Fundamental accounting assumptions under AS-1

The three fundamental assumptions

AS-1 (Disclosure of Accounting Policies) identifies three assumptions as fundamental — Going Concern, Consistency and Accrual. They are called fundamental because financial statements are ordinarily prepared on the footing that all three hold.

Beyond the question: the disclosure rule that follows from that. Because their acceptance and use are assumed, the fundamental assumptions are not ordinarily stated, and disclosure becomes necessary only if they are not followed. A set of accounts that says nothing about them is therefore understood to have observed all three. The burden falls the opposite way round from an ordinary accounting policy, which must be disclosed whether or not it is the obvious choice.

1. Going Concern

The enterprise is assumed to continue in operation for the foreseeable future: that it has neither the intention nor the necessity to liquidate or curtail materially the scale of its operations.

Its practical consequence is the one that shows on the face of the balance sheet: a concern that intends to go on using its assets in the business values them at cost, and forced-sale or current market value "is not particularly relevant" to it. It is only where a business is winding up and must sell its assets to satisfy creditors that original cost ceases to indicate realisable value.

Illustration (beyond the question). A machine costing ₹6,00,000 with a five-year useful life is depreciated at ₹1,20,000 a year and stands at ₹4,80,000 after one year. Its break-up value on that date is only ₹1,75,000. The accounts show ₹4,80,000, not ₹1,75,000: and they are right to, precisely because the firm intends to keep using the machine. Were the going-concern assumption to fail, the ₹1,75,000 would become the relevant figure and the assumption's failure would have to be disclosed.

It is also the going-concern assumption that makes depreciation meaningful at all: spreading a cost over a useful life presupposes that there will be a business there to use the asset over that life.

2. Accrual

Revenues and costs are recognised as they are earned or incurred, not as cash is received or paid, and they are recorded in the financial statements of the periods to which they relate.

Illustration (beyond the question). A firm pays ₹66,000 of rent in cash during the year and still owes ₹6,000 at the year end, so the charge for the year is ₹72,000. It receives ₹40,000 in professional fees and has earned a further ₹8,000 it has not yet billed, so its income for the year is ₹48,000. On a cash basis the result would be −₹26,000; on the accrual basis it is −₹24,000. The two bases give genuinely different answers, which is why the standard fixes on one of them.

Accrual is what makes outstanding expenses, prepaid expenses, accrued income and income received in advance necessary at all; without it none of those adjustments would arise.

3. Consistency (named, as the question asks for only two to be explained)

It is assumed that accounting policies are consistent from one period to another, which is what makes the results of one period comparable with another. Consistency does not freeze a policy for ever: it requires that a change be made only for good reason, and be disclosed when made.