Though accounting for income and expenses in a business environment is a complex process, the basics of accounting are relatively simple. A system known as the Generally Accepted Accounting Principles defines four basic assumptions, four basic principles and four basic constraints to business accounting. The four basic principles of GAAP deal with the way that money flows into and out of the business as well as the way that this flow is documented.
The cost principle states that the actual cost of assets must be recorded instead of recording the cost based on market value or inflation adjustment. This ensures that the recorded cost of inventory and other purchases is reflected accurately in the accounting ledger. The principle is sometimes referred to as the "historical cost principle" because costs are recorded based on the actual cost at the time of purchase instead of being an estimated or adjusted cost recorded at a later time.
The revenue principle states that revenue should be recorded at the time that it is earned, not at the time when payment is received. This prevents errors in accounting caused by delayed payments since any money still owed to the company is evident within the accounting ledger. The revenue principle also serves as the basis for the accrual accounting method, causing it to occasionally be referred to as the "accrual principle."
The matching principle states that expenses should be matched to the revenue they are related to. The expenses are not recorded at the time they are generated, but instead are recorded once they make a contribution to revenue. This allows the profitability of goods and services to be easily evaluated and also illustrates the connection between expense and income, since products and services are directly matched with the revenue they generate. Some expenses such as administrative costs and employee salaries cannot be directly linked with revenue, of course; these expenses are recorded simply as expenses for the current period.
The disclosure principle states that all of the financial information disclosed by a business should be released in a form that is easy to understand and that this disclosure should be balanced against the cost of compiling and releasing the information. Any information needed to understand financial statements should be included in the body of the statements, in footnotes or in supplemental documents that are provided alongside the statements. The amount of information disclosed should be sufficient for corporate executives to make decisions regarding the company; unnecessary information should be streamlined to keep the cost of producing the statements down.
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