Financial accounting is a specialized branch of accounting that keeps track of a company's

financial transactions. Using standardized guidelines, the transactions are recorded, summarized,
and presented in a financial report or financial statement such as an income statement or a balance
sheet.
Companies issue financial statements on a routine schedule. The statements are
considered external because they are given to people outside of the company, with the primary
recipients being owners/stockholders, as well as certain lenders. If a corporation's stock is publicly
traded, however, its financial statements (and other financial reporting’s) tend to be widely circulated,
and information will likely reach secondary recipients such as competitors, customers, employees,
labor organizations, and investment analysts.
It's important to point out that the purpose of financial accounting is not to report the value of a
company. Rather, its purpose is to provide enough information for others to assess the value of a
company for themselves

Because external financial statements are used by a variety of people in a variety of ways, financial
accounting has common rules known as accounting standards and as generally accepted
accounting principles (GAAP). In the U.S., the Financial Accounting Standards Board (FASB) is the
organization that develops the accounting standards and principles. Corporations whose stock is
publicly traded must also comply with the reporting requirements of the Securities and Exchange
Commission (SEC), an agency of the U.S. government.

Double Entry and the Accrual Basis of

Accounting
At the heart of financial accounting is the system known as double entry bookkeeping (or "double
entry accounting"). Each financial transaction that a company makes is recorded by using this
system.

The term "double entry" means that every transaction affects at least two accounts. For example, if a
company borrows $50,000 from its bank, the company's Cash(A current asset account which includes
currency, coins, checking accounts, and undeposited checks received from customers. The amounts must be
unrestricted. (Restricted cash should be recorded in a different account.) account increases, and the
company's Notes Payable(The amount of principal due on a formal written promise to pay. Loans from banks are
included in this account.) account increases. Double entry also means that one of the accounts must
have an amount entered as a debit, and one of the accounts must have an amount entered as
a credit. For any given transaction, the debit amount must equal the credit amount. (To learn more
about debits and credits, see Explanation of Debits & Credits.)
The advantage of double entry accounting is this: at any given time, the balance of a company's
asset accounts will equal the balance of its liability and stockholders' (or owner's) equity accounts.
(To learn more on how this equality is maintained, see the Explanation of Accounting Equation.)
Financial accounting is required to follow the accrual basis of accounting (as opposed to the "cash
basis" of accounting). Under the accrual basis, revenues are reported when they are earned, not
when the money is received. Similarly, expenses are reported when they are incurred, not when they
are paid. For example, although a magazine publisher receives a $24 check from a customer for an
annual subscription, the publisher reports as revenue a monthly amount of $2 (one-twelfth of the
annual subscription amount). In the same way, it reports its property tax expense each month as
one-twelfth of the annual property tax bill.
By following the accrual basis of accounting, a company's profitability, assets, liabilities and other
financial information is more in line with economic reality. (To learn more on achieving the accrual
basis of accounting, see the Explanation of Adjusting Entries.)

Accrual Basis - The accounting method under which revenues are recognized on the income statement when they
are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by
either an increase in Cash (if the service or sale was for cash), an increase in Accounts Receivable (if the service
was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had
paid in advance for the service).Under the accrual basis of accounting, expenses are matched with revenues on the
income statement when the expenses expire or title has transferred to the buyer, rather than at the time when
expenses are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the
expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will be
paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).

How Does Accrual Accounting Differ from Cash Basis

Accounting?

The main difference between accrual and cash basis accounting lies in the timing
of when revenue and expenses are recognized. The cash method is a more
immediate recognition of revenue and expenses while the accrual method
focuses on anticipated revenue and expenses.
The Cash Method
Revenue is reported on the income statement only when cash is received.
Expenses are only recorded when cash is paid out. The cash method is mostly
used by small businesses and for personal finances.

The Accrual Method

Revenue is accounted for when it is earned. Typically, revenue is
recorded before any money changes hands. Unlike the cash method, the accrual
method records revenue when a product or service is delivered to a customer
with the expectation that money will be paid in the future. Expenses of goods and
services are recorded despite no cash being paid out yet for those expenses.

Example of Accrual and Cash Methods

Let's say you own a business that sells machinery. If you sell $5,000 worth of
machinery, under the cash method, that amount is not recorded in the books until
the customer hands you the money or you receive the check. Under the accrual
method, the $5,000 is recorded as revenue immediately when the sale is made,
even if you receive the money a few days or weeks later.

