Financial Statement Terminology

This lesson presents basic terminology related to financial statements and explains many of the principles underlying financial statement preparation and presentation.

Transcript Below

Another set of concepts is critical to understanding financial statements and conducting financial statement analysis. This set of concepts involves certain assumptions.

The Cost Principle

The first and probably most important of these assumptions is the cost principle. The cost principle means we record and report all financial transactions at cost. That means all assets and liabilities are reported at the original cost. We do not use fair market value.

There are a few exceptions but most assets and liabilities are recorded and reported at cost. Here’s an example to illustrate uniquely.

Example

Let’s say we’re in the business of renting one office desk. We purchase a single desk for $1 ,000 to rent it out. We assume the desk will have a useful life of 10 years. That means we will take one tenth of the $1 ,000 cost each year for the next 10 years as depreciation expense. expense. Therefore, at the end of the first year, the net cost of the desk is $900, which is $1000 minus $100 in depreciation. At the end of the second year, the net cost of the desk is $800. At the end of the 10th year, the net cost of the desk is $0.

After 10 years, we have fully depreciated the desk. Now, I would be remiss if I didn’t stop to mention tax law at this point.

Tax law must be considered a set of principles or rules that in many cases are extremely different from accounting principles. Under tax law, law, specifically Internal Revenue Code Section 179, we could expense the entire $1 ,000 cost in the year we purchased the desk.

It is crucial to remember that tax law and accounting principles are often vastly different. Let’s return to accounting under the cost principle.

After 10 years, the net cost of our desk shown on the balance sheet is zero. And yet, our desk may still have some value. We might even be able to rent it out for another 10 years, even though its net cost is zero. We might even be able to sell our desk for a couple of hundred dollars on Craigslist, but we don’t report that $200 value on the balance sheet. Now take that example and extend it to all the assets owned by a company.

We’re not allowed to record and report an asset’s fair market value primarily because cost is the only completely verifiable method we have for recording and reporting the asset. Fair market value is entirely subjective. Every valuation expert will arrive at a different market value. Whose market value is the correct value?

We must eliminate as much subjectivity and uncertainty as possible in the financial statements. The next assumption is revenue recognition.

Revenue Recognition

Under the cash basis method of accounting, you will recognize revenue when it is received, regardless of when the sale is made. Under the accrual method of accounting, revenue is recognized when it is earned. regardless of when the payment is received. Therefore, revenue recognition has everything to do with a company’s basis of accounting. In my opinion, every company should use the accrual accounting method because it more accurately matches revenues and related expenses within the same period.

But more about that later.

The Matching Principle

The next assumption is the matching principle. Matching is the process of recording and reporting income and related expenses in the same period.

As I already mentioned, the accrual method does a much better job matching expenses to income than the cash basis. The reason for that is due to the timing of income and expenses.

Ordinarily, expenses are incurred close to the time revenue is generated. Think of a specialty contractor. A painter will purchase paint and brushes read a paint sprayer, hire help, pay vehicle expenses all within a short time of invoicing for the work. Therefore the income statement will show the revenue from the invoice and the expenses related to that job.

The painter may have put many of the purchases on account and won’t pay for those purchases until later. The customer might not pay the invoice right away.

Neither of those matter when using the accrual method of accounting. In contrast, if the same painter uses the cash basis method of accounting, expenses will be recorded immediately when paid such as as hiring help and fuel for the vehicle. The remaining expenses on account won’t be recorded until paid, which could be months later. If the customer doesn’t pay the invoice immediately, there’s no revenue to record. Therefore, under the cash basis, the income statement could show some expenses in one period. with no income and income in a future period with little or no expenses.

I’m going to illustrate this point with an extreme case. If a customer has written and mailed the painter a check on December 31st, the painter won’t receive the check until January 3rd or 4th. The painter had no income in December of the prior year.

Even if the customer sends a 1099 to the painter showing the amount paid in December on the cash basis, the painter will not record the income because the painter didn’t receive the income until January.

Suppose the painter paid expenses in December to generate that revenue, such as hiring help, paying for a mobile phone, renting an office, etc. In that case, the painter will record all those expenses in December. The result is a loss in December. The check received in January the following year, with expenses recorded the prior year, will result in income with no offsetting expenses.

The terms to remember for the cash basis are received and paid. Revenue is recorded when it’s received.

Expenses are recorded when paid. The terms to remember for the accrual basis are earned and incurred. Revenue is recorded when it’s earned.

Expenses are recorded when incurred. A true cash basis doesn’t exist. Under a strictly maintained cash basis, you would not have much of a balance sheet. The purchase of assets would all be recorded as expenses. Credit card charges wouldn’t be recorded until the credit card was paid.

Cash received received through loans is about the only item that would show up on a balance sheet. Therefore, the actual method of accounting instead of the cash basis is the modified cash basis.

That’s because we don’t expense the purchase of long -term assets. Inventory, even even on the cash basis, must be recorded using the accrual method, where you can only report the expenses for purchasing or manufacturing goods for sale when the inventory is sold.