Business transactions are economic events that should be recorded in the accounting records.The concepts of recognition, valuation, and classification underlie all business transactions.
Recognition refers to the decision as to when to record a business transaction. Usually, companies set specific recognition policies, such as recognizing revenue when title to goods passes or a service is provided. For example, for Paws and Hoofs Clinic that was introduced at the beginning of the chapter, Jim needs to know when to record the $6,000 fee in his financial statements.
The resolution of this issue is important because the date on which a transaction is recorded affects amounts in the financial statements. Valuation Valuation is the process of assigning a monetary amount to business transactions and the resulting assets and liabilities. Generally accepted accounting principles state that all business transactions should be valued at fair value when they occur.
is the exchange price of an actual or potential business transaction between market participants.2 Recording transactions at the exchange price at the point of recognition is called the cost principle. The cost, or exchange price, is used because it is verifiable. For example, when Jim performs the service for Quarter Horse Stables, he and Quarter Horse Stables will record the transaction in their respective records at the agreed-upon price. Normally, the value of an asset remains at its initial fair value or cost until the asset is sold, expires, or is consumed. However, if a change in the fair value of the asset (or liability) occurs, an adjustment may be required. Different fair-value rules apply to different classes of assets. For example, a building or equipment remains at cost unless convincing evidence exists that the fair value is less than cost. In this case, a loss is recorded to reduce the value from its cost to fair value. Investments, on the other hand, are often accounted for at fair value, regardless of whether fair value is greater or less than cost.
Classification is the process of assigning all the transactions in which a business engages to appropriate categories, or accounts. Classification of debts can affect a company’s ability to borrow money, and classification of purchases can affect its income. One of the most important classification issues in accounting is the difference between an expense and an asset, both represented by debits in the accounts. For example, if Jim buys medicines that are used immediately at the Paws and Hoofs Clinic, their cost is classified as an expense. If the medicines will be used in the future, they are classified as assets. Similarly, if CVs buys paper towels to resell to customers, the cost would be recorded as an asset in the Inventory account. If the paper towels are used for cleaning in the store today, the cost is an expense.