![]() ![]() The cost of an item may be different compared to its true value, but since figuring out the true value would be subjective, stating the assets at historical cost is generally accepted as a fair way to maintain records.įollowing the cost concept of accounting means that unless there are special reasons for doing otherwise, the assumption should be made that the cost of an item is its true value, and all accounting entries should be made at cost. However, there are also some limitations to the cost concept of accounting.įor example, in the context of inflation, the cost concept of accounting would lead to an overstatement of net profit.ĭespite its limitations, the cost concept of accounting is regarded as the best option when compared to the available alternatives. Under this concept, stability in asset prices while recording is achieved. Under the cost concept of accounting, an asset should be recorded at the cost at which it was purchased, regardless of its market value.įor example, if a building is purchased for $500,000, it will continue to appear in the books at that figure, irrespective of its market value. Therefore, if a balance sheet shows an asset at a certain value, it should be assumed that this is its cost unless it is categorically stated otherwise. This flexibility in applying GAAP is why financially intelligent managers need to understand the estimates, bias, and assumptions behind these judgment calls, and how they affect the financials.The cost concept of accounting states that all acquisitions of items (e.g., assets or items needed for expending) should be recorded and retained in books at cost. But GAAP doesn’t spell out everything it allows for plenty of discretion and judgment calls. It helps to ensure the statements’ validity and reliability, and allows for easy comparison between companies and across industries. GAAP defines the standard for creating financial reports in the United States. (Excerpts from Financial Intelligence, Chapter 8 – Costs and Expenses) So long as a company’s logic is reasonable, and so long as that logic is applied consistently, whatever it wants to do in this instance is OK. The key to proper application of GAAP, as accountants like to say, is reasonableness and consistency. ![]() ![]() Companies take those guidelines and apply a logic that makes sense for their particular situations. For example, what about the salary of the person who manages the plant where the product is manufactured? What about the wages of the plant supervisors? You’d think GAAP would say, “The plant manager is out,” or “The supervisor is in.” No such luck GAAP only provides guidelines. Conversely, the cost of supplies used by the accounting department and the salary of the human resources manager are definitely in SG&A, not in COGS or COS.īut then there’s the gray area-and it’s enormous. Some of these decisions are easy: for example the wages of the people on the manufacturing line or the cost of materials used to make the product should definitely go in COGS or COS. The accounting department has to make decisions about what to include in COGS or COS and what to put somewhere else. Another category of operating expense is selling, general, and administrative expenses (SG&A). It includes all the costs directly involved in producing a product or delivering a service. Cost of goods sold or cost of services (also known as COGS and COS) is one category of business expenses. For example, the same expense might be accounted for differently by two different companies, and both companies might still be in perfect compliance with GAAP. GAAP says that all operating expenses must be reflected on a company’s books however, it does not say how to categorize them specifically. One example of the way GAAP can be applied concerns how to account for operating expenses. When a company wants to change how they apply GAAP, they must publicly disclose the change. However, once they pick how they are going to apply GAAP, they must be consistent and use it on an on-going basis. ![]() GAAP runs for thousands of pages and spells out a lot of detailed rules. The Financial Accounting Standards Board (FASB) defines and amends GAAP. Securities and Exchange Commission (SEC) requires that GAAP be followed by all companies whose stock is publicly traded on the open market. GAAP stands for Generally Accepted Accounting Principles. ![]()
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