In order to make sense to outside stakeholders, financial reports must follow a set of guidelines that are shared both within and between industry sectors. Without these accounting assumptions and principles for business, evaluating and investing in a company would be reduced to mere guesswork. In the following sections, we’ll unpack the assumptions and principles that create common ground for accounting practices.
A Means of Comparison
Financial statements would be meaningless if every company used a different way to generate them. You might see the same type of data on all of them, but you’d have no way to know how a company was actually doing if they all had their own set of rules for compiling and presenting financial information. Worse still, you wouldn’t know if the data was accurate, speculative, or even wildly inflated.
This is why accounting assumptions and principles for business exist in the first place. They were established to avoid the scenario we just described. The accounting industry uses these assumptions to give analysts, executives, and other stakeholders a shared, objective way to assess a company’s financial performance.
GAAP and Accounting Practices
The principles that accountants are supposed to adhere to were created by The Financial Accounting Standards Board (FASB). These principles are referred to as Generally Accepted Accounting Principles (GAAP). Their purpose is to formulate and monitor the definitions, methods, and assumptions that all accountants use in their practice.
GAAP prescribes the ways in which a company should present its financial data, thus ensuring that stakeholders can make meaningful comparisons from year to year. This gives all stakeholders the ability to compare different companies objectively and come to informed conclusions about them.
The Securities and Exchange Commission (SEC) governs the proper ways of generating financial reports for publicly-traded companies.
GAAP: Its Accounting Assumptions and Principles for Business
Certain fundamental accounting assumptions and principles for business make up the foundation of GAAP. These are the ten assumptions that underpin GAAP and form the basis for reliable information:
1. Accrual Principles
These principles mandate that all accounting activities should be recorded in a way that reflects the timing of when they occur. Take revenues, for instance. They must be recorded when a buyer receives the product or service they’ve purchased, not when the seller receives payment. Similarly, a company should record expenses when it takes full possession of the products/services they’re purchased from an outside entity, instead of the moment when they pay for them.
2. The Consistency Assumption
Company managers and other stakeholders need to have confidence in the information they see on financial statements. This is why consistent accounting methods are so important when evaluating a company’s financial situation. Consistent modes of financial reporting are especially helpful when comparing companies in the same industry sector.
However, there are a few notable exceptions. These exceptions to the consistency assumption occur when there are two acceptable, but opposing, ways of performing the same accounting function. Take the first-in-first-out (FIFO) and last-in-first-out (LIFO) modes of inventory accounting, for instance. If one company uses the FIFO method and another uses the LIFO method, problems can arise for anyone using the results of their respective inventory calculations. Therefore, it’s important that stakeholders understand how a company performs its inventory accounting and make the necessary adjustments.
3. The Reliability Principle
The information that accounting professionals utilize to compile financial statements can only be derived from transactions that outside parties can verify through supporting documentation.
4. The Assumption of Monetary Unit
All transactions should be recorded in terms of one unit of currency. Using a single unit of currency automatically takes inflation into account and assumes that the dollar’s buying power is constant. This allows for meaningful comparisons between transactions that might have occurred decades apart. Typically, the unit of currency used depends on the country where the company has its base of operations.
5. The Periodicity Principle
Financial statements should always cover transactions that occur during a consistent and uniform period of time. These periods of time can be annual, monthly, or quarterly. However, if the periodicity principle isn’t followed, financial reports will cover varying lengths of time and won’t be comparable in any meaningful way.
6. The Entity Assumption
A financial report should only contain economic information that’s derived from the company’s daily operations. In other words, business and personal transactions should remain separate at all times. This even holds true for a sole proprietorship. While a sole proprietorship and its owner are viewed as the same entity in legal terms, accounting practices should consider them to be separate.
7. The Going Concern or Continuity Principles
Accountants should report on a company’s financial situation in a way that assumes the business will stay in operation indefinitely. In other words, accountants should treat the business as though it were a ‘going concern.’ Otherwise, the information contained in their financial reports would look very different and be of little use to stakeholders.
8. The Principle of Historical Cost
This principle requires that an accountant track the historical cost of a particular asset or group of assets. The historical cost refers to how much the company spent when it originally acquired the asset(s). This value does not change because of inflation, possible resale value, or any other market conditions.
9. The Assumption of Full Disclosure
In addition to what GAAP requires, there is additional performance-related information that a company has to disclose. For example, let’s say that a company is currently being sued for a substantial amount of money. Even though the case has yet to be decided, the lawsuit must still be included in the financial reports.
10. The Conservatism Principle
The conservatism principle becomes operative when two legitimate accounting methods come up with different answers. If this happens, the accountant must use the calculations that come up with a lower amount of income or a lower valued asset. This helps prevent possibly misleading evaluations and assures stakeholders that the reports are accurate.
How Accounting Practice Standards Create Trust and Credibility
The accounting principles and assumptions we’ve discussed give financial reporting a shared framework. GAAP is a group of foundational principles that standardize and monitor the essentials of accounting practices. The regulation provided by GAAP allows stakeholders to assume that a company’s financial statements are reliable enough to be used for cross-comparison and sound decision making.
Lastly, reliable accounting assumptions and principles for business reduce the possibility of haphazard, confusing financial statements. The average business transaction has grown significantly more complex in recent years, and standardized recording methods are necessary for delivering accurate financial data to managers, analysts, shareholders, and the public sphere.
About Zach Inghram
Zach Inghram is a CPA and holds a BBA in accounting from Loyola University Chicago. He has a diverse professional background having held analyst, accountant, and audit roles within the insurance, infrastructure services, and oil & gas industries. As the sole proprietor of Inghram CPA, he provides tax and bookkeeping services locally in the Austin, TX area and remotely around the country. His clients commonly remark that he holds himself to the highest standards of honesty, integrity, and professionalism. In his free time, he and his wife enjoy being outdoors hiking, camping, gardening, and fishing.