For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
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Introduction
The common rules that apply to the financial statements distributed by a U.S. company to external users are referred to as accounting principles, generally accepted accounting principles, GAAP (pronounced gap), or US GAAP. These rules or standards allow lenders, investors, and others to make comparisons between companies’ financial statements.
Since 1973, US GAAP has been developed and maintained by the Financial Accounting Standards Board (FASB), a non-government, not-for-profit organization. In 2009, the FASB launched the Accounting Standards Codification (ASC or Codification), which it continues to update. This electronic database contains the official accounting standards (the equivalent of many thousands of printed pages) which apply to the financial reporting of U.S companies and not-for-profit organizations.
[There is also an International Accounting Standards Board (IASB) that issues International Financial Reporting Standards (IFRS) which we will not be discussing.]
In addition to GAAP, U.S. corporations with capital stock trading on a stock exchange must also comply with the regulations of the Securities and Exchange Commission (SEC) and the Internal Revenue Service (IRS), both of which are U.S. government agencies.
In this explanation we begin with brief descriptions of many of the underlying principles, assumptions, concepts, and qualities upon which the complex and detailed accounting standards are based. Examples include historical cost, revenue recognition, full disclosure, materiality, and consistency.
We then review the effect of those underlying principles and concepts on a company’s financial statements such as:
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Underlying Accounting Principles, Assumptions, etc.
The following chart shows an overview of the accounting profession’s efforts in developing U.S. generally accepted accounting principles (GAAP or US GAAP):
Some of the accounting principles in the Accounting Research Bulletins remain in effect today and are included in the Accounting Standards Codification. However, due to the complexities and sophistication of today’s global business activities and financing, GAAP has become more extensive and more detailed.
Our focus is on the basic, fundamental principles and concepts and what they mean for a business’s financial statements.
We begin with brief descriptions of many of the underlying principles, assumptions, concepts, constraints, qualitative characteristics, etc.
It also means that financial statements can be prepared for a group of separate legal corporations that are controlled by one corporation. This group of commonly owned corporations is referred to as the economic entity. The set of financial statements that reports the combined activity of the group is referred to as consolidated financial statements.
Monetary unit assumption
For U.S. companies, the monetary unit assumption allows accountants to express a company’s wide-ranging assets as dollar amounts. Further, it is assumed that the U.S. dollar does not lose its purchasing power over time. Because of this, the accountant combines the $10,000 spent on land in 1980 with the $300,000 spent on a similar adjacent parcel of land in 2023. The result is that the company’s balance sheet will report the combined cost of two parcels at $310,000.
Going concern assumption
The going concern assumption means the accountant believes that the company will not be liquidated in the foreseeable future. In other words, the company will be able to continue operating long enough to meet its obligations and commitments. As a result, the accountant can continue to report most assets at their historical cost and can defer some costs to future periods.
If the company is not considered to be a going concern (meaning the company will not be able to continue in business), it must be disclosed, and liquidation values become the relevant amounts.
Time period (or periodicity) assumption
Accountants assume that a company’s ongoing complex business operations and financial results can be divided into distinct time periods such as months, quarters, and years.
To report a company’s net income for each month, the company will prepare adjusting entries to record each month’s share of depreciation expense, property taxes, insurance, etc. It will also prepare adjusting entries for expenses that occurred but were not paid. Examples include repairs, interest, utilities, etc.
Cost principle
The cost principle (historical cost principle) means the accountant will record transactions at the cash (or equivalent) amount at the time of the transaction. As a result, a company’s most valuable assets are not recorded or reported. Examples include a company’s trademarks, talented team of researchers, unique website domain names, search engine rankings, etc.
Except for certain marketable investment securities, typically an asset’s recorded cost will not be changed due to inflation or market fluctuations.
Full disclosure principle
The full disclosure principle requires a company to provide sufficient information so that an intelligent user can make an informed decision. As a result of this principle, a company’s financial statements will include many disclosures and schedules in the notes to the financial statements.
