Every small business needs to keep an accurate record of accounting information to see how it’s performing financially month over month and year over year. Is the company generating money or losing money?
Stringent accounting also helps businesses build confidence and trust among their clients and partners. Without adhering to basic fundamental accounting principles, companies may face legal consequences that could eventually result in permanent closure.
What are the Basic Principles of Accounting?
The Financial Accounting Standards Board (FASB) has issued a set of fundamental accounting principles – referred to as Generally Accepted Accounting Principles (GAAP) – as a means to regulate and improve accounting methods in the United States. All publicly-traded organizations in the U.S. must adhere to these principles when recording and managing their financial statements.
While smaller and non-publicly traded companies are not required to follow these GAAP, it is strongly advised as good practice. These standard accounting protocols help businesses to predict cash flow trends, attract potential investors, and plan for operational expansion.
The following are the essential accounting principles and guidelines that will help organizations set the framework for all things accounting. If a small business discloses financial information to the public, it must certify that the documents it presents all adhere to the GAAP at all times.
The 10 Generally Accepted Accounting Principles (GAAP)
The following are the essential accounting principles and guidelines that will help organizations set the framework for all things accounting. If a small businesses discloses financial information to the public, it must certify that the documents it presents all adhere to the GAAP at all times.
1. Economic Entity Principle
The economic entity principle (also known as the separate entity principle), maintains that a business is an entity unto itself and should exist separately from its owner. This principle requires that personal and business transactions be managed independently from each other.
Small businesses registered as a sole proprietorship are not an exception. In the eyes of the law, the sole proprietor and its business are considered one entity because the transactions are reflected on the personal tax return, but accounting for each still needs to be done separately.
2. Full Disclosure Principle
The full disclosure principle requires a company to disclose necessary accounting information to any potential investors or lenders so that these outside financing resources are able make informed decisions about the company. The disclosures may include quarterly earnings, contingent liabilities, stock options, asset retirement obligations, lease records, the company’s financial statements, income taxes, and more.
This principle is purely judgmental in such a way that accountants should only disclose relevant and timely information that has a substantial impact on the company’s financial standing. It also fosters transparency, and prevents any opportunity for fraudulent activities.
3. Cost Principle
The cost principle requires a company’s financial statements to declare the historical cost of all the company’s assets, liabilities, and equity investments. This means the original cost a company paid or was owed for an asset, liability or investment. If any have depreciated or grown in value over time, those changes should not be reflected in the financial statement.
For example: if a company purchased a piece of land and five years later, that land has doubled in value, the company’s accountants should record the original cost that the company paid for the land in its financial records, not its’ current market value.
4. Monetary Unit Principle
The monetary unit principle (or measurement principle) requires accountants to record events or transactions that can be expressed in monetary terms. All other transactions or events that are non-quantifiable should not be included in the company’s books of accounts.
This basic accounting principle is recognized for communicating and analyzing financial information, as long as the books only contain those that can be expressed as a monetary unit. Non-quantifiable items such as employee skill level, quality of customer support, or time lost due to office renovation cannot be converted as a money amount, and therefore they should not be included in the report.
5. Going Concern Principle
When reporting financial statement information, accountants and business owners should treat the company as an indefinite economic entity.
Through the going concern principle, a business is perceived to exist and is to continue its operations until its financial health can no longer sustain its needs. Should the company’s finances fail to sustain its growth, the accountant should disclose this fact or proceed with liquidating the business.
6. Matching Principle
The matching principle states that small businesses, including sole proprietorships, should report their expenses in the same period as their revenue.
Mainly for tax purposes, this fundamental accounting principle states that when businesses report the money they’ve received (revenue), they should also disclose the amount they’ve spent (expenses).
All expenses should match revenues in the financial statement. Costs may take the form of overhead costs, employee benefits, payroll, and the like.
To fulfill this principle, accountants need to use the accrual basis of accounting. It’s a recognized method that records accounting transactions for revenue when earned and expenses when incurred.
7. Conservatism Principle
The conservatism principle is an accounting method for reporting expenses and income. Through this concept, expenses and liabilities are recognized as soon as possible when there is uncertainty about the outcome, but revenues and assets should only be recognized when they are assured to occur.
This principle does not say that accountants must be very conservative when making a choice. Accountants should always be unbiased and truthful when it comes to creating financial reports. That said, if faced with two alternatives, this principle deems that the accountant should select the more conservative option – meaning the one that reports lesser income or more liability.
8. Materiality Principle
The materiality principle allows the accountant to exercise his or her best judgment in recording or correcting financial transaction errors.
This principle highlights the need for accountants to provide their educated judgement when addressing discrepancies in the expense report, especially when the amount in question is immaterial or insignificant.
Business owners will often encounter a slight miscalculation in their financial statements. Some amounts are thoughtfully rounded to the nearest dollar because that small difference is deemed immaterial. In short, accountants will identify an amount as immaterial if it has little to no bearing to the business’ bottom line.
9. Time Period Principle
The time period principle requires businesses to record when transactions are made in profit-and-loss statements, balance sheets, and the like. Accountants should employ concrete time intervals like months, quarters, or fiscal years, which must be specified in the financial statements.
By indicating a particular period of time in the financial statement, accountants are able to see the movement of the business–whether the company was able to meet its quarterly goals or if improvements are necessary to ramp up operations.
10. Revenue Recognition Principle
According to the revenue recognition principle, when a company sells a product or service, accountants should immediately record the sale as revenue even if the customer’s actual payment has not yet come in. This principle allows a business to report a monthly or annual income even when it hasn’t physically received all of the cash it’s owed.
Basic accounting principles serve to guide accountants in their day-to-day duties with the latest, best practices in the field. Not all businesses are mandated to follow these basic accounting procedures. Still, it will go a long way in keeping financial records clean, reliable, and adherent to the demands of the changing times.