LessontwoBalanceofSheetGAAPTheterm"generallyacceptedaccountingprinciples"hasaspecificmeaningforaccountantsandauditors.TheAICPACouncildesignatedFASABasthebodythatestablishesgenerallyacceptedaccountingprinciples(GAAP)forfederalreportingentities.GenerallyAcceptedAccountingPrinciplesAccountantsusegenerallyacceptedaccountingprinciples(GAAP)toguidetheminrecordingandreportingfinancialinformation.GAAPcomprisesabroadsetofprinciplesthathavebeendevelopedbytheaccountingprofessionandtheSecuritiesandExchangeCommission(SEC).Twolaws,theSecuritiesActof1933andtheSecuritiesExchangeActof1934,givetheSECauthoritytoestablishreportinganddisclosurerequirements.However,theSECusuallyoperatesinanoversightcapacity,allowingtheFASBandtheGovernmentalAccountingStandardsBoard(GASB)toestablishtheserequirements.TheGASBdevelopsaccountingstandardsforstateandlocalgovernments.Thecurrentsetofprinciplesthataccountantsuserestsuponsomeunderlyingassumptions.ThebasicassumptionsandprinciplespresentedonthenextseveralpagesareconsideredGAAPandapplytomostfinancialstatements.Inadditiontotheseconcepts,thereareother,moretechnicalstandardsaccountantsmustfollowwhenpreparingfinancialstatements.Someofthesearediscussedlaterinthisbook,butotherareleftformoreadvancedstudy.

Economicentityassumption.Financialrecordsmustbeseparatelymaintainedforeacheconomicentity.Economicentitiesincludebusinesses,governments,schooldistricts,churches,andothersocialorganizations.Althoughaccountinginformationfrommanydifferententitiesmaybecombinedforfinancialreportingpurposes,everyeconomiceventmustbeassociatedwithandrecordedbyaspecificentity.Inaddition,businessrecordsmustnotincludethepersonalassetsorliabilitiesoftheowners.Monetaryunitassumption.Aneconomicentity'saccountingrecordsincludeonlyquantifiabletransactions.Certaineconomiceventsthataffectacompany,suchashiringanewchiefexecutiveofficerorintroducinganewproduct,cannotbeeasilyquantifiedinmonetaryunitsand,therefore,donotappearinthecompany'saccountingrecords.Furthermore,accountingrecordsmustberecordedusingastablecurrency.BusinessesintheUnitedStatesusuallyuseU.S.dollarsforthispurpose.Fulldisclosureprinciple.Financialstatementsnormallyprovideinformationaboutacompany'spastperformance.However,pendinglawsuits,incompletetransactions,orotherconditionsmayhaveimminentandsignificanteffectsonthecompany'sfinancialstatus.Thefulldisclosureprinciplerequiresthatfinancialstatementsincludedisclosureofsuchinformation.Footnotessupplementfinancialstatementstoconveythisinformationandtodescribethepoliciesthecompanyusestorecordandreportbusinesstransactions.Timeperiodassumption.Mostbusinessesexistforlongperiodsoftime,soartificialtimeperiodsmustbeusedtoreporttheresultsofbusinessactivity.Dependingonthetypeofreport,thetimeperiodmaybeaday,amonth,ayear,oranotherarbitraryperiod.Usingartificialtimeperiodsleadstoquestionsaboutwhencertaintransactionsshouldberecorded.Forexample,howshouldanaccountantreportthecostofequipmentexpectedtolastfiveyears?Reportingtheentireexpenseduringtheyearofpurchasemightmakethecompanyseemunprofitablethatyearandunreasonablyprofitableinsubsequentyears.Oncethetimeperiodhasbeenestablished,accountantsuseGAAPtorecordandreportthataccountingperiod'stransactions.Accrualbasisaccounting.Inmostcases,GAAPrequirestheuseofaccrualbasisaccountingratherthancashbasisaccounting.Accrualbasisaccounting,whichadherestotherevenuerecognition,matching,andcostprinciplesdiscussedbelow,capturesthefinancialaspectsofeacheconomiceventintheaccountingperiodinwhichitoccurs,regardlessofwhenthecashchangeshands.Undercashbasisaccounting,revenuesarerecognizedonlywhenthecompanyreceivescashoritsequivalent,andexpensesarerecognizedonlywhenthecompanypayswithcashoritsequivalent.