Revenue recognition principle
Revenues are to be recognized (reported) on a company’s income statement when they are earned. Therefore, a company will report some revenues on its income statement before a customer pays for the goods or services it has received. In the case of cash sales, revenues will be reported when customers pay for their merchandise. If customers pay in advance, the revenues will be recognized (reported) after the money was received.
For example, if an insurance company receives $12,000 on Dec 28, 2023 to provide insurance protection for the year 2024, the insurance company will report $1,000 of revenue in each of the 12 months in the year 2024.
Matching principle or expense recognition
The ideal way to recognize (report) expenses on the income statement is based on a cause-and-effect relationship. For example, if a company sells 5,000 units of Product X, it should report the cost of the 5,000 units on the same income statement as the sales revenues. (Since the cost of sales may be 60% of the sales amount, it is imperative for the cost of goods sold to be calculated accurately.)
When a cause-and-effect relationship isn’t clear, expenses are reported in the accounting period when the cost is used up. For example, the $120,000 cost of equipment with a 10-year life will be charged to expense at a rate of $1,000 per month.
If neither of the above is logical, expenses are reported in the accounting period that the expenses occur. Examples are advertising expense, research expense, salary expense, and many others.
Materiality
The concept of materiality means an accounting principle can be ignored if the amount is insignificant. For instance, large companies usually have a policy of immediately expensing the cost of inexpensive equipment instead of depreciating it over its useful life of perhaps 5 years.
Materiality also allows for a mid-size company to report the amounts on its financial statements to the nearest thousand dollars.
Conservatism
If a company has two acceptable ways to record and/or report a transaction, conservatism directs the accountant to choose the alternative that results in less net income or a smaller asset amount. The accountant should be objective, but when doubt exists, conservatism should be used to break the tie.
Consistency and comparability
Accountants are expected to apply accounting principles, procedures, and practices consistently from period to period. If a change is justified, the change must be disclosed on the financial statements.
Comparability means that the user is able to compare the financial statements of one company to those of another company in the same industry. Comparability is enhanced by requiring the use of generally accepted accounting principles.
Relevance and timeliness
For financial statements to be relevant they should be distributed as soon as possible after the end of the accounting period. In other words, relevance is enhanced by timeliness.
To achieve these characteristics, it is likely that some amounts will need to be estimated.
Objectivity and reliability
Accountants are expected to be objective (unbiased). Many businesses are required to have their financial statements audited to assure the users that the amounts are objective and reliable.
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The Effect of Accounting Principles on Financial Statements
Now that you have been introduced to many of the underlying accounting principles and concepts, let’s examine what they mean for a company’s financial reporting.
Distributing a complete set of financial statements
The accounting profession believes that a single financial statement is not sufficient for someone to understand a company’s financial affairs. Therefore, if a company releases its financial statement(s) to someone outside of the company, it should distribute a set of financial statements containing the following:
The balance sheet reports the assets, liabilities, and stockholders’ equity as of the final moment of the accounting period (December 31, June 30, etc.).
The other financial statements report the amounts that occurred throughout the accounting period shown in the heading (year ended December 31, three months ended June 30, etc.).
The notes to the financial statements are referenced on each financial statement to inform the user that the notes are an integral part of each financial statement. The notes are necessary because a company’s business activity cannot be communicated completely by the amounts appearing on the face of the financial statements.
In addition to complying with US GAAP, corporations with capital stock that is traded on a stock exchange must also comply with some additional rules and communication required by the U.S. Securities and Exchange Commission (SEC). Regular U.S. corporations must also comply with federal and state income tax reporting regulations.
Accrual Method of Accounting
To properly (report) revenues and expenses on the income statement, and assets and liabilities on the balance sheet, companies must use the accrual method of accounting (or accrual accounting). The following examples illustrate accrual accounting:
Revenues are reported on the income statement when they have been earned. Generally, this means there will also be a related asset reported on the company’s balance sheet, such as cash or accounts receivable. In accounting terminology, the revenues and the related asset are recognized (reported on the financial statements) when the revenues and asset have been earned.
A simple example of revenue recognition occurs when a company completes a service for $5,000 on December 28. On the same day, the company bills the customer $5,000 with credit terms of net 30 days. A month later (on January 29) the company receives the $5,000.
