3.1.3 Accounting Principles

When are business transactions accounted for? Most of us when we keep accounts (such as in a checkbook) record transactions when we receive money or make payments - so-called "cash-basis" accounting. But businesses recognize transactions when they have their primary economic impact, not when cash come in and goes out - so-called "accrual-basis" accounting. In fact, GAAP and the IRS require this method. By using accrual accounting, businesses avoid a number of problems and temptations to manipulate reporting of financial results. For example, under accrual accounting the purchase of inventory in one year, though used over many years, is treated as a series of purchases that occur each time a sale is made. And a sale is recorded when cash is paid or there is a credit commitment. This means revenues and expenses are often accrued even though they have not been billed and no right to payment yet exists!

One of the most surprising (and discomforting) aspects about accounting is its focus on historical costs. Accountants (as instructed by GAAP) look at the original purchase price of assets when almost certainly they do not reflect current value (or market price). If accounting is supposed to give a current picture of a firm's finances, why look at the original purchase price of its assets? There are some practical answers:

• Historical costs reflect how items are initially entered under double-entry bookkeeping
• Historical costs are objective and verifiable, making manipulation tougher
• Historical costs avoid the constant task of re-valuing assets as their market value falls and rises

And finally, using historical costs gives the accounting profession gravitas - the appearance of being conservative and trustworthy.