Stephen L. Nelson - QuickBooks 2022 All-in-One For Dummies

The expense principle states that an expense occurs when the business uses goods or receives services. In other words, the expense principle is the flip side of the revenue principle. As is the case with the revenue principle, if you receive some goods, simply receiving the goods means that you’ve incurred the expense of the goods. Similarly, if you’ve received some service — services from your lawyer, for example — you’ve incurred the expense. It doesn’t matter that your lawyer takes a few days or a few weeks to send you the bill. You incur an expense when goods or services are received.

The matching principle is related to the revenue and expense principles. The matching principle states that when you recognize revenue, you should match related expenses with the revenue. The best example of the matching principle concerns the case of businesses that resell inventory. In the example of the hot dog stand, you should count the expense of a hot dog and the expense of a bun on the day when you sell that hot dog and that bun. Don’t count the expense when you buy the buns and the dogs; count the expense when you sell them. In other words, match the expense of the item with the revenue of the item.

Accrual-based accounting, which is a term you’ve probably heard, is what you get when you apply the revenue principle, the expense principle, and the matching principle. In a nutshell, accrual-based accounting means that you record revenue when a sale is made and record expenses when goods are used or services are received.

The cost principle states that amounts in your accounting system should be quantified, or measured, by using historical cost. If you have a business, and the business owns a building, that building — according to the cost principle — shows up on your balance sheet at its historical cost. You don’t adjust the values in an accounting system for changes in a fair market value. You use the original historical costs.

I should admit that the cost principle is occasionally violated in a couple of ways. The cost principle is adjusted through the application of depreciation, which I discuss in Book 1, Chapter 3. Also, fair market values are sometimes used to value assets, but only when assets are worth less than they cost.

The objectivity principle states that accounting measurements and accounting reports should use objective, factual, and verifiable data. In other words, accountants, accounting systems, and accounting reports should rely on subjectivity as little as possible.

An accountant always wants to use objective data (even if it’s bad) rather than subjective data (even if the subjective data is arguably better). The idea is that objectivity provides protection from the corrupting influence that subjectivity can introduce into a firm’s accounting records.

The continuity assumption — accountants call it an assumption rather than a principle for reasons unknown to me — states that accounting systems assume that a business will continue to operate. The importance of the continuity assumption becomes clear if you consider the ramifications of assuming that a business won’t continue. If a business won’t continue, it becomes very unclear how one should value assets if the assets have no resale value. This sounds like gobbledygook, but think about the implicit continuity assumption built in to the balance sheet for the hot dog stand at the beginning of the day. (This is the balance sheet that shows up in Table 1-4earlier in this chapter.)

Implicit in that balance sheet is the assumption that hot dogs and hot dog buns have some value because they can be sold. If a business won’t continue operations, no assurance exists that any of the inventory can be sold. If the inventory can’t be sold, what does that say about the owner’s equity value shown in the balance sheet?

You can see, I hope, the sorts of accounting problems that you get into without the assumption that the business will continue to operate.

The unit-of-measure assumption assumes that a business’s domestic currency is the appropriate unit of measure for the business to use in its accounting. In other words, the unit-of-measure assumption states that it’s okay for U.S. businesses to use U.S. dollars in their accounting, and it’s okay for UK businesses to use pounds sterling as the unit of measure in their accounting system. The unit-of-measure assumption also states, implicitly, that even though inflation and occasionally deflation change the purchasing power of the unit of measure used in the accounting system, that’s still okay. Sure, inflation and deflation foul up some of the numbers in a firm’s financial statements. But the unit-of-measure assumption says that’s usually okay — especially in light of the fact that no better alternatives exist.

The separate-entity assumption states that a business entity, like a sole proprietorship, is a separate entity — a separate thing from its business owner. Also, the separate-entity assumption says that a partnership is a separate thing from the partners who own part of the business. This assumption, therefore, enables one to prepare financial statements just for the sole proprietorship or just for the partnership. As a result, the separate-entity assumption also relies on a business to be separate, distinct, and definable compared with its business owners.

I’m not going to talk much about tax accounting or tax preparation in this book, but one key reason why you do accounting and use a program such as QuickBooks is to make your tax accounting easier. That’s obvious. So a fair question is this: How does what I’ve said so far relate to income tax return preparation?

This question is a tough one to answer. Tax laws typically don’t map to generally accepted accounting principles. Generally accepted accounting principles aren’t the same things as income tax laws. If you use good basic accounting practices as you operate QuickBooks, however, you get financial information that you can use to easily prepare your tax returns, especially if you get some help from your certified public accountant (CPA).

If you want, you can also use income tax rules to fine-tune your accounting and bookkeeping. This practice, which is technically known as an other comprehensive basis of accounting (OCBOA), is generally considered to be an appropriate way to perform accounting for small and medium-size enterprises.

Chapter 2

IN THIS CHAPTER

Checking out the fiddle-faddle method of accounting

Grasping how double-entry bookkeeping works

Looking at an (almost) real-life example