On December 28, the company records a $5,000 increase in its current asset account Accounts Receivable and a $5,000 increase in its income statement account Revenues Earned. On January 29, when the company receives the $5,000, it will increase its cash by $5,000 and will reduce its accounts receivable by $5,000.
Expenses are reported (recognized) on the income statement when an expense occurs. The date of the company’s payment to the vendor is not relevant.
To illustrate, assume that a company incurs a $3,000 repair expense on December 26. On December 28, the company receives the vendor’s invoice stating that the bill is to be paid within 15 days. On January 8, the company pays $3,000 to the vendor.
The company must record the $3,000 increase in its expenses and liabilities as of December 26 or 28. When the company pays the vendor $3,000 on January 8, the company will decrease its cash balance and will decrease its liabilities.
In short, the company’s financial statements are more complete when the accrual method is used.
To comply with the accrual method, companies record adjusting entries as of the final day of the accounting period. Adjusting entries make certain that the proper amount of expenses and liabilities, and the proper amount of revenues and assets, are reported on the appropriate period’s financial statements.
Revenues Reported on the Income Statement
Under the accrual method, revenues are reported or recognized on the company’s income statement for the period in which the revenues were earned.
Depending on the transactions, revenues may be earned and reported on a company’s income statements at any of the following times:
Before receiving the money from customers (sales and services were provided on credit)
At the time customers pay (cash sales)
After money is received from customers (some future services were required)
To achieve the accrual method, companies will make the following revenue-related adjusting entries at the end of the accounting period to:
Accrue revenues (and the related receivables) that were earned, but the company had not yet billed the customer
Defer revenues (and the related liabilities) for money received from customers, but not yet earned by the company
In 2014, the FASB issued an Accounting Standards Update (ASU) entitled Revenue from Contracts with Customers (Topic 606) which provides extensive guidance for reporting revenues on the income statement.
Expenses Reported on the Income Statement
Under the accrual method, expenses are to be reported (recognized) on the company’s income statement during the accounting period in which the expenses:
Were caused by revenues (e.g., matching the cost of goods sold and sales commissions with the related revenues)
Expired or were used up (e.g., matching prepaid insurance to the accounting periods in which the prepaid amount had expired; systematically allocating the cost of equipment used in the business to the accounting periods in the equipment’s useful life)
Had no future economic benefit that could be measured (e.g., advertising expense, office salaries, research expenses)
To achieve the accrual method, companies will make accrual, deferral, depreciation, and other adjusting entries for expenses at the end of each accounting period.
Note: To learn more about the income statement, visit our Explanation and Quiz for this topic.
Assets Reported on the Balance Sheet
The cost principle (or historical cost principles) means that a company’s assets are recorded at their cost at the time of the transaction. Once recorded, the cost of most assets (some marketable investment securities are an exception) will not be increased because of inflation or increases in market value.
To illustrate, assume that 18 years ago a company purchased a parcel of land for its future use at a cost of $50,000. Today, the market value of the land is $300,000. The company’s current balance sheet will report the land at its cost of $50,000.
A company that sells goods will report its inventory at its cost, not at the sales value.
The cost principle prevents a company from recording and reporting its talented employees as assets. Similarly, a company’s brands and logos that were developed internally and enhanced through advertising expenses cannot be reported as assets.
If an asset’s fair value drops below its book or carrying value, the asset’s book value may have to be decreased and an impairment loss reported on the income statement.
Liabilities Reported on the Balance Sheet
Liabilities are a company’s obligations resulting from a past transaction. Typical liabilities include accounts payable, notes or loans payable, wages payable, interest payable, taxes payable, customer deposits, deferred revenue, and more.
At the end of each accounting period, there will be amounts owed by a company, but the company has not yet been billed or has not yet processed the transaction. A few examples include:
Interest on loans payable
Electricity and gas charges
Wages for hourly paid employees that have been earned but not yet processed
Repair work that was recently done by a contractor
These obligations and the related expense must be recorded for the financial statements to be complete and to comply with the accrual method of accounting. This is done with accrual-type adjusting entries.