The same principle applies to expenses. If you receive an electric bill for $1,700,
under the cash method, the amount is not added to the books until you pay the
bill. However, under the accrual method, the $1,700 is recorded as an expense
the day you receive the bill.

Advantages and Disadvantages of Both Methods

The advantages of the cash method include its simplicity since it only accounts
for cash paid or received. Tracking cash flow of a company is also easier with the
cash method.

A disadvantage of the cash method is that it might overstate the health of a

company that is cash-rich but has large sums of accounts payables that far
exceed the cash on the books and the company's current revenue stream. An
investor might conclude the company is making a profit when in reality the
company is losing money.

The advantage of the accrual method is that it includes accounts receivables

and payables and, as a result, is a more accurate picture of the profitability of a
company, particularly in the long term. The reason for this is that the accrual
method records all revenues when they are earned and all expenses when they
are incurred.

For example, a company might have sales in the current quarter that wouldn't be
recorded under the cash method because revenue isn't expected until the
following quarter. An investor might conclude the company is unprofitable when
in reality the company is doing well.

The disadvantage of the accrual method is that it doesn't track cash flow and,
as a result, might not account for a company with a major cash shortage in the
short term, despite looking profitable in the long term. Another disadvantage of
the accrual method is that it can be more complicated to implement since
it's necessary to account for items like unearned revenue and prepaid
expenses.

Accounting Principles
If financial accounting is going to be useful, a company's reports need to be credible, easy to
understand, and comparable to those of other companies. To this end, financial accounting follows a
set of common rules known as accounting standards or generally accepted accounting
principles (GAAP, pronounced "gap").
GAAP is based on some basic underlying principles and concepts such as the cost principle,
matching principle, full disclosure, going concern, economic entity, conservatism, relevance, and
reliability. (You can learn more about the basic principles in Explanation of Accounting Principles.)

Basic Accounting Principles and

Guidelines
Since GAAP is founded on the basic accounting principles and guidelines, we can better understand
GAAP if we understand those accounting principles. The following is a list of the ten main accounting
principles and guidelines together with a highly condensed explanation of each.

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the
business owner's personal transactions. For legal purposes, a sole proprietorship and its owner are
considered to be one entity, but for accounting purposes they are considered to be two separate
entities.
2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S.
dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not
changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For
example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2018
transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing activities of a
business in relatively short, distinct time intervals such as the five months ended May 31, 2018, or
the 5 weeks ended May 1, 2018. The shorter the time interval, the more likely the need for the
accountant to estimate amounts relevant to that period. For example, the property tax bill is received
on December 15 of each year. On the income statement for the year ended December 31, 2017, the
amount is known; but for the income statement for the three months ended March 31, 2018, the
amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each income
statement, statement of stockholders' equity, and statement of cash flows. Labeling one of
these financial statements with "December 31" is not good enough–the reader needs to know if the
statement covers the one week ended December 31, 2018 the month ended December 31, 2018
the three months ended December 31, 2018 or the year ended December 31, 2018.
4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash
equivalent) when an item was originally obtained, whether that purchase happened last year or thirty
years ago. For this reason, the amounts shown on financial statements are referred to
as historical cost amounts.
Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as
a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence, an
asset amount does not reflect the amount of money a company would receive if it were to sell the
asset at today's market value. (An exception is certain investments in stocks and bonds that are
actively traded on a stock exchange.) If you want to know the current value of a company's long-term
assets, you will not get this information from a company's financial statements–you need to look
elsewhere, perhaps to a third-party appraiser.
5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that
information should be disclosed within the statement or in the notes to the statement. It is because of
this basic accounting principle that numerous pages of "footnotes" are often attached to financial
statements.

As an example, let's say a company is named in a lawsuit that demands a significant amount of
money. When the financial statements are prepared it is not clear whether the company will be able
to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of
the full disclosure principle the lawsuit will be described in the notes to the financial statements.

A company usually lists its significant accounting policies as the first note to its financial statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to carry out its
objectives and commitments and will not liquidate in the foreseeable future. If the company's
financial situation is such that the accountant believes the company will not be able to continue on,
the accountant is required to disclose this assessment.
The going concern principle allows the company to defer some of its prepaid expenses until future
accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting. The matching
principle requires that expenses be matched with revenues. For example, sales commissions
expense should be reported in the period when the sales were made (and not reported in the period
when the commissions were paid). Wages to employees are reported as an expense in the week
when the employees worked and not in the week when the employees are paid. If a company
agrees to give its employees 1% of its 2018 revenues as a bonus on January 15, 2019, the company
should report the bonus as an expense in 2018 and the amount unpaid at December 31, 2018 as a
liability. (The expense is occurring as the sales are occurring.)
Because we cannot measure the future economic benefit of things such as advertisements (and
thereby we cannot match the ad expense with related future revenues), the accountant charges the
ad amount to expense in the period that the ad is run.

