February 23, 2020
How to Get Comfortable With Accounting Principles
While accounting might be a chore, it’s critical for your business. It’s safe to say that every entrepreneur can benefit from understanding accounting principles.Proper accounting is important for two main reasons. First, it will help make filing and paying taxes more efficient. Second, accounting helps you understand your business’s financial health.
By understanding your financial health, you can make smarter decisions about where, when, and how you spend money. Additionally, a clear view of your financial picture enables you to plan more effectively for the future.
For example, if you’re planning a purchase, it may reduce your tax burden to complete the purchase earlier. Without a clear financial picture, though, you can’t know for sure.
Sound accounting also helps you avoid surprises. For example, with a system in place, you’re far less likely to run into unexpected cash flow issues. That’s not to say you won’t ever run into issues but at least you’ll have time to plan accordingly.
All that said, diving into accounting can be intimidating. So in this post, we’re going to help you get comfortable with accounting principles.
Why Is GAAP Useful For Business?
There’s considerable subjectivity when it comes to accounting. This subjectivity makes it difficult to compare one business’s financial statements to others. GAAP, or Generally Accepted Accounting Principles, seeks to solve this. GAAP is a standardized methodology for recording financial transactions and events. These principles enable people to interpret financial statements.These principles also enable auditors to attest to the validity of your financial statements. If you need a business loan or investors, your financial documents must be constructed using GAAP. Otherwise, an independent auditor can’t attest to the validity of your financial statements.The Major Accounting Principles Explained
GAAP is founded on ten principles that inform specific accounting rules. These principles of accounting guide how you should assemble your financial statements. They also define certain terms and establish assumptions to create a framework for accounting. In the following sections we’ll quickly explain these ten principles.Economic Entity Assumption
Under the law, a sole proprietor and its owner are the same. Under the economic entity assumption, the owner and sole proprietorship are separate. So accountants must separate a sole proprietorship’s business transactions from personal transactions. This assumption is the reason you’re not allowed to take personal expenses against your business income. It’s not uncommon for new business owners to violate this assumption. If you have, you can still correct the mistake. While sole proprietorships are the focus, this assumption also applies to other business entities. Partnerships, corporations, and government agencies are all subject to the economic entity assumption.Monetary Unit Assumption
When someone looks at a financial statement, they need units of measurement. Those units of measurement must be reasonably stable and comparable to other units. The monetary unit assumption dictates that business transactions are measurable in stable units. So all financial statements must be expressed in a stable currency like dollars, yen, or pounds. Notably, the principle doesn’t require accountants to recognize inflation. This can make for deceiving financials, but this assumption is to ensure transactions are measurable in the short-term. Otherwise, it’d be impossible to accurately compare financial statements. Though it is important to note that, over longer time periods, inflation can skew financial records.
3. Time-Period Assumption
As you may have noticed, accounting principles create a framework to make financial information easier to use. The time-period assumption makes it possible to report business activities in short, distinct periods. This makes it far easier to compare and evaluate business performance. Also, this assumption applies to any variation of accrual-based accounting and cash-based accounting. The time-period assumption allows your accountant to show, for example, how your business is growing over time. Without this assumption, it’d be difficult to measure business performance. Almost every meaningful business performance measure requires a distinct time period as context. Otherwise, financial reports would be far less useful.4. Cost Principle
The cost principle is also known as the historical cost principle. It requires that an asset be recorded at its cash amount at the time the asset was acquired. Let’s say you purchase a property for $100,000. If that property appreciates and is worth $200,000, the recorded amount stays the same. This principle also means that any assets not acquired in a transaction won't be reported. For example, if you develop a valuable trademark over several years, it won’t appear on your balance sheet. However, if you purchase a trademark for $100,000 in a transaction, that trademark will be reported.5. Full Disclosure Principle
If you’ve ever read footnotes on a financial statement, that’s because of the full disclosure principle. Under this principle, information that’s relevant to the person using the financial statement must be disclosed. Generally, this information is expressed in the footnotes, because it enable investors or lenders to properly evaluate your business. For example, let’s say your company is being sued. Based on your financial statements alone, an investor couldn’t tell how a pending lawsuit might affect your business. In this scenario, you’d need to describe the lawsuit in a footnote to comply with the full disclosure principle.6. Going Concern Principle
This principle represents “the assumption that an entity will remain in business for the foreseeable future.” For example, without the going concern principle, it wouldn’t make sense to defer recognition of certain expenses. That’s something accountants must do regularly. However, this principle doesn’t hold if the entity is going to halt operations. If that’s the case, then the accounting will change. For example, an asset owned by an entity that’s closing may be written down to its liquidation value. This is because that asset isn't going to generate future profits. So, its value is no longer based on its ability to generate profits.7. Matching Principle
Accountants rely on the matching principle to ensure that the financial position of a company is fairly represented. This principle states that “expenses must be matched in the same accounting period as the revenues they helped to earn.” We need this principle to ensure there’s consistency in financial documents. Otherwise, documents like the balance sheet or income statements would be distorted. For example, without the matching principle, you could recognize expenses later than appropriate. As a result, your net income would appear higher. For an investor or lender, this higher net income would create a misleading view of your business.8. Revenue Recognition Principle
If you’re familiar with the accrual basis of accounting, you’re familiar with the revenue recognition principle. This principle states that revenue should be recorded when it’s earned, not when payment is collected. For example, let’s say your lawn mowing company provides services to a customer on a weekly basis. However, that customer pays monthly. Rather than only recording revenue when each monthly payment is made, revenue would be recorded each week. This also applies to advance payments. If that same lawn mowing customer paid for the year upfront, you’d still record revenue weekly. In other words, you’d take the upfront payment and allocate it in weekly increments.9. Materiality
Materiality allows accountants to ignore certain standards if the net effect of doing so is immaterial. In other words, if the user of a financial statement won’t be misled, the accountant can ignore a standard. Of course, it can be subjective as to what accountants deem “misleading.” Therefore, it’s on the accountant to exercise judgment when using this principle. Per the Securities and Exchange Commission, an item that’s at least 5 percent of total assets is considered material. However, that isn't always the case. For example, a less valuable asset that could’ve changed a net profit to a net loss would be considered material.10. Conservatism
This principle guides accountants on when gains and losses should be recognized. Without this principle, it’d be too easy to inflate revenue, profit, or asset valuation. For example, let’s say you buy an asset for $1000. A few months later, you can buy that same asset for $500. Your company must write down that asset to its new value which is the “lower of cost or market.” In this case, “market” would be $500. If that same asset appreciated to $1500 after you purchased it for $1000, the asset’s value would stay the same.