Stockholders’ Equity Reported on the Balance Sheet
Stockholders’ equity or shareholders’ equity is the difference between the amount of a corporation’s assets and liabilities that are reported on the balance sheet. (Owner’s equity is the difference between a sole proprietorship’s assets and liabilities.)
Since most of a company’s assets are reported at cost (or lower), the amount reported as stockholders’ equity is not an indicator of the corporation’s market value. Picture a service business that has developed amazing software that generates huge fees with little expenses and the owners draw out most of the profits. As a result, this service business is extremely valuable but has only a small amount reported on its balance sheet for assets and stockholders’ equity.
Note: To learn more about the balance sheet, visit our Explanation and Quiz for this topic.
Notes to the Financial Statements
The full disclosure principle requires that sufficient financial information be presented so that an intelligent person can make an informed decision. As a result of this principle, it is common to find many pages of notes to the financial statements.
A few examples of the many items disclosed in the notes to the financial statements include:
Summary of significant accounting policies
Leases
Income taxes
Employee benefit plans
Stock options
Commitments and contingencies
Where to Go From Here
We recommend taking our Practice Quiz next, and then continuing with the rest of our Accounting Principles materials (see the full outline below).
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You should consider our materials to be an introduction to selected accounting and bookkeeping topics, and realize that some complexities (including differences between financial statement reporting and income tax reporting) are not presented. Therefore, always consult with accounting and tax professionals for assistance with your specific circumstances.
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Usually financial statements refer to the balance sheet, income statement, statement of cash flows, statement of retained earnings, and statement of stockholders’ equity.
The balance sheet reports information as of a date (a point in time). The income statement, statement of cash flows, statement of retained earnings, and the statement of stockholders’ equity report information for a period of time (or time interval) such as a year, quarter, or month.
The standards, rules, guidelines, and industry-specific requirements for financial reporting.
The general guidelines and principles, standards and detailed rules, plus industry practices that exist for financial reporting. Often referred to by its acronymn GAAP.
A nongovernment group of seven members assisted by a large research staff which is responsible for the setting of accounting standards, rules, and principles for financial reporting by U.S. entities. Go to www.fasb.org for more information.
Includes the main financial statements (income statement, balance sheet, statement of cash flows, statement of retained earnings, statement of stockholders’ equity) plus other financial information such as annual reports, press releases, etc.
The accounting and reporting standards developed by the International Accounting Standards Board (IASB). IFRS are used by business entities in most countries. The most notable exception is the U.S. where business entities follow U.S. GAAP, which is the generally accepted accounting standards promulgated by the Financial Accounting Standards Board. There is a goal to move toward the IFRS as the global standard; however, the transition is proving to be difficult.
A heading that includes common stock and preferred stock.
The original cost incurred to acquire an asset (as opposed to replacement cost, current cost, or cost adjusted by a general price index). If a company purchased land in 1980 for $10,000 and continues to hold that land, the company’s balance sheet in the year 2024 will report the land at $10,000 (even if the land is now worth $400,000).
The accounting guideline that permits the violation of another accounting guideline if the amount is insignificant. For example, a profitable company with several million dollars of sales is likely to expense immediately a $200 printer instead of depreciating the printer over its useful life. The justification is that no lender or investor will be misled by a one-time expense of $200 instead of say $40 per year for five years. Another example is a large company’s reporting of financial statement amounts in thousands of dollars instead of amounts to the penny.
A quality of accounting information that facilitates comparing a company’s reporting of one accounting period to another. For example, the reader of a company’s financial statements can assume that the company is using the same inventory cost flow assumption this period as it used last period or last year. (If the company did change, it must be disclosed to the reader.)
The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by either an increase in Cash (if the service or sale was for cash), an increase in Accounts Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).
Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will be paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).
Fees earned from providing services and the amounts of merchandise sold. Under the accrual basis of accounting, revenues are recorded at the time of delivering the service or the merchandise, even if cash is not received at the time of delivery. Often the term income is used instead of revenues.
