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.
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.
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.
What Is Most Important For Businesses?
Accounting principles enable us to understand the financial health of a business. As a business owner, this is important because it allows you to communicate with external stakeholders.
Any time you want to evaluate anything, in business or otherwise, you need context. For example, let’s say you’re testing whether adding the color blue to a retail display will improve sales.
After that change, let’s say sales increased by ten percent from October to November. Based on that, you might think that blue increases sales by ten percent.
However, blue isn’t the only variable in this scenario. There’s also the effect of seasonal trends to consider. To isolate the effect of the color change, you should compare last year’s sales over the same time period. If you didn’t have access to that sales data, you couldn’t isolate the color variable.
In evaluating businesses, accountants, consultants, investors, and lenders need to isolate variables. By ensuring financial statements are comparable, GAAP enables us to get useful context.
Even from the perspective of investors and lenders, every business is unique, which makes for considerable variability.
With so much uncertainty in business, financial documents must be consistent. Only then can external stakeholders make reasonably educated decisions. Many of the concepts detailed in GAAP focus on establishing consistency.
For example, principles governing revenue and expense recognition are critical for consistency. If not for the revenue recognition principle, it’d be impossible to accurately compare any two businesses. Similarly, without the matching principle, it’d be easy for businesses to inflate their value.
Ultimately, ignoring the consistency principle would be bad for everyone. Investors wouldn’t invest as much, and lenders couldn’t originate as many loans due to the risk. The economy as a whole would function far less efficiently without consistent financial records.
Imagine you’re considered expanding your business to a new location. For argument’s sake, let’s say this is your third location, so you understand the costs and risks involved. Not only that, you have the financial records for each store you opened.
You can go back and look at the startup costs, timing, and initial revenues. However, let’s say your accountant didn’t disclose a significant discount that you got on many of your startup costs.
Without that information in the records, your cost numbers aren’t reliable. Moreover, if you rely on those costs, you might not budget enough, which could cause cash flow problems.
Similar issues arise for many other kinds of business decisions when records aren’t reliable. This is the reason principles like full disclosure are so important. GAAP ensures that financial records are reliable because if they weren’t, they’d be useless.
Our Last Words On GAAP
Unlike public companies, private businesses aren’t required to use GAAP. However, financial records following GAAP are required in certain scenarios. In fact, any time you provide financial statements to people outside your business, you’ll need to follow GAAP. Therefore, if you’re seeking funding from lenders or investors, your records must follow GAAP.
However, even if you’re not required to use it, GAAP is useful. It enables you to measure yourself against other companies. It also helps you measure your business’s performance over time.
Finally, GAAP also enables outsiders to understand your business. If you employ consultants, this can help facilitate more meaningful, insightful conversations.
If you’re not currently following GAAP, the sooner you can switch over the better. The longer you wait, the more of your records you’ll need to reconstruct if you do need to switch over.
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Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.