Accounting is an essential factor in successful business management, hence knowing accounting principles will help you make better financial decisions relying on the historical data you gain from previous sales and cost trends. But what are Accounting principles? Accounting principles are the rules and guidelines companies and other business must follow when reporting financial data; it is widely accepted. And they also ensure that companies abide by the same practices and standards when making financial statements.
Below are the nine essential accounting principles that small business owners should know:
It refers to two accounting methods:
Income and costs are matched to the accounting periods in which they are spent. For example, the accrual method would consider accounts receivable as soon as an invoice is delivered, regardless of whether the invoice is actually paid.
Income and expenses are only shown on financial statements when they are paid and received. Accounts receivable would not be taken into account by this method. Instead, money would only be counted as income once an invoice is reimbursed. Many small companies start with cash-basis accounting, but accrual-basis financial statements provide a more accurate picture of a business's financial health. Generally accepted accounting principles (GAAP) mandates public companies to always go for accrual accounting.
The principle of consistency dictates that once you choose an accounting method, whether cash or accrual, you should consistently use that method to track your company's finances. This lets you compare performance between different accounting periods in a fair way. When filing taxes for a small business, the Internal Revenue Service also wants consistency. If you choose a method of accounting and then want to change it later on, you have to get permission from tax authorities.
3. Going Concern
The "going concern" idea states that you should assume your business is doing well financially and will stay so for a while. This occasionally allows companies to defer recognizing certain expenses to the upcoming accounting period. The accountant or auditor is entirely independent in making assumptions if there is evidence that the business can't repay the loans or satisfy other commitments. In a particular scenario, the corporation should start thinking about the liquidation value of its assets.
In the conservatism principle, income and spending are handled in different ways. Businesses should only record income when they know it will be identified, like when they have a purchase order or a signed invoice. However, businesses should record expenses as soon as there is a reasonable likelihood they will be incurred. This is a point in favor of financial statements that are more conservative and less risky. For cash flow reasons, it's better to overemphasize your expenditures than your earnings.
5. Economic Entity Assumption
According to this accounting idea, you shouldn't mix your business and personal funds. Only business transactions should be shown on a business's financial statements. For example, you shouldn't use a credit card for your business to pay for personal things. Follow this idea to make it easier to manage bookkeeping online, and if you're an organization or limited liability company, you could even get in trouble with the law. In these situations, the only way to keep your limited liability protections is to keep your business finances separate from your personal finances.
Whatever financial transactions could significantly impact business decisions should be recorded. Even if this means recording small transactions, the idea is that it's better to show a complete picture of the business. This becomes crucial if the business undergoes an audit. Business accounting software simplifies keeping track of every small transaction because it syncs automatically with your business credit cards and checking accounts.
The "matching" idea asserts that you should simultaneously record income and expenses related to income to show any cause-and-effect associations between income and buying. For example, if you pay a salesperson a commission for a sale recorded in January, the commission should also be recorded in January.
8. Accounting Equation
This simple formula will enable you to comprehend how transactions are recorded:
Assets = liabilities + equity of the owner
As the equation shows, assets are on the left side. In the same way, your assets move to the general ledger's left side. If you get money in cash, your accounting software will take money out of your cash account. On the right side of the equation, liabilities and owner's equity are credited. In the same way, you put them on the general ledger's right side. For example, if the company gives out stock shares, your software would add that amount to the owner's equity account.
9. Accounting Period
The 'accounting period' principle suggests that financial records should be confined to the period under consideration. To do this, you need to understand the profit and loss statement, the balance sheet, and the cash flow statement.Read more about accounting statements
Both the profit and loss report and the cash flow statement cover a certain amount of time, like a quarter or a year. A balance sheet shows a business's assets and debts at a particular time. Suppose you prepared a profit and loss statement for the year's first quarter. You wouldn't include transactions that happened before or after the quarter. This ensures that the organization can fairly assess how well it did at different points.