Examples of revenue accounts include: Sales, Service Revenues, Fees Earned, Interest Revenue, Interest Income. Revenue accounts are credited when services are performed/billed and therefore will usually have credit balances. At the time that a revenue account is credited, the account debited might be Cash, Accounts Receivable, or Unearned Revenue depending if cash was received at the time of the service, if the customer was billed at the time of the service and will pay later, or if the customer had paid in advance of the service being performed.
If the revenues earned are a main activity of the business, they are considered to be operating revenues. If the revenues come from a secondary activity, they are considered to be nonoperating revenues. For example, interest earned by a manufacturer on its investments is a nonoperating revenue. Interest earned by a bank is considered to be part of operating revenues.
One of the main financial statements (along with the balance sheet, the statement of cash flows, and the statement of stockholders’ equity). The income statement is also referred to as the profit and loss statement, P&L, statement of income, and the statement of operations. The income statement reports the revenues, gains, expenses, losses, net income and other totals for the period of time shown in the heading of the statement. If a company’s stock is publicly traded, earnings per share must appear on the face of the income statement.
Costs that are matched with revenues on the income statement. For example, Cost of Goods Sold is an expense caused by Sales. Insurance Expense, Wages Expense, Advertising Expense, Interest Expense are expenses matched with the period of time in the heading of the income statement. Under the accrual basis of accounting, the matching is NOT based on the date that the expenses are paid.
Expenses associated with the main activity of the business are referred to as operating expenses. Expenses associated with a peripheral activity are nonoperating or other expenses. For example, a retailer’s interest expense is a nonoperating expense. A bank’s interest expense is an operating expense.
Generally, expenses are debited to a specific expense account and the normal balance of an expense account is a debit balance. When an expense account is debited, the account credited might be Cash (if cash was paid at the time of the expense), Accounts Payable (if cash will be paid after the expense is recorded), or Prepaid Expense (if cash was paid before the expense was recorded.)
Things that are resources owned by a company and which have future economic value that can be measured and can be expressed in dollars. Examples include cash, investments, accounts receivable, inventory, supplies, land, buildings, equipment, and vehicles.
Assets are reported on the balance sheet usually at cost or lower. Assets are also part of the accounting equation: Assets = Liabilities + Owner’s (Stockholders’) Equity.
Some valuable items that cannot be measured and expressed in dollars include the company’s outstanding reputation, its customer base, the value of successful consumer brands, and its management team. As a result these items are not reported among the assets appearing on the balance sheet.
One of the main financial statements. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.
Obligations of a company or organization. Amounts owed to lenders and suppliers. Liabilities often have the word “payable” in the account title. Liabilities also include amounts received in advance for a future sale or for a future service to be performed.
Also referred to as shareholders’ equity. At a corporation it is the residual or difference of assets minus liabilities.
An accounting principle/guideline that allows the accountant to keep the sole proprietor’s business transactions separate from the owner’s personal transactions even though a sole proprietorship is not legally separate from the owner.
A simple form of business where there is one owner. Legally the owner and the sole proprietorship are the same. However, for accounting purposes the economic entity assumption results in the sole proprietorship’s business transactions being accounted for separately from the owner’s personal transactions.
An accounting guideline where the U.S. dollar is assumed to be constant (no change in purchasing power) over time. This allows an accountant to add one dollar from a transaction in 2010 to one dollar in 2024 and to show the result as two dollars. It also means that items that cannot be expressed in dollars do not appear in the financial statements. For example, how would you express on a company’s balance sheet the value of loyal customers or a brilliant, aggressive management team?
An accounting guideline which allows the readers of financial statements to assume that the company will continue on long enough to carry out its objectives and commitments. In other words, the accountants believe that the company will not liquidate in the near future. This assumption also provides some justification for accountants to follow the cost principle.
This is the bottom line of the income statement. It is the mathematical result of revenues and gains minus the cost of goods sold and all expenses and losses (including income tax expense if the company is a regular corporation) provided the result is a positive amount. If the net amount is a negative amount, it is referred to as a net loss.
