In this guide, we’ll break down 10 of the basic principles of business accounting, as defined by “GAAP,” or the generally accepted accounting principles that govern the field of accounting. Here’s a quick look at the key accounting principles:
Before we explain 10 of the most common basic accounting principles, let’s start with a brief overview. What are the basic principles of accounting?
The basic principles of accounting are not just any arbitrary principles that differ from accountant to accountant. Instead, the field of accounting is governed by a series of principles or rules as defined by the Financial Accounting Standards Board (FASB).
These accounting principles are often referred to as GAAP (pronounced “gap”)—meaning generally accepted accounting principles. On the whole, however, GAAP consists of three parts:
In this case, we’re discussing number one, the basic accounting principles that dictate how your accountant does their job. These accounting principles guarantee consistency in accounting reports and financial statements among all businesses and therefore, help protect business owners, consumers, and investors from fraud. Ultimately, then, the more you understand about these basic accounting principles, the easier it will be to work with any accounting professional you hire for your business.
Although there are numerous principles and guidelines that make up GAAP as defined by the FASB, you can condense them into this list of 10 basic accounting principles that are some of the most commonly used in the industry—and therefore, some of the most important to understand. So, what are the basic principles of accounting? Let’s break them down:
In essence, the economic entity assumption principle is the accounting concept that states that a business is an entity unto itself and should be treated as such. This principle is also sometimes called the “separate entity assumption.”
It is because of the economic entity assumption principle, therefore, that your accountant would advise you to separate your business transactions from your personal transactions—and the reason it’s so important to open a separate business bank account. Even in the case of a sole proprietorship, where your business activity appears on your personal tax return, the economic entity assumption still applies— because, legally, your business can exist independently of you.
So, not only does the economic entity assumption protect your personal finances by insisting that they’re separate from your business finances, but for sole proprietors, abiding by this basic accounting principle also makes the process easier if you decide to incorporate in the future.
The monetary unit assumption principle dictates that all financial activity be recorded in the same currency—which in the case of U.S. businesses, means in U.S. dollars. The monetary unit assumption principle, therefore, is the reasoning behind why you have to go through the extra effort to complete your business bookkeeping for foreign transactions.
Moreover, 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.
The specific time period assumption requires that a business’s financial reports show results over a distinct period of time in order for them to be meaningful to those reviewing them. Additionally, this accounting principle specifies that all financial statements must indicate the specific time period that they’re covering on the actual document.
It is because of this principle that your balance sheet always reports information as of a certain date and your profit and loss statement encompasses a date range. Once again, all of your financial statements—income statement, cash flow statement, statement of shareholders’ equity, etc. must show the time period for the activity reported in order for you to be able to draw insights from them.
The cost principle dictates that the cost of an item doesn’t change in financial reporting. Therefore, even if you’ve bought an item within a year that’s grown substantially in value—a building, for example—your accountant will always report that asset at the amount for which it was obtained. In other words, you’re always reporting the historical cost of the asset or item.
This basic accounting principle is important because it reminds business owners not to confuse cost with value. Although the value of items and assets changes over time, the gain or loss of your assets is only reflected in their sale or in depreciation entries. If you need a true valuation of your business without selling your assets, then you’ll need to work with an appraiser, as opposed to relying on your financial statements.
The full disclosure principle is a principle you may have heard in the news in regard to businesses releasing information. Under this basic accounting principle, a business is required to disclose all information that relates to the function of its financial statements in notes for the reader that accompany the statements. Generally, these notes first list the business’s accounting policies and follow with any additional relevant information.
This accounting principle helps ensure that stockholders, investors, and even the general public are not misled by any aspect of a business’s 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—meaning the business will not liquidate in the foreseeable future. It is because of this basic accounting principle, then, why you defer the recognition of expenses to a later accounting period.
Moreover, this accounting principle also dictates that if an accountant thinks—based on a business’s financial statements—that they’ll be forced to liquidate, they must disclose this assessment.
For tax purposes, many small businesses, especially sole proprietorships, 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). However, the matching principle specifies that businesses should use the accrual method of accounting and report all financial information using that method.
Under this basic accounting principle, expenses should be matched with revenues and therefore, 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.
This being said, even if your tax return is based on the cash method of accounting, your accountant may prepare your financial reports using the accrual basis of accounting. Ultimately, accrual-based reports not only reflect the matching principle, but they also provide a better analysis of your business’s performance and profitability than cash-based statements.
Like the matching principle, the revenue recognition principle relates to the accrual basis of accounting. The revenue recognition principle dictates that revenue is reported when it’s earned, regardless of when payment for the product or service is actually received. With this basic accounting principle, therefore, your business could earn a monthly revenue even if you haven’t received any actual cash that month.
The purpose of the revenue recognition principle, then, is to accurately report income, or revenue, when the sale is 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 allows an accountant to use their best judgment in recording a transaction or addressing an error.
To explain, the materiality principle may come into play when an accountant is reconciling a set of books or completing a business tax return. If during this process the accountant finds that the account is off by a relatively small amount in relation to the overall size of the business, they may deem the discrepancy as immaterial. It’s up to the accountant to use their professional judgment to determine if the amount is immaterial.
This is all the more important because immaterial discrepancies can be disregarded, but material discrepancies must be addressed—just as immaterial expenses can be recognized at the time of purchase, but material expenses must be depreciated over time.
Ultimately, this principle highlights an accountant’s ability to exercise judgment and use their professional opinion—since businesses come in all sizes, an amount that might be material for one business may be immaterial for another—and it’s up to the accountant to make this decision.
Moreover, the materiality principle explains why your accountant might round the amounts on your financial statements to the nearest dollar.
The principle of conservatism is the second principle that allows an accountant to use their best judgment in particular situations. In this case, when there’s more than one acceptable way to record a transaction, the principle of conservatism instructs the accountant to record expenses and liabilities as soon as possible, but to only record revenues and gains when they occur.
Using this accounting principle, then, your accountant will be more likely to anticipate losses in your reports, but not revenues or profits—hence they’re being more conservative with the business’s financial success.
It’s important to understand, however, that this basic accounting principle is only invoked when there are multiple acceptable ways for the accountant to record the transaction. The principle of conservatism does not allow a business accountant to completely disregard other accounting principles.
At the end of the day, the field of accounting is vast and complex—but, by understanding these 10 basic accounting principles you’ll have better insight into a core piece of your business’s financial processes—whether or not you outsource these processes to a professional.
Plus, by learning about these accounting principles and adhering to them, you’ll be able to communicate more effectively with any accountant or bookkeeper you hire throughout your business’s lifetime.
This being said, however, not every business is required by law to comply with GAAP, but most accountants will insist on following these principles to ensure there’s never a question about the integrity of your business’s financial statements.
Therefore, if you have any questions about your bookkeeping and accounting tasks and processes and how they may or may not relate to any of these accounting principles, you should feel free to ask your accountant, or, if you don’t yet work with one, seek one out for answers. This way, you’ll arm yourself with all of the accounting knowledge you need to address issues as they arise and ultimately, promote your business’s financial success.
Billie Anne Grigg is a contributing writer for Fundera.
Billie Anne has been a bookkeeper since before the turn of the century. She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. She is also a guide for the Profit First Professionals organization.
Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.