I imagine you started your business to be able to do all of the bookkeeping and run financial reports every month. I also bet that makes your accountant very happy now that their job is as sweet as cherry pie. Ok, so maybe that is not why you started your business, but it is a necessary part of doing business. Keeping top notch bookkeeping records will help you make future critical business decisions along with remaining in compliance. Understanding these 10 basic principles will make it a little more clear why your bookkeeper and/or accountant ask for certain things and/or make you do the not so fun part of running your business. There are only 10 so it won’t be too bad.
Let’s start: You may have heard the word “gap” which is really GAAP which stands for Generally Accepted Account Principles. GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions, assumptions, and methods. This helps you prepare consistent financial statements from year to year. Although variations may exist, we (the people – investors, consumers, your brother-in-law) can make reasonably confident conclusions when comparing one company to another or to industry standards. Well, the time has come, below are the 10 basic accounting principles as defined by GAAP. Enjoy!
Basic Accounting Principle 1: Economic Entity Assumption
It’s #1 for a reason…it is very important. It essentially means that a business is an entity unto itself, separate from the individual or shareholder. Legally, your business can exist independently of you and should be treated that way. This is why you need separate bank accounts and credit/debit cards. It is impossible to get an accurate understanding of the financial well being of the business if unrelated personal items are included.
Basic Accounting Principle 2: Monetary Unit Assumption
All financial transactions should be recorded in monetary units (currency) and assumes that those monetary units are stable and dependable. As in the US Dollar, Yen, Euro. Any non-financial or non-monetary information that cannot be measured in a monetary unit is not recorded. Such as the value of the management team. Consistent units allows for comparisons to other companies and comparable to other currencies to evaluate your business.
Basic Accounting Principle 3: Specific Time Period Assumption
All financial statements have to indicate the time period for the activity reported in order for them to be meaningful to those reviewing them. Without knowing what time the report or statement covers it is impossible to determine if the balances are for one week, one month or one year. The time period provides context and detail for analysis. The Balance Sheet is a point in time where the Income (P&L) Statement is for a period of time.
Basic Accounting Principle 4: Cost Principle
From a bookkeeping point of view, the term “cost” refers to the amount spent when an item was originally obtained, whether that purchase happened last year or 15 years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts. It is 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 the sale of assets as well as in depreciation entries.
Basic Accounting Principle 5: Full Disclosure Principle
Information that may affect the business ability to meet future obligations or significant changes in operations should be included in the notes sections of the financial statements. This allows investors and lender not misled by any aspect of the financial reports. Example: A pending lawsuit against the business should be disclosed.
Basic Accounting Principle 6: Going Concern Principle
As far as one can see, the business will not be going out of business. Good! It also allows for expenses to be deferred into future periods with the understanding the business will continue to carry out its objectives and commitments. Such as: Prepaid insurance. If an accountant is concerned the business might be forced to liquidate, the information should be disclosed in the financial statements.
Basic Accounting Principle 7: Matching Principle
For tax purposes, most small businesses are on a cash basis, meaning revenue is reported when cash is received and expenses are reported when cash is spent. Under the matching 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, you will want to review your financial reports on an accrual basis. Accrual basis reports reflect the matching principle and provide a better analysis of your business’ performance and profitability than cash basis statements. Such as being able to identify and take action on bills that have not yet been paid or if payment has not been received on an open customer invoice.
Basic Accounting Principle 8: Revenue Recognition Principle
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 revenue recognition principle accurately reports income, or revenue, when the sale was made, even if you invoice your customer and receive payment at a later time. Note: All components of the Service or Sale must have been performed or completed in the corresponding time period to be able to be recorded as revenue.
Basic Accounting Principle 9: Materiality
The concept allows you to violate one of the other accounting principles if the amount is insignificant or immaterial so as to not mislead the reader of your financial statements. Example: Expensing an office chair at the time of purchase vs depreciating it over its useful life. Is $50 material? Or maybe $500? Or $5,000? $500,000? Professional judgement is needed to determine what actions, if any, need to be taken to address the concern. Since businesses come in all sizes, an amount that might be significant—or material—for one business, may be insignificant—or immaterial—for another.
Basic Accounting Principle 10: Conservatism
This principle utilizes the concept of recognizing expenses and liabilities as soon as possible when there is uncertainty about the outcome, and to only recognize revenues and assets when there is an assurance of receipt. When there’s more than one acceptable way to record a transaction, the principle of conservatism instructs the accountant to choose the option that reflects:
- Less net income
- Decrease in assets/equity,
- and/or an increase in liabilities.
This leads to anticipation or disclosure of losses, but it does not allow a similar actions for gains. It’s important to understand this principle is only invoked when either way the accountant can record the transaction is acceptable. It doesn’t allow for the complete disregard other accounting principles.
Not every small business is required by law to comply with GAAP. There are revenue thresholds and industry types that determine compliance. However, this is a best practice successful business owners use enable them to make better business decisions. Ultimately, understanding these principles and working with your bookkeeper / accountant will make the entire process run smoothly.
Bonus-You will be ready for tax season without having to stress or lose any sleep. Another best practice is to hire a great bookkeeper such as Bookkeeping By Rine, LLC to help you keep your bookkeeping in order. Doing so will allow you to spend your time doing what you do best, and get back to enjoying the reason you started this business in the first place.