Understanding basic accounting principles will help you to stay on top of your small business’s finances.
Many small business accountants do some subjective adding and subtracting at their discretion, but most follow these fundamental accounting principles:
- Economic entity principle
- Monetary unit assumption
- Time period principle
- Cost principle
- Full disclosure principle
- Going concern principle
- Revenue recognition principle
- Matching principle
- Materiality principle
- Conservatism principle
Let’s take a look at each of these fundamental accounting principles, learn what they mean and how you can use them to analyze costs and spot trends to lead to more profitability for your business.
Why Should an Entrepreneur Know Basic Accounting Principles?
Generally accepted accounting principles (GAAP) set the rules, standards and methods for companies’ accounting practices.
By following what is defined as the overarching accounting principles, you’ll have guidelines for the following:
- What should be included on financial reports
- How and when to file financial reports
- What standards and methods to apply to the process
- Expectations for ethical behavior
These principles enforce transparency and consistency, allowing for easier year-over-year financial comparisons and can help safeguard against misleading accounting practices.
Top 10 Basic Accounting Principles for Small Business
These 10 general accounting principles are a series of standards to apply to your financial reporting process.
1. Economic Entity Principle
This is a crucial yet basic accounting concept: Owners must keep their personal and business finances separate.
Business expenses — from rent to supplies purchases to payroll — assets (such as property or equipment) and revenue should be recorded separately from your personal financial records. Also, note that if you own 2 or more businesses, the financial records should be kept with their respective company. Keeping these finances separate gives you a clear view of how your business is performing.
2. Monetary Unit Assumption
This aspect of business accounting basics maintains you should track only the transactions that can be expressed as a consistent, stable monetary unit. An American small business would use the U.S. dollar.
There are 2 important factors to remember with monetary unit assumption. First, recordings are restricted to assets with an objective monetary value. For example, while excellent quality control might ultimately contribute to your business’s success, it can’t be recorded on a balance sheet. Also, this factor of key accounting principles doesn’t acknowledge inflation. If you purchased property or a significant piece of equipment 20 years ago, its cost is recorded as what you paid at that time. This is because calculating revenue with inflation can lead you to overestimate and undervalue your current performance.
3. Time Period Principle
One of the basic accounting principles and practices is stating exactly when the data was taken when you’re completing reports and financial documents (balance sheet, income statement, profit and loss statement, etc.). For example, a balance sheet should state when it was created. A balance sheet created on April 1 should state that the data is “as of” April 1.
If you’re reporting for a weekly range, make that clear. For example, you could write “the week ending April 1” so readers can tie the financial information to specific dates.
Small business tip: Don’t limit your financial reporting to quarterly and yearly reviews. Getting monthly, weekly or even daily information could help you spot opportunities to maximize your business’s performance.
4. Cost Principle
The cost accounting principle for small business ensures you correctly value the expenses of your company’s assets.
When tracking your business costs, it might be tempting to look at an asset’s current value. While it’s important to consider depreciation in other areas of accounting, you’ll want to record exactly what you paid for something when calculating these costs. This is similar to one of the features in the monetary unit assumption of accounting principles. You won’t record a business purchase at its current value; list it with the original cost.
5. Full Disclosure Principle
The full disclosure principle is one of the key general accounting principles — be as transparent as possible on your financial statements. You must disclose factors that impact your business’s financial picture, including:
- Your accounting policies
- Audited financial statements
- Material losses
These fundamental accounting principles aim to provide complete context to anyone who uses the information, be it a lawyer, stockholder or someone else. Avoid potential litigation or federal sanctions by following this principle.
6. Going Concern Principle
This small business accounting principle is based on whether your business is expected to continue operations.
A business that isn’t considered a “going concern” will have finances that trend downward. In contrast, a business that’s not expected to shutter will continue to spend and settle debts ahead of schedule. If an accountant believes the business might not be a going concern, an external auditor will review these finances and determine whether the business can sustain operations. If not, key stakeholders must be made aware, so they aren’t blindsided when a company ceases operations because of poor finances.
7. Revenue Recognition Principle
If using the accrual basis accounting method, you should also follow the revenue recognition principle. With this part of basic accounting principles, you should record revenue at the time of the sale, regardless of whether you’ve yet received the payment.
Remember to have certain criteria in place before using the revenue recognition principle, including:
- You have a credit agreement with your customer.
- You’ve delivered the product or service and then billed the customer.
- You know you can collect the amount you’re owed.
8. Matching Principle
The matching accounting principle for small business ensures your revenue and expenses are reported at the time they happen. This is the main tenet of accrual basis accounting.
For example, you should list employee wages for the period the work was performed instead of the week they receive their check.
9. Materiality Principle
The materiality principle lets an accountant use their professional discretion to ignore one of the generally accepted accounting principles and determine how to report an expense.
If an expense is deemed “immaterial” or having little consequence to the bottom line, it may be permissible to count a long-term expense now instead of spreading out the cost.
This accounting principle also allows small business owners to round their financial reports up or down to the nearest hundred or thousand, depending on their size. Such changes are considered permissible so long as they aren’t misleading and don’t bear any consequences for false reporting or stock evaluations.
Conservatism doesn’t allow accountants to ignore other key accounting principles, but they can still use their judgment.
If the accountant has multiple options to report an income or expense, conservatism allows them to choose the one that results in less net income. Despite the term, accountants don’t have to be conservative (they should always be honest and fair), but they can choose to go with the lower amount. This can help guard against overestimating future gains.
Being conservative does have its benefits. If you think you’ve made a little less, this principle makes it less likely you’ll create expenses you may not need.