Revenuerecognitionprinciple.Revenueisearnedandrecognizeduponproductdeliveryorservicecompletion,withoutregardtothetimingofcashflow.SupposeastoreordersfivehundredcompactdiscsfromawholesalerinMarch,receivestheminApril,andpaysfortheminMay.ThewholesalerrecognizesthesalesrevenueinAprilwhendeliveryoccurs,notinMarchwhenthedealisstruckorinMaywhenthecashisreceived.Similarly,ifanattorneyreceivesa$100retainerfromaclient,theattorneydoesn'trecognizethemoneyasrevenueuntilheorsheactuallyperforms$100inservicesfortheclient.Matchingprinciple.

Thecostsofdoingbusinessarerecordedinthesameperiodastherevenuetheyhelptogenerate.Examplesofsuchcostsincludethecostofgoodssold,salariesandcommissionsearned,insurancepremiums,suppliesused,andestimatesforpotentialwarrantyworkonthemerchandisesold.ConsiderthewholesalerwhodeliveredfivehundredCDstoastoreinApril.TheseCDschangefromanasset(inventory)toanexpense(costofgoodssold)whentherevenueisrecognizedsothattheprofitfromthesalecanbedetermined.Costprinciple.Assetsarerecordedatcost,whichequalsthevalueexchangedatthetimeoftheiracquisition.IntheUnitedStates,evenifassetssuchaslandorbuildingsappreciateinvalueovertime,theyarenotrevaluedforfinancialreportingpurposes.Goingconcernprinciple.Unlessotherwisenoted,financialstatementsarepreparedundertheassumptionthatthecompanywillremaininbusinessindefinitely.Therefore,assetsdonotneedtobesoldatfire-salevalues,anddebtdoesnotneedtobepaidoffbeforematurity.Thisprincipleresultsintheclassificationofassetsandliabilitiesasshort-term(current)andlong-term.Long-termassetsareexpectedtobeheldformorethanoneyear.Long-termliabilitiesarenotdueformorethanoneyear.Relevance,reliability,andconsistency.

Tobeuseful,financialinformationmustberelevant,reliable,andpreparedinaconsistentmanner.Relevantinformationhelpsadecisionmakerunderstandacompany'spastperformance,presentcondition,andfutureoutlooksothatinformeddecisionscanbemadeinatimelymanner.Ofcourse,theinformationneedsofindividualusersmaydiffer,requiringthattheinformationbepresentedindifferentformats.Internalusersoftenneedmoredetailedinformationthanexternalusers,whomayneedtoknowonlythecompany'svalueoritsabilitytorepayloans.Reliableinformationisverifiableandobjective.Consistentinformationispreparedusingthesamemethodseachaccountingperiod,whichallowsmeaningfulcomparisonstobemadebetweendifferentaccountingperiodsandbetweenthefinancialstatementsofdifferentcompaniesthatusethesamemethods.

Principleofconservatism.Accountantsmustusetheirjudgmenttorecordtransactionsthatrequireestimation.Thenumberofyearsthatequipmentwillremainproductiveandtheportionofaccountsreceivablethatwillneverbepaidareexamplesofitemsthatrequireestimation.Inreportingfinancialdata,accountantsfollowtheprincipleofconservatism,whichrequiresthatthelessoptimisticestimatebechosenwhentwoestimatesarejudgedtobeequallylikely.Forexample,supposeamanufacturingcompany'sWarrantyRepairDepartmenthasdocumentedathree-percentreturnrateforproductXduringthepasttwoyears,butthecompany'sEngineeringDepartmentinsiststhisreturnrateisjustastatisticalanomalyandlessthanonepercentofproductXwillrequireserviceduringthecomingyear.UnlesstheEngineeringDepartmentprovidescompellingevidencetosupportitsestimate,thecompany'saccountantmustfollowtheprincipleofconservatismandplanforathree-percentreturnrate.Lossesandcosts—suchaswarrantyrepairs—arerecordedwhentheyareprobableandreasonablyestimated.Gainsarerecordedwhenrealized.Materialityprinciple.Accountantsfollowthematerialityprinciple,whichstatesthattherequirementsofanyaccountingprinciplemaybeignoredwhenthereisnoeffectontheusersoffinancialinformation.Certainly,trackingindividualpaperclipsorpiecesofpaperisimmaterialandexcessivelyburdensometoanycompany'saccountingdepartment.Althoughthereisnodefinitivemeasureofmateriality,theaccountant'sjudgmentonsuchmattersmustbesound.SeveralthousanddollarsmaynotbematerialtoanentitysuchasGeneralMotors,butthatsamefigureisquitematerialtoasmall,family-ownedbusiness.

