GAAP and the Income Statement

An income statement prepared using GAAP will show revenue when it accrues. This is not necessarily when the cash comes in. The general rule (the realization principle) is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. In practice, this principle usually means that revenue is recognized at the time of sale, which need not be the same as the time of collection.

Expenses shown on the income statement are based on the matching principle. The basic idea here is to first determine revenues as described previously and then match those revenues with the costs associated with producing them. So, if we manufacture a product and then sell it on credit, the revenue is realized at the time of sale. The

PART ONE Overview of Corporate Finance production and other costs associated with the sale of that product will likewise be recognized at that time. Once again, the actual cash outflows may have occurred at some very different time.

As a result of the way revenues and expenses are realized, the figures shown on the income statement may not be at all representative of the actual cash inflows and outflows that occurred during a particular period.

noncash items

Expenses charged against revenues that do not directly affect cash flow, such as depreciation.

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