Here we are going to introduce the most 10 basic accounting principles that will help understand the accounting process better.
In today’s age of digitalization, people are coming with lot of small business ideas. But within a few year, most of them start suffering in accounting as they are unaware of generally accepted accounting principles.
You should always be concerned with mastering even the most basic accounting principles as it will help you understand why the accountant you hired is doing such seemingly specific things.
The more you understand about the purpose of generally accepted accounting principles (or GAAP), the more you will know why (and how) these principles of accountancy help protect business owners, consumers and investors, for instance, 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!
We are going to save you the driest stuff within these basic accounting principles as we say. you are not training to be a CPA, but because you want to work better with yours. In this article, you will learn the 10 basic accounting principles which every business owner must know.
Accounting Principles are considered the backbone of every business that teaches and guides every business owner on how to perform well with full confidence while performing the tasks of recording and maintaining cash inflows and outflows and all the required accounting operations.
Ever wonder why your accountant harps on you about keeping your business transactions separate from your personal transactions? Well, this is not because your accountant wants to make their job easier (although, yes, separate transactions definitely do help at times).
The reason they will not budge on this is because of 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 also called the ‘separate entity assumption’.
This basic accounting principle is a large part of the reason why your accountant insists you open a separate business bank account when you open your business.
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.
The monetary unit assumption principle dictates to a record all activity in the same currency. This is why you have to go through the extra effort to complete your 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 many decades.
A balance sheet always reports information as of a certain date. Profit and loss statements also called income statements that encompass a date range. All financial statements have to indicate the time period for the activity reported in order for them to be meaningful to those reviewing them.
In a nutshell, we can say that the dates are really very important. So, always check your financial statements for dates. A balance sheet will indicate the report is either ‘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 does not change on financial reporting. Thus, even if you have purchased something within that year that has skyrocketed in value, for example, a building, then accountants will still always report the asset at the amount for which it was obtained even though its relative market value has changed.
The basic account principle teaches something pretty important for small business owners in general, and that is, it is important not to confuse cost with value.
The value of things does change over time and reflects in the gain or loss on the sale of assets as well as in depreciation entries.
If you need a true valuation of your business without selling off your assets, you will 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.
This refers to the ‘non-death principle’. The going concern principle assumes the business will continue to exist and function with no defined end date. This principle is what lets a business defer the recognition of expenses to a later accounting period. If an accountant’s concerns the business might be forced to liquidate, they have to disclose this under GAAP principles.
For tax purposes, most small businesses are on a cash basis, meaning revenue reports while receiving cash and reporting expenses while cash spending or your business’ credit card is charged. Requiring Certain businesses to report all financial information on an accrual basis, largely due to the matching principle.
Under the matching principle, sales and the expenses use to produce those sales which report 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 basis reports reflect the matching principle and provide a better analysis of your business’ performance and profitability than cash-basis statements.
Under the accrual basis of accounting, revenue reports when it earns, regardless of when payment receives for the product or service. Similar to the matching principle. The revenue recognition principle accurately reports income, or revenue, while making the sale, even if you bill your customer or receive payment at a later time.
The materiality principle is one of two basic accounting principles. That let 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.
disregarding Immaterial discrepancies but necessary to address. Similarly, immaterial expenses recognize at the time of purchase, but material expenses depreciate over time.
Therefore, empowerment is important here for the accountant to use their professional opinion. Since businesses come in all sizes. a significant amount of 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. There is more than one acceptable way to record a transaction. The principle of conservatism instructs the accountant to choose the option that is best for the business they are working with.
So, it is important to understand that the invoking principle when the accountant can record the transaction will be acceptable. It does not allow the accountant to completely disregard other accounting principles.
Consistency Accounting Principles wants from small to well-established businesses to follow the same accounting methods, principles, and procedures until they reach the next year in order to the valid and meaningful comparison between years.
Not every business has a requirement of law to comply with GAAP. However, most accountants will insist on following them And as Tax Day approaches. We can imagine the idea of getting an audit might give you the scare. So adherence to these basic accounting principles ensures there is never a question about the integrity of your financial statements.
Therefore, understanding the basics of these accounting principles will help demystify some of those requests your accountant makes or help you understand a process.
And that will make your interactions with your accountant smoother. You will get the notification to identify when something seems amiss in your financial records. So you can address issues as they arise rather than when they become insurmountable.