Accounting Assumptions

Welcome Friends, you are welcome to learnvern. I am Anshu Sachan.

In the last session we saw the types of account, that were personal account, real account and nominal account. We also saw the fundamental accounting rules of the same accounts.

In today’s session, we will be learning about the various accounting assumptions. As I have told you that accounting is a science. So there are various assumptions also. You all know that even a mathematical model, is based on some assumption. As if this thing happens, or if this scenario happens. Then only this model would be successful. Similarly to this in accounting, whenever we do accounting, so we take some accounting assumptions.

So that accounting assumption, as when we are writing an account, then at that time we are assuming. That these three assumptions are being fulfilled. In this the first assumption is, Going Assumption. Now, what is going concern? Going concern is an assumption that my business is not going to close down in future. My business would keep on functioning for a long period of time. This is an assumption that I have taken. Based on that, I would be writing the books of accounts. Like, I have paid for an insurance of 1 year. My books of account are made during the months of January to December. Now, the insurance for which I have paid is between the months of April to March. Okay. I have paid for it 3 months in advance.

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If I take a proper example. Then suppose we have an accounting period from January 2021 to December 2021. But the insurance that I have paid for is from April 2021 to March 2022. Now, what I would do is, I will make a prepaid entry, I have made an advanced payment. So, this is a going concern assumption, that even in the next year my business would continue to function in the next year. Okay. So on the basis of going concern I have prepared the accounts and the entries have been passed. Like when we are maintaining the accounts then there is a concept called historical cost concept.

Let’s assume that I have bought a vehicle today, at the cost of 50 thousand rupees. So in the fixed assets I would show it as 50k itself. Okay. And in the next year that fixed assets would be visible at the rate of 50k only. Even if the value of that has one down. This is called the historical cost concept. Though I would still be depreciating the price of the vehicle, I will have created the provision of the depreciating cost. But the fixed asset, if I have purchased the vehicle in 2020 for the price of 50k. And if the vehicle is still with me. Then the value of the vehicle would still be 50k, though the depreciation provision is already made. But the account of my asset, it would be maintained for the 50 thousand. This is a historical cost concept. Now, this historical cost concept would only be followed if the Going Concern Assumption is already fulfilled. This means that my business would not be shutting down, in the next 3 to 4 years or in the future. There is a word, foreseeable future, this means that the immediate future, in that my business would not be shutting down. Its not my intention to shut the business and also there are no factors or reasons that would close my business.

Now, based on all these, the going concern. The account is written based on this. This is a very important assumption, if your auditor is auditing your account, and you think that this business would not be able to survive and would eventually close down, then the accounts of that are presented separately. In that the historical concept is not followed. In that condition, you need to show the assets based on the market value. Understood. So, historical concept and the net realisable concept. Both of these depend upon, if you are following the going concern. If you feel like it, you can go online, and look for Tata and Reliance, the companies which produce annual reports. You all might know, the annual report is a financial statement of the whole year. You can find it online and analyse it. When you read it you can see the note for Going Concern. This is compulsory, any auditor first checks if the going concern is present or not. That means whether this closes down in the foreseeable future or not. If it closes down then the presentation of it would be different and also, if the auditor thinks that the accounts that have been prepared, in there the going concern is not being followed. Then he would give his own observations, as these are the ways because of which I think that this business would not be able to survive.

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Let’s take an example. Suppose I am a mobile manufacturing company. Okay. I am fighting a case for patent infringement. The case that has been made is very massive, that in case if the decision is made against me then I would have to stop this whole business. So in this case the going concern is not being followed. So the presentation of the whole account will change and you cannot write this account in the normal way. You need to convert everything into the market value and then show it.

I hope that you have understood what I want to say about the going concern. Going concern is a very basic and fundamental assumption. If it is getting full filled then only you would be able to maintain a proper books of account and then only you would be able to write the proper books of account. Okay.

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The second one is consistency. As you all know that in any matter, consistency is valuable, then only it would lead you to the desirable outcome. The expectations that you have, like this would be the profit be or this kind of performance I could have this year. I will get to learn this thing. When I would be consistently and properly maintaining all the things around me. If your consistency is like that sometimes the profit is very high and then sometimes the profit suddenly stoops very low. If you have not been following any practice for the bookkeeping then, it would not give you proper books of account. Also your results would not be proper. Okay.

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So consistency means, let's take an example, let's understand the depreciation policy. Suppose in my business there are 10 computers, then I have decided that those 10 computers would become obsolete in 3 years, meaning they would depreciate, meaning their value would become zero. So what I did is, I have given it a depreciation method, I hope that you know that there are two methods for the depreciation. One is the straight line method and one is the reducing balance method. When we will be learning further then we will be learning about what are the depreciation policies. Generally, the depreciation policies would be decided by the management, that is, business. As how to depreciate the value. Okay.

