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The fundamental or bedrock concepts are the 'accruals' or matching concept and the going concern concept. They are explained and discussed in much more detail in Chapter 5, but they must be introduced now as the accruals concept underlies the distinction between cash reports and the P&L account and the going concern concept is fundamental to the amounts shown in the balance sheet.
Going concern - a fundamental concept, also termed an underlying assumption
The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations, the significance of this being that balance sheet asset values will hold good.
Accruals or matching concept
Cash receipts and payments may well underlie the greater part of recorded income and expense and for a very simple cash business the entire records. But even simple and small businesses and certainly large entities will owe and be owed money. Thus a cash picture of a business is needed to manage cash flow and balances, but reporting results or performance has to include sales made but not settled in cash and expenses incurred but not paid in cash, the idea being to match a defined period's income with its expenses and thus reveal the (accrued) profit or loss.
Income statement - the P&L account
The P&L account summarizes the income, revenue or sales, and costs or expenses for a period.
We all know intuitively what income is: cash from or due from sales, revenue earned; and also what an expense or cost is: reduction in cash or a liability taken on for a necessary expenditure that generates income. Sometimes expenses or costs are without any benefit and of course should be avoided.
Here are definitions from GAAP:
Profit is frequently used as a measure of performance or as the basis for other measures, such as return on investment or earnings per share. The elements directly related to the measurement of profit are income and expenses. The elements of income and expenses are defined as follows:
(a) Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
(b) Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
The definition of income encompasses both revenue and gains.
Gains include, for example, those arising on the disposal of non-current assets. The definition of income also includes unrealized gains; for example, those arising on the revaluation of marketable securities and those resulting from increases in the carrying amount of long-term assets.
The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. Expenses that arise in the course of the ordinary activities of the entity include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment.
Losses represent other items that meet the definition of expenses and may or may not arise in the course of the ordinary activities of the entity.
The definition of expenses also includes unrealized losses, for example, those arising from the effects of increases in the rate of exchange for a foreign currency in respect of the borrowings of an entity in that currency.
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