Accounting can be thought of as the immune system for any business. It prevents small errors from compounding over time and eventually leading to serious financial strain, and it can help companies make corrections from unsound business practices to avoid bankruptcy. Furthermore, good accounting can help businesses find ways to succeed and thrive , even in tough economic conditions. Accounting principles are crucial tenets of proper accounting practices. They help businesses to maintain accurate records and ensure a low risk of financial recording mistakes. Perhaps more importantly, basic accounting principles are upheld by accountants and law-abiding businesses throughout the United States. It’s important to know about these basic accounting principles if you want to adhere to stock market regulations and to remain transparent with your shareholders. Let’s break down the 14 basic accounting principles you should know now.
Accounting principles are collections of accounting practices that, over time, have been developed and standardized through common usage. Accountants these days are taught many of these principles in order to perform their accounting work accurately. Furthermore, businesses and organizations must typically adhere to accounting principles both to make sure they accurately keep track of their books and to make sure they do business legally without the risk of fraud.
In a nutshell, the so-called “ generally accepted accounting principles ” are a collection of accounting principles and standards that any publicly traded companies in the US have to comply with. In other words, companies that want to be economically successful in the US and trade on the stock market must abide by the GAAP. The GAAP serves as a good benchmark collection of accounting principles that most companies will follow when practicing good accounting in general. Even privately held companies and many nonprofit organizations are sometimes required to be GAAP-compliant if they want to qualify for certain loans. If accounting principles help accountants navigate accounting tasks through general rules and guidelines, the GAAP is a kind of standardized list of accounting principles that are commonly understood and adhered to by legitimate businesses or organizations. Technically, the GAAP consists of:
It’s always a good idea to make sure your company adheres to the GAAP if you ever want to be traded publicly and if you want other businesses or shareholders to trust your financial statements.
Let’s break down some of the most important accounting principles to know and adhere to.
The accrual principle states that all accounting transactions should be recorded during appropriate accounting periods. In most cases, these are periods where the transactions actually occur as opposed to when cash is deposited into a company’s account. It’s an important principle since it helps financial statements show the truth of what happened during certain accounting time frames and prevents accounting information from being delayed or accelerated by cash flow.
The conservatism principle states that accountants and businesses should record both expenses and liabilities ASAP. Furthermore, it states the revenues and assets should only be recorded when you are sure that they will occur. The benefits are pretty easy to grasp. The conservatism principle prevents businesses from recording revenue that they haven’t already received (and thus misleading shareholders) and it helps businesses to be conservative in their spending by recording any expenses or liabilities quickly.
The consistency principle is a bit abstract but is still important for general accounting practices. It asks accountants to continue to use any accounting principle or method they began with so long as they don’t have a demonstrably better principle or method. In practical terms, this principle is meant to prevent businesses from switching between different accounting methods or treatments for their transactions without cause. This makes it easier for audits or other accountants to track what happened with a given company's financial documents.
The cost principle states that businesses should only record their assets, equity investments, and any liabilities at original purchase costs. However, some businesses ignore this principle these days since they may opt to adjust assets and liabilities according to fair values instead.
The economic entity principle is the idea that any business transactions should be kept separate from the transactions of its owners or other businesses. It prevents owners from accidentally mixing their personal revenue and expenses from those of their small businesses. It also prevents assets and liabilities from mixing between different commercial entities, which can cause serious trouble in the event of an audit.
The full disclosure principle states that businesses and their accountants should include all information necessary to understand financial statements in or alongside those financial statements. In other words, financial documents should be understandable by themselves without needing additional documents for clarification. This prevents confusion both within a business and in the event of an outside audit.
The going concern principle is more of a philosophy than the other principle so far. It allows accountants and business owners to act as though the business will remain in operation for the foreseeable future. In practical terms, this allows businesses to defer the recognition of certain expenses, like depreciation, until they would likely kick in or come into effect. This prevents businesses from counting expenses that would realistically not apply for some years to come when making business decisions.
The matching principle is a simplistic concept that states you should record all expenses related to revenue at the same time that you record the original revenue. For example, if you record revenue from selling several retail inventory items, you should also record the expenses for inventory and cost of goods. This both helps you keep up with the accrual basis of accounting mentioned above and helps avoid mistakes between profits and costs of operation.
The materiality principle states that you should always record transactions and accounting records if, by not doing so, you might alter the business decision-making process or the conclusions that someone might come to if they read a company's financial statements. It’s a bit of a vague principle in comparison to the others. But it’s important to maintain transparency and to make sure that accountants within your business can all work together without confusion.
The monetary unit principle states that businesses should only record transactions that can accurately be stated in terms of currencies or units of value. This prevents businesses from estimating the value of their assets and liabilities too much and keeps things grounded in real, precise numbers.
The objectivity principle is exactly what it sounds like: it's the principle that states any accounting data should be as accurate and unbiased as possible. Personal opinions, such as your gut feelings or hypothetical dreams about the future of your company, should never be taken into account or recorded as official data. Furthermore, accounting data should be supported by evidence wherever possible. Financial evidence can include things like receipts, invoices, vouchers, and even balance sheets from previous quarters. Objective viewpoints are important both so executives and shareholders can make sound business decisions and so auditors are not misled.
The reliability principle focuses on proven transactions. According to this principle, only transactions that you can prove should be recorded. This is particularly important for auditors, who use “physical” evidence like recorded transactions to come to conclusions about their subject organizations.
The revenue recognition principle is similar to the last. It states that revenue should only be recognized when the business in question has mostly or substantially completed the earnings process. This prevents businesses from reporting earnings and revenue when it’s too early to guarantee that said income will be added to the company’s coffers.
Lastly, the time period principle essentially states that businesses should try to report the results of their activities over a set and standard period of time. For instance, accountants should not record business transactions over a quarter of three months, then record business transactions over a single month timeframe later. This allows accountants to make standard sets of comparable timeframes, helping them to create long-form or trend analyses using accounting software .
As you can see, the above accounting principles are oftentimes fairly standard or common sensical. But it’s still important to know these accounting principles and to make sure that your own business’s accountants follow them when possible, as the principals help to ensure a fair standard of business and communication for all enterprises throughout the U.S. Still have questions? Contact Seek Capital and don’t hesitate to check out our other guides on running your business ! Sources https://www.accounting.com/resources/gaap/#:~:text=Generally%20accepted%20accounting%20principles%2C%20or,approved%20accounting%20methods%20and%20practices . https://www.investopedia.com/terms/a/accrualaccounting.asp#:~:text=Accrual%20accounting%20is%20an%20accounting,recognized%20in%20the%20same%20period . https://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176154526495