Assets are recorded at cost, which equals the value exchanged at the time of their acquisition. These CDs change from an asset (inventory) to an expense (cost of goods sold) when the revenue is recognized so that the profit from the sale can be determined.Ĭost principle. Consider the wholesaler who delivered five hundred CDs to a store in April. Examples of such costs include the cost of goods sold, salaries and commissions earned, insurance premiums, supplies used, and estimates for potential warranty work on the merchandise sold. The costs of doing business are recorded in the same period as the revenue they help to generate. Similarly, if an attorney receives a $100 retainer from a client, the attorney doesn't recognize the money as revenue until he or she actually performs $100 in services for the client. The wholesaler recognizes the sales revenue in April when delivery occurs, not in March when the deal is struck or in May when the cash is received. Suppose a store orders five hundred compact discs from a wholesaler in March, receives them in April, and pays for them in May. Revenue is earned and recognized upon product delivery or service completion, without regard to the timing of cash flow. Under cash basis accounting, revenues are recognized only when the company receives cash or its equivalent, and expenses are recognized only when the company pays with cash or its equivalent. Accrual basis accounting, which adheres to the revenue recognition, matching, and cost principles discussed below, captures the financial aspects of each economic event in the accounting period in which it occurs, regardless of when the cash changes hands.
In most cases, GAAP requires the use of accrual basis accounting rather than cash basis accounting. Once the time period has been established, accountants use GAAP to record and report that accounting period's transactions.Īccrual basis accounting. For example, how should an accountant report the cost of equipment expected to last five years? Reporting the entire expense during the year of purchase might make the company seem unprofitable that year and unreasonably profitable in subsequent years. Using artificial time periods leads to questions about when certain transactions should be recorded. Depending on the type of report, the time period may be a day, a month, a year, or another arbitrary period. Most businesses exist for long periods of time, so artificial time periods must be used to report the results of business activity. Footnotes supplement financial statements to convey this information and to describe the policies the company uses to record and report business transactions.
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The full disclosure principle requires that financial statements include disclosure of such information. However, pending lawsuits, incomplete transactions, or other conditions may have imminent and significant effects on the company's financial status. Financial statements normally provide information about a company's past performance. dollars for this purpose.įull disclosure principle. Businesses in the United States usually use U.S. Furthermore, accounting records must be recorded using a stable currency. Certain economic events that affect a company, such as hiring a new chief executive officer or introducing a new product, cannot be easily quantified in monetary units and, therefore, do not appear in the company's accounting records. An economic entity's accounting records include only quantifiable transactions. In addition, business records must not include the personal assets or liabilities of the owners. Although accounting information from many different entities may be combined for financial reporting purposes, every economic event must be associated with and recorded by a specific entity. Economic entities include businesses, governments, school districts, churches, and other social organizations. Financial records must be separately maintained for each economic entity. Some of these are discussed later in this book, but other are left for more advanced study.Įconomic entity assumption. In addition to these concepts, there are other, more technical standards accountants must follow when preparing financial statements. The basic assumptions and principles presented on the next several pages are considered GAAP and apply to most financial statements. The current set of principles that accountants use rests upon some underlying assumptions.
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