Financial reporting rests on a set of foundational principles and assumptions. The going concern assumption presumes that a business will continue operating indefinitely, which justifies capitalizing assets over their useful lives. The economic entity assumption treats the business as separate from its owners and other entities, while the monetary unit assumption records transactions in a stable currency and ignores inflation. The time period assumption divides the life of the business into artificial periods such as quarters or years so that periodic financial statements can be produced. A fiscal year is any 12-month accounting period, which may end on a date other than December 31.
Several principles shape how transactions are recognized and reported. The cost (or historical cost) principle requires assets to be recorded at the cash or cash-equivalent amount paid at acquisition, providing objective and verifiable amounts. The matching principle requires expenses to be recorded in the same period as the revenues they helped generate, ensuring accurate measurement of profitability. The revenue recognition principle states that revenue is recorded when it is earned and realizable, not necessarily when cash is received, often requiring persuasive evidence of an arrangement and delivery. The conservatism principle advises understating assets or income and overstating liabilities when uncertainty exists, while materiality determines whether an item's size is significant enough to influence decisions. The full disclosure principle requires all relevant information affecting decisions to appear in the financial statements or accompanying notes.
These principles guide the construction of the four core financial statements. The balance sheet presents assets, liabilities, and equity at a specific point in time, reflecting the accounting equation in detail. The income statement reports revenues, expenses, and net income over a period, following the relationship Net Income = Revenues - Expenses. The statement of retained earnings shows how the retained earnings balance changed, beginning with the prior balance, adding net income, and subtracting dividends; this statement links the income statement to the balance sheet. The cash flow statement summarizes cash inflows and outflows from operating, investing, and financing activities, explaining changes in the cash balance over a period. Underlying the statements is a choice of timing basis: accrual accounting records revenues when earned and expenses when incurred, while cash basis accounting records them only when cash changes hands. Accrual accounting provides a more accurate picture of performance, but cash basis is simpler and common in small businesses.