Unit 3.4 Chp 1-4

12 UNIT 3 FINANCIAL ACCOUNTING FOR A TRADING BUSINESS
concern assumption allows us to record these Accounts Receivable (or ‘debtors’) as
assets because at some stage in the future the business is likely to receive the cash.
The same applies to amounts the business owes to its Accounts Payable (or ‘creditors’)
for its credit purchases, which will only be paid in the future.
Further, because Going concern assumes the entity does not need or intend to
liquidate (sell) all its assets immediately, those assets do not need to be valued at
their current market value (what they would realise if sold today). Instead, assets can
be valued at what they represent in terms of future contribution to the business (i.e.
purchase price less any Accumulated depreciation).
Period assumption
the assumption that reports
are prepared for a particular
period of time, such as a month
or year, in order to obtain
comparability of results
Study tip
See Section 1.6 for a
discussion of the
difference between assets
and expenses.
Accrual basis assumption
the assumption that revenues
are recognised when earned
and expenses are recognised
when incurred, so profit is
calculated as revenue earned
in a particular period less
expenses incurred in that period
Period assumption
The Period assumption states that reports are prepared for a particular period of time,
such as a month or a year, in order to obtain comparability of results. This assumption
has the effect of helping to define the when of reporting, effectively ‘putting brackets’
around the transactions that are included (and excluded) in the reports, based on when
they occurred. A period can be as short as the owner requires, but in most cases, to
meet taxation requirements, is no longer than a year.
The adoption of this assumption is a direct consequence of the Going concern
assumption, which assumes the business will continue to operate into the future.
Assuming the business will continue indefinitely would mean we could never calculate
profit, as the firm’s operations would never be finished.
However, if we divide the life of the business into periods of time (such as a month
or a year), it allows for profit to be determined for that period. Further, in calculating that
profit figure, we use only the revenue earned for the period, less the expenses incurred
for the period. Revenues and expenses earned or incurred outside of the current period
are excluded from the current reports, and reported in the (previous or future) period
when they occurred or will occur.
The Period assumption is also significant in distinguishing between assets (whose
benefit extends into future reporting periods) and expenses (whose benefit is totally
consumed within one reporting period ). Both will bring economic benefits to the
business, but for differing lengths of time (and across different periods).
Accrual basis assumption
Whereas the Period assumption helps us to define the period of time for which we are
reporting, the Accrual basis assumption helps us to decide what needs to happen for
items to be included in the reports at that time.
Strictly speaking, Accrual Accounting means that the Elements of the reports (assets,
liabilities, owner’s equity, revenues and expenses) are recognised and reported when
they satisfy the definitions and recognition criteria for those elements. That is, items
should be reported if and when they meet all parts of the definition. As a result, it is
important that accountants understand and can apply the definitions of these elements.
(Section 1.6 will explore these definitions in detail.)
In practice, the Accrual basis assumption is most directly applied to revenues and
expenses, so profit is calculated by subtracting expenses incurred for the period from
revenue earned for that period.
Under the Accrual basis the definition of revenue is satisfied at the point of sale,
because this is when the economic benefit from the sale (represented by cash or an
amount due to be received from Accounts Receivable) can be measured in a faithful
and verifiable manner (by reference to the source document). This means revenues are
recognised in the period in which they are earned.
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