Friday, April 16, 2010

Accounting methods

Financial statements follow the same general format from company to company. Depending on the nature of the company's business, however, specific line items may vary. Still, the statements are usually similar enough to allow you to compare one business's performance against another's. The reason for this similarity is that accountants abide by Generally Accepted Accounting Principles, or GAAP.

Most companies use accrual accounting: Income and expenses are booked when they are incurred, regardless of when they are actually received or paid. This system relies on the matching principle, which helps companies understand the true causes and effects of business activities. Accordingly,

  • revenues are recognized during the period in which the sales activity occurred
  • expenses are recognized in the same period as their associated revenues.
For example, at Amalgamated Hat Rack Co., which manufactures hat racks from imitation moose antlers, the revenue for a customer order is booked as each hat rack ships—even if payment is made on account and the cash is not received immediately. Similarly, if Amalgamated receives 2,000 brass hooks from a contracted supply company, those hooks are not all expensed at once. Rather, they are expensed on a per-unit basis: if it takes five brass hooks to make one hat rack, then the brass hooks are expensed five at a time as each hat rack is shipped out.

Occasionally, a very small company will begin its existence using cash-basis accounting, which counts transactions when cash actually exchanges hands. This practice is less conservative when it comes to expense recognition, but sometimes more conservative when it comes to revenue recognition. But as companies increase in size and complexity, it becomes more important to match revenues and expenses in the appropriate time periods, so they tend to switch over to accrual accounting.

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