Final answer:
E. Records expenses based on the matching principle
An income statement according to GAAP records expenses based on the matching principle, reflecting financial performance over a period rather than on a cash basis. It differs from cash flow statements and balance sheets.
The understanding of accounting and economic profit is also vital for a comprehensive view of a firm's profitability.
Step-by-step explanation:
An income statement prepared according to GAAP reflects the financial activities of a firm over a stated period of time, specifically focusing on revenue, expenses, profits, and losses.
This aligns with Option E, as GAAP requires that expenses be recorded based on the matching principle, which states that expenses should be recognized in the same period as the revenues they helped to generate, regardless of when the cash transactions occur.
It's also important to differentiate between accounting profit and economic profit. Accounting profit is considered a cash concept, which is total revenue minus explicit costs — the difference between dollars brought in and dollars paid out. In contrast, economic profit includes both explicit and implicit costs, and as a result, gives a more comprehensive view of a firm's profitability.
In terms of costs, a firm's total costs can be divided into fixed costs and variable costs. Fixed costs, or sunk costs, do not change with the level of production and should not affect future production or pricing decisions.
Variable costs vary with the level of output and typically show diminishing marginal returns, which means that the cost of producing each additional unit rises.