Let me get back to the example, as we have purchased a computer, we have 5 computers and I have to depreciate it. I have also decided that the computers would have depreciated in 3 years. So the depreciation that I have done in 1 year, I calculated the amount of it and booked the depreciation expense for it. In the second year, I thought that no, these will work for 6 years and not for 3 years. So, you would again change the depreciation. What will happen here is, no consistency would be followed. If you are consistent then if you have decided it once then don’t change it. Let it be 3 years and 3 years itself. You will follow this policy, not just for this year but also for the next two years also. Okay. This is called consistency.

You have already seen the materiality concept. So, if the expense is over 5k, then only I will capitalise it. If the expense is greater than 5k then only I will count it as a capital asset, and then I will depreciate it. So, this was the policy that I have made. But if you change the policy as, no I will keep 2k and not 5k. This won’t work. If you continue to do things like this then your books of account would not give you a proper output. The reason that we have made this book, the advantages and benefits of it. That we would not get to see. Understanding me?

Consistency is a thing that you need to follow. Either it can be an accounting policy, depreciation policy, or some other things required for the decision making. If you have written as, if I do not get the money in 10 days then I would make a provision of it, it will be called bad debt. Bad debt provision means, that there is a chance that the money would not be returned. So, I have already decided that if I do not get the money after 10 days then there would be a provision for that. If next year your mood changes and you think that, no, it should not be after 10 days, it should be after 5 days. It does not happen like that. If you are doing the bookkeeping then you need to follow and maintain a consistent policy.

As a businessman do I need to decide this? Yes, your accountant would ask you how you want to depreciate the assets. Because you are the proper person, who knows and can guess as after 5 years, the technology of the computer will become obsolete. Maybe this technology would not exist. So, I would need to replace this thing with something else. Hence, as a businessman and as a management, you need to decide the accounting policy. For a computer the depreciation policy would be different than a plant and machinery. Because the computer is a technology based system and you need to know how fast the technology is progressing. So it will become obsolete faster. Whereas the plant and machineries, its depreciation would last longer for like 10 years or 15 years. Okay. So its depreciation rate would be different. Its policy would be different. But if you have decided then you should consistently follow it, you should not change it every year. You can change it only if you have any one of the two reasons. First one is if there is a notification from the government or the government has changed the rules of some sorts. So, according to that you might have to change something in your policy.

The second one is, you need to show that, if you are changing the policy then your books of account would be able to show better judgement and better scenarios. Understanding me? There are two things, any government rule changes as there is no control from our side. Government earlier exempted something from GST but in the next annual general meeting for the GST, the panel decided to add that thing under the GST. So, now you would have to change some policies from your side. That can be easy and you can do it, as you are changing your policies according to the changes in the government rules. Then the second thing, you realised that, you are obsoleting your computer within 3 years. So, it is not showing a proper picture. Since the last 6 to 7 years, I have had a policy in which computers became obsolete in 3 years. But that was not showing me a proper position or a proper performance. Because my computers are becoming obsolete in 2 years itself. Okay.

Now, you have a base and you also have history, track record. On whose basis you can show, that these systems are not taking 3 years but 2 years only to become obsolete. That's the reason why I am changing my depreciation policy from 3 years to 2 years. Understood?

All this means that the changes that you are making in your policy, then you need to convince and also prove it that this updated policy would result in better preparation of the books of accounting. So, in these two conditions, you can change your consistent depreciation policies.

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Then the third one is Accrual Basis. What happens in Accrual basis is, whenever you think that there would be a future loss, or you think that you will definitely lose this case, so you will make a provision for that, now itself. Accrual basis means, as you incur the expense, or as you made the payment, whichever happens first among them, you would need to book them accordingly. Suppose, that the computer that you have purchased. I have made an AMC contract for it, AMC means annual maintenance contract. I have paid 1 thousand per computer and I have 6 computers, so I have paid 6k for my computers.

Now what I have done is, for any AMC you need to make an advance payment. As for the year 2021 you have to make a payment in the year 2020. Okay. so you have paid the money in advance. So what I have said is, as soon as an expense is made, or you give money, whichever happens first among them, you need to book it accordingly. Okay. This is known as Accrual Basis. Payment or incurrence. You made a payment or you incurred, whichever happens first, according to that you need to record the transaction. Okay. This is called Accrual Basis.

Like there were 3 types of accounts, there were 3 types of accounting rules, these 3 are the main assumptions, although there are a lot more assumptions. Without these assumptions you cannot prepare the account. And If you have ignored these 3 assumptions, then your accounts would not be giving you the desirable output.

If you have any queries and comments……

In the next session, we will be seeing what ledger is. We have learned the accounting principles, accounting types and we have also learned the fundamental assumption. Now we will get into ledger posting. For that we need to learn, what is ledger and what is the method for writing the account. Okay.

Until then, Thank You.