May 16, 2022 May 16, 2022/ Steven Bragg
Key accounting assumptions state how a business is organized and operates. They provide structure to how business transactions are recorded. 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. The latter approach will not result in financial statements that can be audited.
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.
May 16, 2022/ Steven Bragg/
The Conceptual Framework for Financial Reporting (2010) provides important information on the concepts which underlie the preparation and presentation of financial statements. This framework is of great benefit to all financial statement users. It has several components that are outlined in figure 1 below.
Outline of the IASB Conceptual Framework
Figure 1 – IFRS Framework for the Preparation and Presentation of Financial Reports
Main Objective of the Conceptual Framework
The Conceptual Framework (2010) has a core objective from which all its other aspects flow. This central objective is “to provide financial information which is useful to both current and potential providers of resources (investors, lenders, other creditors) in decision-making.“
The financial information to be provided will include: (i) information on a company’s financial position (its resources and financial obligations); (ii) information on a company’s financial performance (information which explains why the company’s financial position changed in the past); and (iii) information on the company’s cash and cash equivalents.
Qualitative Characteristics
The Conceptual Framework (2010) identifies relevance and faithful representation as the two fundamental qualitative characteristics which make financial information useful. Financial information is relevant if it would potentially affect or make a difference in its consumer’s decision. Faithful representation relates to the fact that information that represents an economic phenomenon should ideally be complete, neutral, and free from error.
The Conceptual Framework (2010) also identifies comparability, verifiability, timeliness, and understandability as the four enhancing qualitative characteristics of information:
- comparability permits the identification and understanding of similarities and differences between items of information;
- verifiability means that different observers would independently agree that the information that is presented faithfully represents the economic phenomena that it alleges to represent;
- timeliness refers to the availability of information to decision makers when it is needed i.e. before the need for decision-making arises; and
- understandability means that the information should be comprehensible to its users who have a reasonable knowledge of business and economic activities, and are willing to diligently study it.
Constraints on Financial Reports
The cost of providing and using financial information is a constraint that must be balanced with the benefits that are to be derived from the information.
Elements of Financial Statements
The financial effects of transactions and other events are represented in financial statements by grouping them into broad classes or elements. The grouping is done according to their economic characteristics.
The elements of financial statements that are directly related to financial positions are assets, liabilities, and equity. The elements directly related to financial performance, on the other hand, are income and expenses.
Accrual accounting and ‘going concern’ are two key assumptions that underlie the preparation of financial statements. These assumptions determine how financial statement elements are recognized and measured. Accrual accounting means that financial statements reflect transactions in the period in which they occur and not necessarily when cash movement occurs. ‘Going concern’ means that a company is assumed to continue in business for the foreseeable future.
Recognition refers to the inclusion of an item on the balance sheet or income statement. An item should be recognized if it is probable that future economic benefits that are associated with it will flow to or from the reporting entity, and it has a cost or value that can be reliably measured.
In measuring financial statement elements, the following bases of measurement may be used:
- historical cost: this refers to the amount of cash or cash equivalents paid or the fair value of what was given to purchase an asset. Concerning liabilities, it refers to the amount of proceeds received in exchange for an obligation;
- amortized cost: this refers to the historical cost after adjustments are made for amortization, depreciation, depletion, and/or impairment;
- current cost: concerning assets, this refers to the amount of cash or cash equivalents that would have to be paid to purchase the same or an equivalent asset today. Concerning liabilities, the current cost refers to the undiscounted amount of cash or cash equivalents that are required to settle the obligation today;
- realizable (settlement) value: realizable value refers to the amount of cash or cash equivalents that could currently be obtained by selling an asset in an orderly disposal. Concerning liabilities, settlement value refers to the undiscounted amount of cash or cash equivalents that are expected to be paid to satisfy the liabilities in the normal course of business;
- present value: concerning assets, this refers to the present discounted value of the future net cash inflows that an asset is expected to generate during the normal course of business. In regard to liabilities, PV refers to the present discounted value of the future net cash outflows that will likely be required to settle the liabilities of the normal course of business; and
- fair value: this refers to the amount at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
According to the Conceptual Framework (2010), which of the following are the two fundamental qualitative characteristics that make financial information useful?
- Timeliness and understandability.
- Relevance and faithful representation.
- Accrual accounting and going concern.
Solution
The correct answer is B.
The Conceptual Framework (2010) identifies relevance and faithful representation as the two fundamental qualitative characteristics which make financial information useful.
‘Timeliness’ and ‘understandability’ are two of the enhancing qualitative characteristics of information, while ‘accrual accounting’ and ‘going concern’ are the underlying assumptions identified by the Conceptual Framework (2010).