Accounting principles are the rules and guidelines that companies must follow when reporting financial data. These standards are implemented to improve the quality of any business’s financial report. This article will give you a detailed look at small businesses’ essential accounting principles and practices.
What are accounting principles and practices?
Accounting principles are the standards and criteria that businesses must stick to while presenting accounting transactions.
In the US, the Financial Accounting Standards Board (FASB) produces the Generally Accepted Accounting Principles (GAAP), a defined set of accounting principles.
Each set of accounting principles’ actual objective is to guarantee that a statement of financial position is accurate, uniform, and consistent. This makes it easy for shareholders to examine and obtain information from its financial statements, such as historical trend data.
The accounting principles also make it easier to compare financial information between organizations and help reduce fraudulent activity by boosting openness and identifying red flags.
Some of the most basic accounting principles are the following:
- Accrual principle
- Conservatism principle
- Consistency principle
- Cost principle
- Economic entity principle
- Full disclosure principle
- Going concern principle
- Matching principle
- Materiality principle
- Monetary unit principle
- Reliability principle
- Revenue recognition principle
- Time period principle
Why understanding accounting principles and practices is important
These accounting principles and practices are critical in enhancing the quality of a business’s financial reports. They produce logical and improved accounting statements that accountants can follow and readers can understand easily.
They also facilitate the comparison of financial statements and serve as the foundation for calculating taxable income. Accounting principles and practices also help investors, lenders, creditors, and shareholders make more accurate decisions for the business.
Examples of the most common accounting principles and practices
In this part, we’ll take a closer look at the most common accounting principles and practices.
Revenue recognition principle
The revenue recognition principle requires you to only record revenue when the business has completed the earnings process, not when the associated cash is collected.
For example, a snow plowing service completes the plowing of a mansion for its standard fee of $500. It can recognize the revenue immediately upon completion of the plowing, even if the house owner hasn’t paid the company yet. This concept is also included in the accrual basis of accounting.
The cost principle requires that a business should only record its assets, liabilities, and equity investments at their original purchase costs. Furthermore, the amount recorded will not be adjusted for inflation or market value changes.
The only exception to this principle is a change in the market value of short-term investments in a corporation’s capital stock that is actively traded on a major stock exchange.
For example, a business purchased an office building for $280,000 in 2015. In 2022, the property is appraised at a value of $400,000. The business may not change the cost principle since this increase relates to the increase in market value. Instead, the business might credit the difference in value to an equity account. Therefore, the actual cost principle still reflects the initial purchase price of the building and not the increased value.
The matching principle requires that when you record revenue, you should record all related expenses in the same reporting period.
For example, your employee earns a 5% commission on an $8,000 contract signed and recorded in February. The commission of $8,000 is paid in March. In this case, you should record the commission expense in February so that the expense is recognized in the same reporting period as the associated contract.
Full disclosure principle
The full disclosure principle requires businesses to include in or alongside their financial statements all of the information that may impact a reader’s interpretation of those statements.
For example, business owners don’t want to reveal the real situation of their business to outsiders, such as customers, investors, or competitors, as it can lead to bankruptcy. However, according to the Full disclosure principle, the business is required to disclose such situations in its financial statements.
You might also be interested in:
- Is Double-Entry Accounting Right for Your Business? Your Complete Guide!
- 7 Steps of The Accounting Process for Small Business
The bottom line
Understanding the accounting principles and practices helps complete and strengthen your business’s financial statements, making it easier to analyze and extract necessary financial information from these reports. From that, business owners and investors can make more accurate decisions, manage cash flow, and improve their businesses in the long run.
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