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You have a lot to do running a small business—and hopefully your books aren’t one of them. Having a good accountant or bookkeeper can help your business save money and avoid mistakes, so it is highly recommended that all small businesses invest in this relationship early.
So, assuming you have appropriately outsourced this crucial responsibility, why should you be concerned with mastering even the most basic business accounting principles when you have bigger fish to fry? Doesn’t hiring an accountant mean you don’t have to study this sort of thing?
Well, theoretically yes. But knowing basic accounting principles—or at least the gist of them—will help you understand why that accountant you hired is doing such seemingly specific things. If you’ve ever gotten frustrated by your accountant’s adherence to a set of seemingly arbitrary rules, you might be more relaxed to know that they’re not arbitrary at all.
Accounting is governed by a series of 10 principles or rules. These accounting standards are often referred to as GAAP (pronounced “gap”)—which is an accounting term that means generally accepted accounting principles. Accounting principles reference these rules or guidelines that your business must follow when preparing financial statements.
The more you understand about the purpose of generally accepted accounting principles, the more you’ll know why (and how) these principles of accountancy help protect business owners, consumers, and investors from fraud. They also guarantee a measure of consistency in the accounting reports among all businesses. In order to work in harmony with their accountants, small business owners need to at least know the spirit of these rules!
Ever wonder why your accountant harps on you about keeping your business transactions separate from your personal transactions? This isn’t because your business accountant wants to make their job easier (although, yes, separate transactions definitely do help!).
The reason they won’t budge on this? The economic entity assumption principle. It basically means that a business is an entity unto itself, and should be treated as such (which is also why this is sometimes called the “separate entity assumption”). If you know this basic accounting principle definition, you’ll better under the reason why your accountant insisted you open a separate business bank account when you opened your business. This is business 101.
Even in a sole proprietorship, where your business activity appears on your personal tax return, the economic entity assumption still applies. This is because, legally, your business can exist independently of you. And, another plus is that this will make your life easier if you ever decide to incorporate down the road.
The monetary unit assumption principle dictates all activity be recorded in the same currency. This is why you have to go through the extra effort to complete your business bookkeeping for foreign transactions.
Another assumption under this basic accounting principle is that the purchasing power of currency remains static over time. In other words, inflation is not considered in the financial reports of a business, even if that business has existed for decades.
An accounting balance sheet always reports information as of a certain date. Profit and loss statements, also called income statements, encompass a date range. All financial statements, including an income statement, cash flow statement, and statement of shareholders’ equity, have to indicate the time period for the activity reported in order for them to be meaningful to those reviewing them.
In short: Dates are really, really important. Always check your financial statements for dates. A balance sheet will indicate the report is “as of” or “at” a certain date. Profit and loss statements will indicate they are for a specific date range.
The cost principle in accounting outlines that the cost of an item doesn’t change on the financial reporting. So, even if you’ve bought something within the year that’s skyrocketed in value—let’s say a building, for instance—even though its relative market value has changed, accountants will still always report the asset at the amount for which it was obtained. In other words, they will report the historical cost of the asset.
Knowing this basic accounting principle definition teaches something pretty important for small business owners in general: It’s important not to confuse cost with value. The value of things does change over time, and this is reflected in the gain or loss on sale of assets as well as in depreciation entries. If you need a true valuation of your business without selling off your assets, you’ll need to bring in an expert in business valuations rather than relying on your financial statements.
The full disclosure principle is the generally accepted accounting principle that grabs the most headlines. Under this basic accounting principle, a business is required to disclose all information that relates to the function of its financial statements in notes accompanying the statements. This principle helps make sure stockholders and investors are not misled by any aspect of the financial reports.
Also referred to as the “non-death principle,” the going concern principle assumes the business will continue to exist and function with no defined end date. Knowing this basic accounting principle will help you understand why you defer the recognition of expenses to a later accounting period. If an accountant is concerned the business might be forced to liquidate, they have to disclose this under GAAP principles.
For tax purposes, many small businesses choose to operate on a cash basis, meaning revenue is reported when cash is received and expenses are reported when cash is spent (or when your business’s credit card is charged). But, many businesses are required to report all financial information on an accrual basis, largely due to the matching principle.
Under the matching accounting principle, sales and the expenses used to produce those sales are reported in the same accounting period. These expenses can include wages, sales commissions, certain overhead costs, etc.
Even if your tax return is on a cash basis, your accountant might prepare your financial reports on an accrual basis. Accrual accounting reports reflect the matching principle and provide a better analysis of your business’s performance and profitability than cash basis statements.
Under the accrual basis of accounting, revenue is reported when it’s earned, regardless of when payment for the product or service is actually received. Similar to the matching principle, the basic accounting principle of revenue recognition accurately reports income, or revenue, when the sale was made, even if you bill your customer or receive payment at a later time.
The materiality principle is one of two basic accounting principles that lets the accountant use their best judgment in recording a transaction or addressing an error.
We often see the materiality principle at play when an accountant is reconciling a set of books or completing a tax return. If the account is off by a relatively small amount in relation to the overall size of the business, the discrepancy may be deemed immaterial. Immaterial discrepancies can be disregarded, but material discrepancies must be addressed. Similarly, immaterial expenses can be recognized at the time of purchase, but material expenses must be depreciated over time.
It’s important here for the accountant to be empowered to use their professional opinion. Since businesses come in all sizes, an amount that might be significant—or material—for one business may be insignificant—or immaterial—for another.
The principle of conservatism is the other principle that lets the accountant use their best judgment in a situation. When there’s more than one acceptable way to record a transaction, the principle of conservatism instructs the accountant to choose the option that’s best for the business they’re working with.
It’s important to understand this basic accounting principle is only invoked when either way the accountant can record the transaction is acceptable. It doesn’t allow the accountant to completely disregard other accounting principles.
So, not every business is required by law to comply with GAAP. However, most accountants will insist on following them, regardless of whether your business is bound by law to comply with GAAP. And as your business tax deadline approaches, we can imagine the idea of getting an audit is incredibly scary—so adherence to these basic accounting principles ensures there’s never a question about the integrity of your financial statements.
Also, think of these principles like a language. You may not work with the same accountant or bookkeeper throughout your business’s entire lifetime, but understanding these principles will help you communicate with whoever is in this position, as you’ll always understand the language they speak, the decisions they make, and why.
All in, understanding the basics of these accounting principles will help demystify some of those requests your accountant makes, or help you understand why a process is set up as it is. Plus, you’ll be armed to identify when something seems amiss in your financial records, so you can address issues as they arise rather than when they become insurmountable.
Now that you have a good understanding of the basic accounting principles, accounting formulas should be next on your checklist for understanding the inner workings of accounting.
The 6 Most Important Accounting Formulas You’ll Ever Need to Know