Chapter 3
The Accounting Framework
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The
time period concept
requires that accounting takes place over specific time
periods known as fiscal periods. These fiscal periods are of equal length, and are
used when measuring the financial progress of a business.
Measurement
is the process of determining the amount at which an item is recorded
in the financial statements. Primarily, items must be recorded at their historical cost.
This is sometimes referred to as the cost principle. In almost all cases, the historical
cost is the amount that appears on the source document for the transaction. If the owner purchased
office furniture on sale for $5,000, but knew the furniture was actually worth $7,000 (the price
before the sale), the furniture would be recorded as $5,000, as shown on the receipt.There are times
when the historical cost of an item is not appropriate. For example, a building could be received as
a gift. In such a case, the transaction would be recorded at fair market value, which must be deter-
mined by some independent means.
Revenue recognition
states that revenue can only be recorded (recognized) when goods are sold or
when services are performed.This means that the item sold must be transferred to the buyer and the
buyer has agreed to pay, or has already paid the price for the item. If the transaction involves a large
project such as building a dam, it may take a construction company a number of years to complete.
The construction company does not usually wait until the project is entirely completed before it
recognizes the revenue. Periodically, it bills for work completed and recognizes revenue for the work
completed since the last bill was sent.
Expense recognition
states that an expense must be recorded in the same accounting period in
which it was used to produce revenue. For example, suppose a manufacturing business spent
$20,000 to produce 1,000 units of inventory in the current accounting period. If 500 units are sold
in each of the following two accounting periods, $10,000 would be expensed in each period.This
concept is commonly referred to as the “matching principle” because expenses must be matched to
the same period as the revenue that they helped to generate. If an expense cannot be tied to
revenue, then it should be recorded in the current period.
Consistency
prevents businesses from changing accounting
methods for the sole purpose of manipulating figures on the finan-
cial statements. Accountants must apply the same methods and
policies from period to period. For example, a merchandising busi-
ness must have a method to assign values to its products and use
the same method from year to year. When a method changes from
one period to another, the change must be clearly explained in the
financial statements.The readers of financial statements have the right to assume that consistency
has been applied if there is no statement to the contrary.
Materiality
refers to the significance of information to users. A piece of information is consid-
ered material if it could influence or change a user’s decision. Material amounts must be recorded
correctly on financial statements. For example, suppose a company paid cash for $100 worth of
office supplies. The supplies could be recorded as an asset and expensed as they are used, or they
can simply be expensed immediately. While recording them as an asset is more accurate, it is also