(To learn more about adjusting entries go to Explanation of Adjusting Entries and Quiz for
Adjusting Entries.)
8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues are
recognized as soon as a product has been sold or a service has been performed, regardless of
when the money is actually received. Under this basic accounting principle, a company could earn
and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that
month.
For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should
recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client pays
the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.
9. Materiality

Because of this basic accounting principle or guideline, an accountant might be allowed to violate
another accounting principle if an amount is insignificant. Professional judgement is needed to
decide whether an amount is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable
multi-million dollar company. Because the printer will be used for five years, the matching principle
directs the accountant to expense the cost over the five-year period. The materiality guideline
allows this company to violate the matching principle and to expense the entire cost of $150 in the
year it is purchased. The justification is that no one would consider it misleading if $150 is expensed
in the first year instead of $30 being expensed in each of the five years that it is used.
Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to
the nearest thousand, or to the nearest million dollars depending on the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item, conservatism
directs the accountant to choose the alternative that will result in less net income and/or less asset
amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be
conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or disclose losses,
but it does not allow a similar action for gains. For example, potential losses from lawsuits will be
reported on the financial statements or in the notes, but potential gains will not be reported. Also, an
accountant may write inventory down to an amount that is lower than the original cost, but will not
write inventory up to an amount higher than the original cost.
Other Characteristics of Accounting
Information
When financial reports are generated by professional accountants, we have certain expectations of
the information they present to us:

1. We expect the accounting information to be reliable, verifiable, and objective.

2. We expect consistency in the accounting information.
3. We expect comparability in the accounting information.

1. Reliable, Verifiable, and Objective

In addition to the basic accounting principles and guidelines listed in Part 1, accounting information
should be reliable, verifiable, and objective. For example, showing land at its original cost of $10,000
(when it was purchased 50 years ago) is considered to be more reliable,
verifiable, and objective than showing it at its current market value of $250,000. Eight different
accountants will wholly agree that the original cost of the land was $10,000—they can read the offer
and acceptance for $10,000, see a transfer tax based on $10,000, and review documents that
confirm the cost was $10,000. If you ask the same eight accountants to give you the
land's current value, you will likely receive eight different estimates. Because the current value
amount is less reliable, less verifiable, and less objective than the original cost, the original cost is
used.
The accounting profession has been willing to move away from the cost principle if there are reliable,
verifiable, and objective amounts involved. For example, if a company has an investment in stock
that is actively traded on a stock exchange, the company may be required to show the current value
of the stock instead of its original cost.

2. Consistency
Accountants are expected to be consistent when applying accounting principles, procedures, and
practices. For example, if a company has a history of using the FIFO cost flow assumption, readers of
the company's most current financial statements have every reason to expect that the company is
continuing to use the FIFO cost flow assumption. If the company changes this practice and begins
using the LIFO cost flow assumption, that change must be clearly disclosed.

3. Comparability
Investors, lenders, and other users of financial statements expect that financial statements of one
company can be compared to the financial statements of another company in the same
industry. Generally accepted accounting principles may provide for comparability between the
financial statements of different companies. For example, the FASB requires that expenses related to
research and development (R&D) be expensed when incurred. Prior to its rule, some companies
expensed R&D when incurred while other companies deferred R&D to the balance sheet and
expensed them at a later date.
Confused? Send Feedback
How Principles and Guidelines Affect
Financial Statements
The basic accounting principles and guidelines directly affect the way financial statements are
prepared and interpreted. Let's look below at how accounting principles and guidelines influence the
(1) balance sheet, (2) income statement, and (3) the notes to the financial statements.

1. Balance Sheet
Let's see how the basic accounting principles and guidelines affect the balance sheet of Mary's
Design Service, a sole proprietorship owned by Mary Smith. (To learn more about the balance sheet
go to Explanation of Balance Sheetand Quiz for Balance Sheet.)
A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity at one point in
time. (In this case, that point in time is after all of the transactions through September 30, 2018 have
been recorded.) Because of the economic entity assumption, only the assets, liabilities, and owner's
equity specifically identified with Mary's Design Service are shown—the personal assets of the
owner, Mary Smith, are not included on the company's balance sheet.

