This entry is part 3 of 8 in the seriesIntro to Financial Reporting
Previously, we discussed the various regulations and regulatory bodies that govern financial reporting. We will now turn to the Generally Accepted Accounting Principles (GAAP) to explain the basic principles used in accounting. In particular, we will discuss the cost, revenue recognition, matching, and full disclosure principles.
While it may sound redundant, the cost principle means that “accounting information is based on an actual cost” (Wild, Shaw, & Chiappetta, 2009, p. 9). In other words, everything is treated as having the value of what was paid for it. So what happens when businesses make a trade or don’t purchase with cash (businesses have been known to buy each other with a mix of cash, stocks, and bonds)? “If something besides cash is exchanged … cost is measured as the cash value of what is given up or received” (Wild, Shaw, & Chiappetta, 2009, p. 10). That caveat here is that if you buy something and get a good deal, such as buying a $7000 asset for $5000, the item will be recognized in your accounting system as having a value of $5000. This is to ensure that the accounting information remains objective (Wild, Shaw, & Chiappetta, 2009, p. 10). Next, we will look at the revenue recognition principle.
The revenue recognition principle determines how and when a company will recognize (record) revenue (Wild, Shaw, & Chiappetta, 2009, p. 10). The primary concept of the revenue recognition principle is that “Revenue is recognized when earned” (Wild, Shaw, & Chiappetta, 2009, p. 10). This doesn’t necessarily mean when the customer or client pays for their good or service, but when the good or service is actually sold (such as on credit). For example, if I configured someone’s network (a service) at an hourly rate, I would be required to recognize and record this earned revenue as soon as the work is done; this is usually done crediting accounts receivable (most accounting software does this automatically when generating an invoice.) This principle is intended to keep companies from recognizing revenue too early to look more profitable while also ensuring that they don’t recognize revenue too late to look less profitable than they really are (Wild, Shaw, & Chiappetta, 2009, p. 10). Now let’s look to the matching principle.
The matching principle dictates that a company must report its expenses in the period that they generated the revenue reported (Wild, Shaw, & Chiappetta, 2009, p. 10). Let’s say, for example, that a company buys 10 pounds of raw material, uses it to make 10 widgets, and then sells 5 of those widgets. Under the matching principle, the company would report the expenses (or, in this case, Cost of Goods Sold) incurred to make the 5 widgets it sold. The remaining 5 (that are now sitting in inventory), would not have their expenses/COGS reported until they too were sold. Finally, we turn to the full disclosure principle.
The full disclosure principle is probably the most basic yet most important principle. The full disclosure principle states that a company must “report the details behind financial statements that would impact users’ decisions” (Wild, Shaw, & Chiappetta, 2009, p. 10). Oftentimes, these details are reported in footnotes of a company’s financial statements or annual reports (Wild, Shaw, & Chiappetta, 2009, p. 10). An example of this from current events is Dell’s recent trouble with the SEC. Dell’s recent trouble was partially the result of receiving money from CPU manufacturer Intel and disguising that money as sales (why they hid it is another topic entirely). Users of Dell’s financial reports were led to believe that this extra money was the result of sales. When Intel stopped paying Dell this “incentive money,” Dell then took extra steps to falsify their financial statements to hide the fact that their revenue decreased. Save for the anti-trust violation with Intel, if Dell had just fully disclosed the revenue it was receiving from Intel they may have never felt the pressure to hide the fact that the payments stopped.
In conclusion, the Generally Accepted Accounting Principles (GAAP) are made up of four basic principles. In particular, we discussed the cost, revenue recognition, matching, and full disclosure principles.
Chiappetta, B., Shaw, K., Wild, J. (2009). Principles of Financial Accounting (19th ed.). McGraw-Hill/Irwin.