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.
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.
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.
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.
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.
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.
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.