Journal entries usually dated the last day of the accounting period to bring the balance sheet and income statement up to date on the accrual basis of accounting.
Adjusting entries are made to report (1) revenues that have been earned but not yet entered into the accounting records, (2) expenses that have been incurred but have not yet been entered into the accounting records, (3) revenues already recorded that pertain to a future accounting period, or (4) expenses already recorded that pertain to a future accounting period.
The income statement account which contains a portion of the cost of plant and equipment that is being matched to the time interval shown in the heading of the income statement. (There is no depreciation expense for land.)
The original cost incurred to acquire an asset (as opposed to replacement cost, current cost, or cost adjusted by a general price index). If a company purchased land in 1980 for $10,000 and continues to hold that land, the company’s balance sheet in the year 2024 will report the land at $10,000 (even if the land is now worth $400,000).
An accounting guideline that requires information pertinent to an investing or lending decision to be included in the notes to financial statements or in other financial reports.
Fees earned from providing services and the amounts of merchandise sold. Under the accrual basis of accounting, revenues are recorded at the time of delivering the service or the merchandise, even if cash is not received at the time of delivery. Often the term income is used instead of revenues.
Examples of revenue accounts include: Sales, Service Revenues, Fees Earned, Interest Revenue, Interest Income. Revenue accounts are credited when services are performed/billed and therefore will usually have credit balances. At the time that a revenue account is credited, the account debited might be Cash, Accounts Receivable, or Unearned Revenue depending if cash was received at the time of the service, if the customer was billed at the time of the service and will pay later, or if the customer had paid in advance of the service being performed.
If the revenues earned are a main activity of the business, they are considered to be operating revenues. If the revenues come from a secondary activity, they are considered to be nonoperating revenues. For example, interest earned by a manufacturer on its investments is a nonoperating revenue. Interest earned by a bank is considered to be part of operating revenues. To learn more, see Explanation of Income Statement.
A revenue account that reports the sales of merchandise. Sales are reported in the accounting period in which title to the merchandise was transferred from the seller to the buyer.
Cost of goods sold is usually the largest expense on the income statement of a company selling products or goods. Cost of Goods Sold is a general ledger account under the perpetual inventory system.
Under the periodic inventory system there will not be an account entitled Cost of Goods Sold. Instead, the cost of goods sold is computed as follows: cost of beginning inventory + cost of goods purchased (net of any returns or allowances) + freight-in – cost of ending inventory.
This account balance or this calculated amount will be matched with the sales amount on the income statement.
Cost of goods sold is usually the largest expense on the income statement of a company selling products or goods. Cost of Goods Sold is a general ledger account under the perpetual inventory system.
Under the periodic inventory system there will not be an account entitled Cost of Goods Sold. Instead, the cost of goods sold is computed as follows: cost of beginning inventory + cost of goods purchased (net of any returns or allowances) + freight-in – cost of ending inventory.
This account balance or this calculated amount will be matched with the sales amount on the income statement.
This accounting guideline states that if doubt exists between two acceptable alternatives (in other words the accountant needs to break a tie), the accountant should choose the alternative that will result in a lesser asset amount and/or a lesser profit. A classic example is inventory where the net realizable value (NRV) is less than the actual cost. The accountant must decide whether to leave the inventory at cost or to reduce the inventory amount to its NRV. Conservatism directs the accountant to reduce the inventory to the lower amount (NRV). This results in a lower asset amount and a debit to an income statement account, such as Loss from Reducing Inventory to NRV
The result of two or more amounts being combined. For example, net sales is equal to gross sales minus sales returns, sales allowances, and sales discounts. The net realizable value of accounts receivable is the combination of the debit balance in accounts receivable and the credit balance in the allowance for doubtful accounts. The book value of equipment is also a net amount: the cost of the equipment minus the accumulated depreciation of the equipment.
A qualitative characteristic in accounting. Relevance is associated with information that is timely, useful, has predictive value, and is going to make a difference to a decision maker.
