In our earlier articles, we discussed the Framework for the Preparation and Presentation of Financial Statements and the Components and Users of Financial Statements. We learned that financial statements are prepared using certain rules so that everyone – investors, banks, government, and the public – can trust them.
But there is something even more basic behind all this. Financial statements are prepared based on some basic assumptions. These assumptions are called Fundamental Accounting Assumptions.
These assumptions are so basic that accountants usually do not mention them separately in financial statements. They are taken for granted unless something is different. If any of these assumptions is not followed, then it must be clearly disclosed.
Let us understand these assumptions in a simple and practical way.
What are Fundamental Accounting Assumptions?
Fundamental accounting assumptions are the basic conditions on which financial statements are prepared. These assumptions ensure that accounting information is consistent, meaningful, and reliable.
There are three fundamental accounting assumptions:
- Going Concern
- Accrual Basis
- Consistency
These three assumptions act like the foundation of a building. If the foundation is weak, the whole structure becomes unreliable.
1. Going Concern Assumption
Meaning
The going concern assumption means that a business will continue its operations in the future. It is not expected to close down or sell all its assets in the near future.
In simple words:
“The business will keep running.”
Because of this assumption:
- Assets are recorded at their cost
- Liabilities are shown as payable in future
- Depreciation is charged over useful life
If a business was about to close, everything would be valued at selling price instead of normal value.
Why is Going Concern Important?
Imagine a company owns a machine worth ₹10 lakh. If the company is running normally, the machine is used to earn income over many years. But if the company is about to shut down, that machine will be sold quickly, maybe for ₹4 lakh or ₹5 lakh.
So the value of assets depends on whether the business is continuing or closing. That is why going concern is very important.
Practical Example
Suppose a trader owns a building used for business. If the business is a going concern, the building is recorded as a fixed asset and depreciated over time. But if the business is shutting down, the building is recorded at its selling price.
Therefore, financial statements prepared on going concern basis assume:
- Profits will be reinvested
- Assets will be used
- Liabilities will be paid normally
When Going Concern Is Not Followed
If a business is facing heavy losses, legal cases, or financial problems and may close down, the going concern assumption is no longer valid. In such a case, the company must clearly disclose that financial statements are not prepared on going concern basis.
2. Accrual Basis of Accounting
Meaning
The accrual basis means that income and expenses are recorded when they are earned or incurred, not when cash is received or paid.
In simple words:
“Record transactions when they happen, not when money changes hands.”
Why Accrual Basis Is Important
If we record only cash received and cash paid, profits can be misleading. A business may receive a lot of money today for work done earlier or may delay payments to show higher profit.
Accrual accounting gives the real performance of a business.
Example
Suppose:
- A company sells goods worth ₹50,000 in March but receives money in April
- It pays salary for March in April
Under accrual basis:
- Income of ₹50,000 is recorded in March
- Salary expense is also recorded in March
This shows the correct profit of March.
Under cash basis:
- Both would be recorded in April, which is incorrect.
Cash Basis vs Accrual Basis
| Cash Basis | Accrual Basis |
| Records when money is received or paid | Records when income is earned or expense is incurred |
| Can show wrong profit | Shows true profit |
| Not suitable for companies | Mandatory for companies |
That is why Indian law requires companies to follow accrual accounting.
3. Consistency Assumption
Meaning
Consistency means that the same accounting methods are used from one year to another.
For example:
- If depreciation is charged using straight-line method this year, the same method should be used next year
- If inventory is valued using FIFO, it should continue unless there is a valid reason to change
Why Consistency Is Important
Consistency makes financial statements comparable. Users can compare:
- This year vs last year
- One company vs another company
If accounting methods keep changing, comparisons become meaningless.
When Can Accounting Policies Be Changed?
Accounting policies can be changed only if:
- It is required by law
- It is required by accounting standards
- It results in more accurate and fair presentation
When a change is made, it must be clearly disclosed.
Why These Assumptions Are Not Disclosed Normally
Since these assumptions are always followed, financial statements do not mention them. It is understood that:
- The business is continuing
- Accrual accounting is used
- Same policies are followed
But if any of these assumptions is not followed, then disclosure becomes compulsory.
How These Assumptions Support Financial Statements
These three assumptions ensure that:
- Profits are not manipulated
- Assets are not undervalued or overvalued
- Financial statements remain reliable
They create a strong base for all accounting information.
Conclusion
The Fundamental Accounting Assumptions are the backbone of financial reporting. Without them, financial statements would lose their meaning.
- Going Concern ensures the business is treated as continuing
- Accrual Basis ensures income and expenses are recorded correctly
- Consistency ensures fair comparison
Together, they make financial statements useful, trustworthy, and transparent.
Frequently Asked Questions (FAQs)
1. What are fundamental accounting assumptions?
They are basic principles on which financial statements are prepared, such as going concern, accrual basis, and consistency.
2. What is the going concern assumption?
It assumes that a business will continue its operations in the foreseeable future and will not shut down.
3. What does accrual basis of accounting mean?
It means income and expenses are recorded when they are earned or incurred, not when cash is received or paid.
4. Why is consistency important in accounting?
Consistency ensures that financial statements can be compared from one year to another and between different companies.
5. Are fundamental accounting assumptions disclosed in financial statements?
They are not disclosed unless any of them is not followed. If an assumption is violated, it must be clearly stated.
6. Can accounting policies be changed?
Yes, but only if required by law, accounting standards, or if it results in better and fairer presentation.
7. Why are these assumptions important for users of financial statements?
They ensure that financial information is reliable, fair, and useful for decision-making.
