, that a business is drawing up its financial statements at 31 December 2008. Normally, using the historical cost concept, the assets would be shown at a total value of $100,000. It is known, however, that the business will be forced to close down in February 2009, only two months later, and the assets were expected to sell for only $150,000.

In this case it would not make sense to keep to the going concern concept, and so we can reject the historical cost concept for asset valuation purposes. In the balance sheet at 31 December 2008 the assets will therefore be shown at the figure of $150,000. Rejection of the going concern concept is the exception rather than the rule.

Examples where the going concern assumption should be rejected are:

If the business is going to close down in the near future.

Where shortage of cash makes it almost certain that the business will have to cease trading;

Where a large part of the business will almost certainly have to be closed down because of a shortage of cash.

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(Frank Wood and Alan Sangster (2008), Business Accounting 1 (eleventh edition), Pearson Education Limited, UK)

b. Historical Cost Convention VS Going Concern Convention

This 'going concern' concept has important implications for the valuation of assets and liabilities of the business. By applying the 'going concern' concept, accountants are able to report long-term assets in a Statement of Financial Position (balance sheet). If the assumption were not applied, the accountant would need to write these assets off as costs within the year of purchase. Applying the 'going concern' concept also allows accountants to properly allocate transactions, which overlap two consecutive years. Many credit transactions overlap consecutive years.

Also, by applying the concept of a 'going concern', accountants are able to record assets at historical costs. Recording assets at historical cost means the accountant does not need to constantly assess the liquidation value of business assets when preparing the financial statements. For example, partly completed manufactured goods like work-in-progress would have little value in a liquidation valuation. However, under the 'going concern' concept work-in-process assets are recorded at current costs, which would be significantly greater than the liquidated value.

Another aspect of 'going concern' affects directors of companies. This is a slightly different concept to the 'going concern' concept in accounting. The law requires directors of companies to make a declaration that their business continues to be a going concern. This means that the directors believe that the business is able to pay its bill, as they are due. The directors are required to disclose in the notes to the financial statements if there are any factors that may put in doubt the company's status as a 'going concern'.


c. Past Report or an estimating of the future?

In companies, the annual report represents the information given to the shareholders by the directors of their running of the company during a particular year. In other words, it is a description of the directors' 'stewardship' of the company. The financial statements are also given to other interested parties, such as the company's bankers, creditors, inspectors of taxes, etc.

The first major deficiency of financial accounting is that it deals with events that have already occurred. It deals with the past, not the future. It is possible to control something while it is happening, and control can be arrange for something that is going to happen but, when it has already happened without being controlled, the activity has ended and we are too late to do anything about it. For example, if a company incurs a loss and we do not realize it until long after it has happened, the loss obviously cannot be prevented.

What we really want to do is to control affairs so that a loss is not incurred if at all possible, and to be able to call on accounting techniques to help us do so. However, it certainly does not mean that we are not interested in the past. We can learn lessons from the past, which can be very useful in understanding what is going on now, and what is likely to be happening in the future.

The second major deficiency of financial accounting is that it is concerned with the whole of the organization. Thus the trading account of a business may show a gross profit of $60,000 but, while it is better to know that then to have no idea at all of what the gross profit is, it does not tell management much about past transactions. Past records are also use to prepare the forecasted cash flow statement and budgets.

(Frank Wood and Alan Sangster (2008), Business Accounting 2 (Eleventh Edition), Prentice Education Limited)

Cash Flow (FRS 1)

Financial Reporting Standard I (Revised 1996) 'Cash Flow Statements' requires reporting entities within its scope to prepare a cash flow statement in the manner set out in the FRS. Cash flows are increases or decreases in amounts of cash, and cash is cash in hand and deposits repayable on demand at any qualifying institution less overdrafts from any qualifying institution repayable on demand. The FRS applies to all financial statements intended to give a true and fair view of the financial position and profit or loss (or income and expenditure) except those of:

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Subsidiary undertakings where 90 per cent or more of the voting rights are controlled within the group, provided that consolidated financial statements in which those subsidiary undertakings are included are publicly available;

Mutual life assurance companies;

Pension funds;

Open-ended investment funds, subject to certain further conditions;

For two years from the effective date of the FRS, building societies that, as required by law, prepare a statement of source and application of funds in a prescribed format and

Small entities (based on the small companies exemption in companies legislation).


"A parent or holding company be exempt from preparing consolidated accounts; may omit; or must omit results of a subsidiary from the consolidated accounts."

FRS 2 - Consolidated Accounts (FRS 2)

Financial Reporting Standard No. 2 - ' Accounting for Subsidiary Undertakings' (the FRS) sets out the conditions under which an undertaking that is the parent undertaking of other undertakings (its subsidiary undertakings) should prepare consolidated financial statements. The FRS also set out the manner in which consolidated financial statements are to be prepared. The purpose of consolidated financial statements is to provide financial information about the economic activities of a group. The companies ACT 2006 defines a parent undertaking and its subsidiary undertakings that together make up a group. The FRS adopts these definitions.

The FRS supersedes Statement of Standard Accounting Practice No. 14 - 'Group accounts' and the Board's 'Interim Statement: Consolidated Accounts', except for the following paragraphs of the Interim Statement: paragraphs 32 and 33, A9 and A10, on joint ventures and paragraphs 38, A13-A18 and A23 dealing with the amendments to SSAP I 'Accounting for associated companies'.

The FRS applies to all parents undertaking. A parent undertaking that does not report under the Act should comply with the requirements of the FRS except to the extent that any statutory framework under which the undertaking reports does not permit these.

A parent undertaking should prepare consolidated financial statements for its group in accordance with the standard accounting practice set out in the FRS unless it uses one of the exemptions permitted by the Act and set out in paragraph 21 of the FRS.


Legal exemptions from preparing consolidated financial statements

Accounts and reports (sections 380-474) and in Part 16, Audit (sections 475-539) of Companies Act 2006 have become generally effective from 6 April 2008.

However, many of the sections are applicable only to accounting periods beginning on or after that date. Meaning that, the implementation of the new requirements will affect accounts ending from April 2009 onwards and short periods of accounts beginning after 6 April 2008. Some of the new requirements affecting April 2009 year-end accounts have been summarized below:

Companies subject to the small companies regime (Sections 382 and 383)

The new thresholds for a company to qualify as being small, providing that at least two out of the three are met, are as follows:

Turnover not more than 6.5 million

Balance sheet total not more than 3.26 million

Number of employees not more than 50.

Conditions for exemption from audit (Sections 477 and 479)

For exemption from audit a company needs to meet all of the following conditions:

That the company qualifies as small as relation to that year.

That its turnover, in that year, is not more than 6.5 million

That its balance sheet total for that year is not more than 3.26 million


IAS 27 (Consolidated and separate financial statement) exempts a wholly owned subsidiary from preparing consolidated financial statements. In practice, therefore, those companies may have to prepare consolidated financial statements if sufficient of the minority interest demand it. However, in either case, three other conditions must be met for subsidiaries to have exemption from preparing consolidated financial statements:

The exempted entity's debt or equity is not traded in a public market,

The exempted entity did not file, nor is it in the process of filing its financial statements with a securities commission or other regulatory organization for the purpose of issuing any class of instruments in a public market,

The ultimate or any intermediate parent produces consolidated financial statements available for public use that comply with International GAAP.

Reasons of companies do not want to prepare consolidated accounts.

Preparing of consolidated accounts would be costly because it needs to employ a CPA to prepare the consolidated accounts.

Holdings Company and subsidiaries may have different company policy and standard.

It may also have a different year-end closing date

They may belong to different industries.