Give the same year of transactions to two people with no rules and they will report two different profits. One counts a customer's deposit as revenue the day it arrives; the other waits until the work is done. One shows the building at what it cost; the other at what a neighbour's house sold for. Investors, lenders and the government could never compare businesses, or even the same business year to year. Generally accepted accounting principles (GAAP) exist to stop that. In BAF3M you learned the names of the principles. This lesson is about using them: for each one, what concrete decision does it force when you sit down to record a transaction or prepare a statement?
The conceptual framework: what makes information useful
Both Canadian frameworks (ASPE for private enterprises and IFRS for publicly accountable enterprises) start from the same idea. The objective of financial reporting is to provide information that is useful to investors, lenders and other creditors when they decide whether to provide resources to the business. Every rule below is a way of making the statements more useful for that decision. Usefulness is broken into qualitative characteristics.
| Characteristic | What it means | Question an accountant asks |
|---|---|---|
| Relevance (fundamental) | The information can make a difference to a decision: it helps predict the future or confirms or corrects past expectations. | Would a lender or investor care about this, or decide differently because of it? |
| Faithful representation (fundamental) | The numbers show what really happened: complete, neutral (not slanted toward a desired result) and free from error. | Does this entry show the economic reality, or the result someone wanted? |
| Comparability (enhancing) | Users can compare one company with another, and one year with the next. | Are we using the same methods as last year, and methods others in the industry use? |
| Understandability (enhancing) | Information is classified and presented clearly for a reasonably informed user who studies it with care. | Would a reader understand this line without phoning us? |
| Verifiability and timeliness (enhancing) | Independent observers could reach a similar result; information arrives in time to matter. | Is there evidence behind this, and are we reporting soon enough? |
The four assumptions beneath every statement
| Assumption | What it says | Decision it drives |
|---|---|---|
| Going concern | The business will keep operating for the foreseeable future. | Report equipment at cost less accumulated amortization, not at what it would fetch in a fire sale. Classify assets and liabilities as current and long-term. |
| Business entity | The business is separate from its owner and from other businesses. | The owner's personal grocery bill paid from the business account is Drawings, never an expense. |
| Monetary unit | Transactions are recorded in a stable currency (CAD), ignoring inflation. | A building bought for $300,000 in 2005 stays at $300,000 cost even though dollars bought more then. Staff morale is not recorded at all. |
| Time period | The life of the business can be divided into equal periods (months, quarters, years). | Revenue and expenses must be assigned to the right period, which is why adjusting entries exist. |
The principles that drive recording decisions
| Principle | Rule | Concrete decision |
|---|---|---|
| Cost | Assets are recorded at their historical cost: everything paid to acquire them and get them ready for use. | Delivery and installation of a machine are debited to Equipment, not to an expense. |
| Revenue recognition (realization) | Revenue is recorded when it is earned, not when cash arrives. | A deposit for work not yet done is a liability (Unearned Revenue). |
| Matching | Expenses are recorded in the same period as the revenue they helped earn. | Amortize a delivery van over the years it is used; accrue December wages paid in January. |
| Full disclosure | Anything that would change a reader's decision must be reported, in the statements or the notes. | A lawsuit or a major loan guarantee is described in the notes. |
| Consistency | Use the same methods from period to period; disclose any change and its effect. | Do not switch from straight-line to declining-balance just to raise this year's profit. |
| Materiality | Amounts too small to influence a decision may be treated in the simplest way. | A $15 stapler is expensed immediately rather than amortized for ten years. |
| Conservatism (prudence) | When genuinely uncertain, choose the option that does not overstate assets or income. | Inventory is reported at the lower of cost and net realizable value. |
Revenue recognition deserves a closer look because it is the principle most often abused. Under ASPE, revenue is recognized when the seller has performed (for goods, the significant risks and rewards of ownership have passed to the buyer; for services, the work is done), the amount can be measured reliably, and collection is reasonably assured. IFRS uses a five-step model and asks when control of the goods or services passes to the customer. In ordinary transactions both reach the same answer: a sale on account is revenue on the day the goods are delivered, a customer's advance payment is not revenue until the work is performed.
Linking each principle to an accounting practice
- Matching produces adjusting entries: accrued wages, expired insurance, used supplies and amortization all move costs into the period that benefited.
- Cost produces asset valuation: capital assets appear at cost minus accumulated amortization, never at an appraisal (under ASPE).
- Revenue recognition produces Unearned Revenue and Accrued Revenue (Accounts Receivable for work done but not yet billed).
- Conservatism produces the lower of cost and net realizable value for inventory and the allowance for doubtful accounts.
- Full disclosure produces the notes to the financial statements, including the accounting policies used.
- Time period plus matching produce the whole adjust-then-close rhythm at the end of each fiscal period.