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GAAP – Periodicity Principle
This discussion focuses on the objectives, description and application of this principle. Examples will be given to strengthen the understanding and capability to apply this principle at real situation.
Objective:
To divide the economic life of a business into shorter artificial time periods in order to assess and compare the financial conditions and results of operations for specific periods of time.
Description:
Business keeps operating continuously, but investors and financial information user could not wait until the closure of the business to obtain the bottom line or financial positions of the company. As such, the periodicity principle requires financial information to be reported in artificial period intervals, such as 12-months, quarters and months. Application:
Some business, especially the service sector, by nature keeps running continuously 24 hours a day, 7 days a week nonstop. For example, a hotel will host guests overnight and the water/electricity bills keep running at the same time. These processes and activities will continue until the hotel cease operations.
For investor and management, they could not wait that long to obtain financial information for their decision making. In order to provide timely information, it is necessary to “draw a timeline” for reporting. Usually this timeline is drawn for the intervals of months, quarters or year to enhance comparability across industries and within the organization for different period.
When we draw such timeline, it does not necessary mean that all operations have to stop at that point of time. For example, if a hotel is reporting their financial information at the end of the month, they could not ask the guest to leave the hotel by the midnight of the last day of month, and they could not cut off the electricity and water from running.
As such, in order to appropriately allocate all revenue and expenses to the time periods, we need to go through a process of “estimation” or “accrual basis”. When the “estimation”or “accrual” process is consistently applied every month, we could ensure the financial reporting for each time period intervals is accurate and comparable for use to measure the performance of the company.
Example:
You are operating a car rental company, a hotel has agreed to rent your cars for the whole year for $240,000 and payment will be made every quarter. The other expenses you incurred included salaries ($8,000/mth), office rental ($60,000/yr), electricity & water (utilities depend on consumptions), maintenance (depends on consumptions) and depreciation ($60,000/yr).
To comply with the “periodicity” principle and to meet your owner’s requirement, the car rental company is required to produce monthly financial reports.
Entries at end of each month:
For Revenue:
Dr. Accounts Receivable….. $20,000
Cr. Revenue……………………..$20,000*
*($240,000 / 12 months)
For Expenses:
Dr. Salaries expense …………$8,000
Cr. Accounts payable …………. $8,000
Dr. Office Rental expense……$5,000*
Cr. Prepare rent …………. $5,000
*($60,000/12 months)
Dr. Utilities expense…………$XXX (depends on actual consumptions) Cr. Accounts payable …………$XXX
Dr. Maintenance expense……$XXX (depends on actual consumptions) Cr. Accounts payable …………$XXX
Dr. Depreciation exp ense……$5,000
Cr. Accumulated depreciation….$5,000*
*($60,000/12 months)
To comply with the monthly reporting requirement in accordance to the periodicity principle, we have calculated the revenue and expenses of the company for the month. After we put in the above entries for both revenue and expenses, we will be able to get an idea on the performance of the company for that particular month (if the company is making profit or loss). After we have the data for couple months, the management could investigate the fluctuations and look into means for improvements.
