company, or limited liability partnership becomes a separate legal entity. In many cases, this separate legal entity protects investors from creditors that have a claim on the assets of the business. By comparison, in a sole proprietorship or a partnership, the sole proprietor and the partners are liable for the debts and obligations of the proprietorship or the partnership.
If you have questions about the correct business form in which to operate, talk with a good local attorney or accountant. They can assist you in choosing the appropriate business form and in considering both the legal and tax aspects of choosing a particular form. As a general rule, more-sophisticated business forms such as corporations, limited liability companies, and limited liability partnerships deliver significant legal and tax benefits to investors and managers. Unfortunately, these more-sophisticated business forms also require considerably more legal and accounting fiddle-faddling.
The Philosophy of Accounting
Maybe the phrase philosophy of accounting is too strong, but accounting does rest on a rather small set of fundamental assumptions and principles. People often refer to these fundamentals as generally accepted accounting principles.
I want to quickly summarize what these principles are. I find — and I bet you’ll find the same thing — that understanding the principles provides context and makes accounting practices more understandable. With this in mind, let me go through the half dozen or so key accounting principles and assumptions.
These basic accounting principles underlie business accounting. These principles and assumptions are implicit in all the discussions in this entire book. It’s no exaggeration to say that they permeate almost everything related to business accounting.
Revenue principle
The revenue principle, also known as the realization principle, states that revenue is earned when the sale is made. Typically, the sale is made when goods or services are provided. A key component of the revenue principle, when it comes to the sale of goods, is that revenue is earned when legal ownership of the goods passes from seller to buyer.
Note that revenue isn’t earned when you collect cash for something. It turns out, perhaps counterintuitively, that counting revenue when cash is collected doesn’t give the business owner a good idea of what sales really are. Some customers may pay deposits early, before actually receiving the goods or services. Often, customers want to use trade credit, paying a firm at some point in the future for goods or services. Because cash flows can fluctuate wildly — even something like a delay in the mail can affect cash flow — you don’t want to use cash collection from customers as a measure of sales. Besides, you can easily track cash collections from customers. So why not have the extra information about when sales actually occur?
Expense principle
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.
Matching principle
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.
Cost principle
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.
Objectivity principle
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.
Continuity assumption
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 1-4 earlier 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.
Unit-of-measure assumption
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