TheAccountingEquationTheabilitytoreadfinancialstatementsrequiresanunderstandingoftheitemstheyincludeandthestandardcategoriesusedtoclassifytheseitems.Theaccountingequationidentifiestherelationshipbetweentheelementsofaccounting.Assets.Anassetissomethingofvaluethecompanyowns.Assetscanbetangibleorintangible.Tangibleassetsaregenerallydividedintothreemajorcategories:currentassets(includingcash,marketablesecurities,accountsreceivable,inventory,andprepaidexpenses);property,plant,andequipment;andlong-terminvestments.Intangibleassetslackphysicalsubstance,buttheymay,nevertheless,providesubstantialvaluetothecompanythatownsthem.Examplesofintangibleassetsincludepatents,copyrights,trademarks,andfranchiselicenses.

Abriefdescriptionofsometangibleassetsfollows.

Currentassetstypicallyincludecashandassetsthecompanyreasonablyexpectstouse,sell,orcollectwithinoneyear.Currentassetsappearonthebalancesheet(andinthenumberedlistbelow)inorder,frommostliquidtoleastliquid.Liquidassetsarereadilyconvertibleintocashorotherassets,andtheyaregenerallyacceptedaspaymentforliabilities.

Cashincludescashonhand(pettycash),bankbalances(checking,savings,ormoney-marketaccounts),andcashequivalents.Cashequivalentsarehighlyliquidinvestments,suchascertificatesofdepositandU.S.treasurybills,withmaturitiesofninetydaysorlessatthetimeofpurchase.Marketablesecuritiesincludeshort-terminvestmentsinstocks,bonds(debt),certificatesofdeposit,orothersecurities.Theseitemsareclassifiedasmarketablesecurities—ratherthanlong-terminvestments—onlyifthecompanyhasboththeabilityandthedesiretosellthemwithinoneyear.Accountsreceivableareamountsowedtothecompanybycustomerswhohavereceivedproductsorservicesbuthavenotyetpaidforthem.Inventoryisthecosttoacquireormanufacturemerchandiseforsaletocustomers.Althoughserviceenterprisesthatneverprovidecustomerswithmerchandisedonotusethiscategoryforcurrentassets,inventoryusuallyrepresentsasignificantportionofassetsinmerchandisingandmanufacturingcompanies.Prepaidexpensesareamountspaidbythecompanytopurchaseitemsorservicesthatrepresentfuturecostsofdoingbusiness.Examplesincludeofficesupplies,insurancepremiums,andadvancepaymentsforrent.Theseassetsbecomeexpensesastheyexpireorgetusedup.

Property,plant,andequipmentisthetitlegiventolong-livedassetsthebusinessusestohelpgeneraterevenue.Thiscategoryissometimescalledfixedassets.Examplesincludeland,naturalresourcessuchastimberormineralreserves,buildings,productionequipment,vehicles,andofficefurniture.Withtheexceptionofland,thecostofanassetinthiscategoryisallocatedtoexpenseovertheasset'sestimatedusefullife.Long-terminvestmentsincludepurchasesofdebtorstockissuedbyothercompaniesandinvestmentswithothercompaniesinjointventures.Long-terminvestmentsdifferfrommarketablesecuritiesbecausethecompanyintendstoholdlong-terminvestmentsformorethanoneyearorthesecuritiesarenotmarketable.Liabilities.Liabilitiesarethecompany'sexistingdebtsandobligationsowedtothirdparties.Examplesincludeamountsowedtosuppliersforgoodsorservicesreceived(accountspayable),toemployeesforworkperformed(wagespayable),andtobanksforprincipalandinterestonloans(notespayableandinterestpayable).Liabilitiesaregenerallyclassifiedasshort-term(current)iftheyaredueinoneyearorless.Long-termliabilitiesarenotdueforatleastoneyear.Owner'sequity.Owner'sequityrepresentstheamountowedtotheownerorownersbythecompany.Algebraically,thisamountiscalculatedbysubtractingliabilitiesfromeachsideoftheaccountingequation.Owner'sequityalsorepresentsthenetassetsofthecompany.Inasoleproprietorshiporpartnership,owner'sequityequalsthetotalnetinvestmentinthebusinessplusthenetincomeorlossgeneratedduringthebusiness'slife.Netinvestmentequalsthesumofallinvestmentinthebusinessbytheownerorownersminuswithdrawalsmadebytheownerorowners.Theowner'sinvestmentisrecordedintheowner'scapitalaccount,andanywithdrawalsarerecordedinaseparateowner'sdrawingaccou