The statement of comprehensive income covers the same period of time as the income statement, and consists of two major sections:
Net income (taken from the income statement)
Other comprehensive income (adjustments involving foreign currency translation, hedging, and postretirement benefits)
The sum of these two amounts is known as comprehensive income.
The amount of other comprehensive income is added/subtracted from the balance in the stockholders’ equity account Accumulated Other Comprehensive Income.
The difference between assets and liabilities, such as stockholders’ equity, owner’s equity, or a nonprofit organization’s net assets.
Also used to indicate an owner’s interest in a personal asset. For example, the owner of a $200,000 house with a $75,000 mortgage loan is said to have equity of $125,000.
One of the main financial statements (along with the income statement and balance sheet). The statement of cash flows reports the sources and uses of cash by operating activities, investing activities, financing activities, and certain supplemental information for the period specified in the heading of the statement. The statement of cash flows is also known as the cash flow statement.
Also referred to as footnotes. These provide additional information pertaining to a company’s operations and financial position and are considered to be an integral part of the financial statements. The notes are required by the full disclosure principle.
A current asset resulting from selling goods or services on credit (on account). Invoice terms such as (a) net 30 days or (b) 2/10, n/30 signify that a sale was made on account and was not a cash sale.
A record in the general ledger that is used to collect and store similar information. For example, a company will have a Cash account in which every transaction involving cash is recorded. A company selling merchandise on credit will record these sales in a Sales account and in an Accounts Receivable account.
A revenue, expense, gain, or loss account.
The supplier of goods or services.
A bill issued by a seller of merchandise or by the provider of services. The seller refers to the invoice as a sales invoice and the buyer refers to the same invoice as a vendor invoice.
A current asset which indicates the cost of the insurance contract (premiums) that have been paid in advance. It represents the amount that has been paid but has not yet expired as of the balance sheet date.
A related account is Insurance Expense, which appears on the income statement. The amount in the Insurance Expense account should report the amount of insurance expense expiring during the period indicated in the heading of the income statement.
In accounting this means to defer or to delay recognizing certain revenues or expenses on the income statement until a later, more appropriate time. Revenues are deferred to a balance sheet liability account until they are earned in a later period. When the revenues are earned they will be moved from the balance sheet account to revenues on the income statement.
Expenses are deferred to a balance sheet asset account until the expenses are used up, expired, or matched with revenues. At that time they will be moved to an expense on the income statement.
The systematic allocation of the cost of an asset from the balance sheet to Depreciation Expense on the income statement over the useful life of the asset. (The depreciation journal entry includes a debit to Depreciation Expense and a credit to Accumulated Depreciation, a contra asset account). The purpose is to allocate the cost to expense in order to comply with the matching principle. It is not intended to be a valuation process. In other words, the amount allocated to expense is not indicative of the economic value being consumed. Similarly, the amount not yet allocated is not an indication of its current market value.
A current asset whose ending balance should report the cost of a merchandiser’s products awaiting to be sold. The inventory of a manufacturer should report the cost of its raw materials, work-in-process, and finished goods. The cost of inventory should include all costs necessary to acquire the items and to get them ready for sale.
When inventory items are acquired or produced at varying costs, the company will need to make an assumption on how to flow the changing costs. See cost flow assumption.
If the net realizable value of the inventory is less than the actual cost of the inventory, it is often necessary to reduce the inventory amount.
The book value of an asset is the amount of cost in its asset account less the accumulated depreciation applicable to the asset. The book value of a company is the amount of owner’s or stockholders’ equity. The book value of bonds payable is the combination of the accounts Bonds Payable and Discount on Bonds Payable or the combination of Bonds Payable and Premium on Bonds Payable.
A decrease in the value of a long term asset to an amount that is less than the amount shown under the cost principle.
This current liability account will show the amount a company owes for items or services purchased on credit and for which there was not a promissory note. This account is often referred to as trade payables (as opposed to notes payable, interest payable, etc.)
A current liability account that reports the amounts owed to employees for hours worked but not yet paid as of the date of the balance sheet.
This current liability account reports the amount of interest the company owes as of the date of the balance sheet. (Future interest is not recorded as a liability.)
For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
