The purpose of any financial statement is to provide information about an entity’s transaction history that is USEFUL for internal and external users. You can read more about accounting and the purpose of Financial Statements here (refer to What is accounting blog)
STANDARDS AND REGULATIONS
Financial Statements that are presented externally (to people OUTSIDE the organization) need to be prepared by following US Generally Accepted Accounting Principles (US-GAAP). In other words, there are rules and principles that MUST be followed and adhered to, and US-GAAP is what tells us what to do and how to do it.
How to classify every day business activity, which account to tag the transactions to and how to present the financials are all detailed in US-GAAP. It does not matter if you are the business owner, CFO or bookkeeper, these rules be observed when preparing financial statements.
The method of accounting that is required is called “Accrual Basis Accounting”.
Accrual Basis Accounting:
Accrual Basis explains how, when and how much to recognize the everyday business activities. There are some fundamental assumptions and principles that make up the accrual basis of accounting standard:
- Going Concern Assumption – the entity is presumed that the entity will continue to operate in the foreseeable future. In other words, it is presumed that the company will be able to pay its obligations in the next year.
- Revenue Recognition Principle – Revenue should be recognized (RECORDED) when REALIZED (OR REALIZABLE) and EARNED. Recognized literally means the moment when something can and is recorded in the financial records. Realized (Realizable) means that there is an exchange for CASH or CLAIMS TO CASH. This simply means that the SELLER has a LEGAL CLAIM to sell their product or service in exchange for cash or other form of asset.
- Matching Principle – Expenses are incurred to generate a specific amount of revenue during a period of time. The matching principle means that revenue recognized should be matched to the related expense incurred.
- Conservative Principle – financial statements must be presented in a way that is accurate, relevant and faithfully represented. However, professional judgement is used when estimates are required (i.e. Allowance for Bad Debts is an estimate that is required to determine how much revenue is UNLIKELY to be collected). Since professional judgement is used, when in doubt, the preparer must select from alternative US-GAAP methods that is least likely to overstate assets/revenues/gains and/or understate liabilities/expenses/losses. The conservative approach means the company is not exaggerating either the “good stuff” or the “bad stuff”.
Since businesses must use the revenue recognition principle, the accounting (recording) for each transaction does NOT necessarily match when CASH is exchanged. For example, a Builder A Company builds commercial property and invoices for their service over time to their customers. The revenue recognition principle dictates that Builder A Company must include the revenue amounts when the earnings process is complete, or virtually complete and they have a LEGAL CLAIM TO THE CASH. It does not matter if their customers paid the invoice or not.
Cash Basis Accounting:
This method of accounting is NOT US-GAAP approved, but can be used for internal managers and operates WITHIN the company. This method of accounting ignores the above revenue recognition principle and follows the CASH FLOW. Revenue and Expenses are recorded when received and paid only, NOT using the Matching principle.
This method is easier and cheaper to follow, however, it does not represent the company’s true performance and efficiencies. A full set of financial statements in accordance with US-GAAP include: Statement of Financial Position (Balance Sheet), Income Statement (P&L), Statement of Comprehensive Income, Statement of Cash Flows and Statement of Changes in Owners Equity. However, many small and mid-sized, private entities use only the Balance Sheet, Profit & Loss and Statement of Cash Flows.
This publication is designed to provide information of federal tax and accounting laws and/or regulations. It is presented with the understanding that the author is not rendering legal or accounting services.
This text is not intended to address every situation that arises or provide specific, strategic tax and/or accounting planning advice. This text should not be used solely to answer tax and/or accounting questions and you should consult additional sources of information, as needed, to determine the solution to tax and/or accounting questions.
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