The assets listed on the balance sheet have a cost that can be measured and each amount shown
is the original cost of each asset. For example, let's assume that a tract of land was purchased in
1956 for $10,000. Mary's Design Service still owns the land, and the land is now appraised at
$250,000. The cost principle requires that the land be shown in the asset account Land at its original
cost of $10,000 rather than at the recently appraised amount of $250,000.
If Mary's Design Service were to purchase a second piece of land, the monetary unit
assumption dictates that the purchase price of the land bought today would simply be added to the
purchase price of the land bought in 1956, and the sum of the two purchase prices would be
reported as the total cost of land.
The Supplies account shows the cost of supplies (if material in amount) that were obtained by Mary's
Design Service but have not yet been used. As the supplies are consumed, their cost will be moved
to the Supplies Expense account on the income statement. This complies with the matching
principle which requires expenses to be matched either with revenues or with the time period when
they are used. The cost of the unused supplies remains on the balance sheet in the asset account
Supplies.
The Prepaid Insurance account represents the cost of insurance that has not yet expired. As the
insurance expires, the expired cost is moved to Insurance Expense on the income statement as
required by the matching principle. The cost of the insurance that has not yet expired remains on
Mary's Design Service's balance sheet (is "deferred" to the balance sheet) in the asset account
Prepaid Insurance. Deferring insurance expense to the balance sheet is possible because of another
basic accounting principle, the going concern assumption.
The cost principle and monetary unit assumption prevent some very valuable assets from ever
appearing on a company's balance sheet. For example, companies that sell consumer products with
high profile brand names, trade names, trademarks, and logos are not reported on their balance
sheets because they were not purchased. For example, Coca-Cola's logo and Nike's logo are
probably the most valuable assets of such companies, yet they are not listed as assets on the
company balance sheet. Similarly, a company might have an excellent reputation and a very skilled
management team, but because these were not purchased for a specific cost and we cannot
objectively measure them in dollars, they are not reported as assets on the balance sheet. If a
company actually purchases the trademark of another company for a significant cost, the amount
paid for the trademark will be reported as an asset on the balance sheet of the company that bought
the trademark.

2. Income Statement
Let's see how the basic accounting principles and guidelines might affect the income statement of
Mary's Design Service. (To learn more about the income statement go to Explanation of Income
Statement and Quiz for Income Statement.)
An income statement covers a period of time (or time interval), such as a year, quarter, month, or
four weeks. It is imperative to indicate the period of time in the heading of the income statement
such as "For the Nine Months Ended September 30, 2018". (This means for the period of January 1
through September 30, 2018.) If prepared under the accrual basis of accounting, an income statement
will show how profitable a company was during the stated time interval.
Revenues are the fees that were earned during the period of time shown in the heading.
Recognizing revenues when they are earned instead of when the cash is actually received follows
the revenue recognition principle and the matching principle. (The matching principle is what steers
accountants toward using the accrual basis of accounting rather than the cash basis. Small business
owners should discuss these two methods with their tax advisors.)
Gains are a net amount related to transactions that are not considered part of the company's main
operations. For example, Mary's Design Service is in the business of designing, not in the land
development business. If the company should sell some land for $30,000 (land that is shown in the
company's accounting records at $25,000) Mary's Design Service will report a Gain on Sale of Land of
$5,000. The $30,000 selling price will not be reported as part of the company's revenues.
Expenses are costs used up by the company in performing its main operations. The matching
principle requires that expenses be reported on the income statement when the related sales are
made or when the costs are used up (rather than in the period when they are paid).
Losses are a net amount related to transactions that are not considered part of the company's main
operating activities. For example, let's say a retail clothing company owns an old computer that is
carried on its accounting records at $650. If the company sells that computer for $300, the
company receives an asset (cash of $300) but it must also remove $650 of asset amounts from its
accounting records. The result is a Loss on Sale of Computer of $350. The $300 selling price
will not be included in the company's sales or revenues.

3. The Notes To Financial Statements

Another basic accounting principle, the full disclosure principle, requires that a company's financial
statements include disclosure notes. These notes include information that helps readers of the
financial statements make investment and credit decisions. The notes to the financial statements are
considered to be an integral part of the financial statements.