Financial Statements are prepared based on certain assumptions which are neither disclosed nor required to be disclosed, so they are called Fundamental Accounting Assumptions, like Going Concern, Consistency & Accrual.
As per AS 1 of the ICAI, certain fundamental accounting assumptions underlie the preparation and presentation of financial statements. They are usually not specifically stated because their acceptance and use are assumed. Disclosure is necessary only if they are not followed.
The following have generally been accepted as fundamental accounting assumptions:
a. Going Concern
The enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of the operations.
It is assumed that accounting policies are consistent from one period to another.
Revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate. (The considerations affecting the process of matching costs with revenues under the accrual assumption are not dealt with in this standard.
What is Going Concern ?
The financial statements are normally prepared based on the assumption that operations of an enterprise will continue in the foreseeable future, i.e. neither there is any need nor any intention to materially curtail/ reduce the scale of operations or level of activities. In case of intention or necessity to enter into a scheme of arrangement with the enterprise’s creditors or to liquidate in near future, may not allow an enterprise to prepare the financial statements based on ‘going concern’ assumption.
Financial statements prepared on going concern basis recognise among other things the need for sufficient retention of profit to replace assets consumed in operation and for making adequate provision for settlement of its liabilities. If any financial statement is prepared on a different basis, e.g. when assets of an enterprise are stated at net realisable values (NRV) in its financial statements, such basis is required to be disclosed.
Use of ‘going concern’ assumption in preparation of financial statements reflects that such entity has intention to continue business activities/ operation in foreseeable future. In other words there is no plan to discontinue/ liquidate the business in near future.
What is Consistency ?
The principle of consistency refers to the practice of using same accounting policies for similar transactions from one accounting period to another. The consistency improves comparability of financial statements through times. However, an accounting policy can be changed in exceptional circumstances, if the change is required,-
(i) by a statute;
(ii) by an accounting standard; or
(iii) for more appropriate presentation of financial statements.
What is Accrual basis of accounting ?
Under the ‘Accrual’ based accounting, transactions are recognised as soon as they occur, whether or not cash or cash equivalent is actually received/ paid or not. Accrual basis ensures better matching between revenue and cost. Profit/ loss calculated based on accruals, reflects activities of the enterprise during an accounting period, rather than cash flows generated by it.
Accrual basis may be a more logical approach for profit determination vis-a-vis the cash basis of accounting, however it exposes an enterprise to the risk of recognising an income before actual receipt. The accrual basis can therefore overstate the divisible profits. Dividend decisions based on such overstated/ unrealised profit may lead to erosion of capital. For this reason, accounting standards require that no revenue should be recognised unless the amount of consideration and actual realisation of the consideration is reasonably certain.
Despite the possibility of distribution of profit not actually earned, accrual basis of accounting is generally followed because of its logical superiority over cash basis of accounting. Section 209(3)(b) of the Companies Act makes it mandatory for companies to maintain accounts on accrual basis only. It is not necessary to expressly state that accrual basis of accounting has been followed in preparation of a financial statement. In case, any income/ expense is recognised on cash basis, the fact should be stated.
Assumption relating to Accrual indicates that Financial Statement have been prepared based on mercantile system, wherein the effect of transactions is recognised/ recorded when they are entered into (and not when the cash is received or paid) and accordingly they get reported in the financial statements of the relevant financial year to which they relate.
However, it may be noted that other accounting assumptions relating to business entity, money measurement, matching, etc. are not fundamental accounting assumptions as per AS 1 of the ICAI.