Explaining accounting principles can be incredibly challenging for us accounting nerds because we so often enjoy going deep into the weeds on them.
However, the intent of this blog is to ensure a few of the most common accounting concepts are easily digestible for individuals from all walks of life – especially small business owners. Keep in mind, however, that this is far from a comprehensive list.
The objective of accounting principles is to create an accurate reflection of a business’s financial health. And though accounting principles can vary depending on which accounting framework we adopt (GAAP, tax basis, cash basis, etc.), this blog assumes financials are GAAP compliant.
1. Accrual Basis Accounting
Accrual basis accounting reflects the most accurate picture of the business in a given period. Because this is an important concept, we devoted an entire blog to explain the difference between cash basis and accrual basis accounting. In a nutshell, accrual basis accounting recognizes revenue when it is earned, not necessarily when payment is received, and recognizes expenses when they are incurred, not necessarily when they are paid.
2. Matching Principle
From a timing perspective, revenue and expenses should be matched against one another in the same period.
For example, if you purchase a lot of inventory this year but don’t sell it until next year, the cost of that inventory (expense) should not be recognized until it is sold. In other words, the revenue (sale of inventory) should be matched against the expense (the cost of the inventory).
Similarly, if you pay commissions to your sales professionals for products sold in February, you should generally also record those respective commissions in February – matching the revenue of products sold against the expense of commissions paid.
3. Going Concern Assumption
Accounting guidance, as we traditionally interpret it, normally operates under the assumption that your business will continue to exist in the foreseeable future. Should you believe, for whatever reason, the business will not continue, GAAP dictates that you recognize and disclose certain items differently.
4. Accounting Conservatism
This concept assumes you act conservatively when managing books. Practically, this means you would book expenses when you become aware of them, and perhaps delay booking income until it becomes more certain.
5. Economic Entity Assumption
This concept states that your books and records of the business should be separate (in its own business entity) from that of its owners, stockholders, or other businesses. For both accounting and tax purposes, it’s not a best practice to intermingle the revenue, expenses, assets, and liabilities of the individual owner and/or multiple businesses.
6. Accounting Disclosures
Numbers tell one story – but words provide tremendous insight. This accounting principle recommends you disclose any clarifying information that is relevant to readers of the financial statement. For example, if you have a large bank loan and the bank has the ability to recall that loan if certain terms are not met, you may be obligated to disclose those terms.
Taking the time to manage accurate, reliable financial statements each month can be challenging – especially if it is only one aspect of your daily responsibilities.
Some of our clients have found that they spend as much as 75% less time focused on accounting when they outsource to ARI.
If you would like to explore if ARI is the right partner to manage your accounting tasks, contact us today.
In the meantime, here are 10 benefits of outsourcing your accounting function which you may not have considered – such as eliminating a single point of failure and reducing your federal and state compliance risks.
Summary:
Understanding core accounting principles helps small business owners make smarter financial decisions. This post breaks down six key concepts- accrual accounting, the matching principle, going concern assumption, conservatism, economic entity assumption, and disclosures- all of which ensure your financial statements accurately reflect your business’s true health.
FAQs:
What are the key accounting principles every small business owner should know?
Every small business owner should be familiar with several foundational accounting principles including: accrual basis accounting, the matching principle, the going concern assumption, accounting conservatism, the economic entity assumption, and disclosure requirements. Together, these principles help ensure that financial statements are consistent, accurate, and reflect the financial health of the business.
How does accrual basis accounting provide a more accurate financial picture?
Accrual basis accounting records revenue when it’s earned and expenses when they’re incurred, rather than when cash is received or paid. This approach gives a more complete and realistic view of a business’s financial performance over time, helping owners make better informed decisions based on actual activity, not just cash flow.
Why is matching principle important when recording revenue and expenses?
The matching principle ensures that expenses are recorded in the same period as the revenues they help generate. This alignment provides a clearer picture of profitability, showing what it costs to earn revenue in a specific period. Without it, financial statements could give a misleading view of business performance.
What does the going concern assumption mean in accounting?
The going concern assumption means that a business is expected to continue operating for the foreseeable future, without plans to liquidate or close. This allows financial statements to be prepared with a long-term perspective, spreading costs and valuing assets based on their ongoing use rather than immediate sale.
Why is is important to keep business and personal finances separate?
Keeping business and personal finances separate helps maintain accurate records, simplifies bookkeeping and tax filing, and protects personal assets. It also reinforces the idea that your business is its own legal and financial entity.
