While accounting may seem like a daunting task, it is actually based on a few basic principles. Small business owners, like yourself, need to be aware of the basic principles of accounting in order to stay on top of their business’ finances. By understanding these principles, you can make informed financial decisions that will help your small business grow and succeed.
This article will outline each principle in detail, explaining what it means and how it affects a small business’s bottom line.
Keep in mind; this is just a primer – accounting is a complex and nuanced field, and you should consult with a Gold Coast accountant if you have specific questions or concerns. But by understanding these basic concepts, you’ll be on your way to making smarter financial decisions for your small business. Let’s get started!
The Accrual Principle can be a difficult idea to understand. The Accrual Principle states that “a business must record the effects of transactions when they occur and not when cash is received or paid.” This means that revenue is recorded when a transaction happens, not when cash is received, and expenses are counted as soon as they happen, not when the bill is actually paid.
There are two ways that you can do accounting, cash-basis accounting and accrual-basis accounting.
With cash-basis accounting, the business does not know how much money they have until they actually get it from selling things or receiving it as payment for services. With accrual-basis accounting, the small business will know how much money they have before they get the money. This is because of what has been done so far and what is expected to happen in the future.
In other words, on cash basis statements, income and expenses can only be shown when they are received or paid. Whereas, on accrual-basis financial statements, income and expenses can be matched to the periods in which they are incurred.
When you account for your small business’s expenses, it is important to make sure that they match the period in which they are incurred. Accrual-basis statements are better than cash-basis statements because you can more accurately identify trends in your business.
Economic entity principle
The Economic Entity Principle is a crucial yet basic accounting concept: Owners must keep their personal finances and business expenses 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.
If you own two or more small businesses, the financial records should be kept with their respective business. Keeping these finances separate gives you a clear view of how your business is performing.
The Cost Principle is one of the most basic accounting rules. It states that “Economically, costs are an amount of money that has been used up to produce revenue during a particular time period.”
When you are figuring out how much something costs, ask yourself what it would have cost if you had to pay for it at that moment. If you own a business, your expenses should reflect what it actually costs to provide for your small business.
Under the cost principle, all expenses incurred by a business should be recorded on its financial statements and charged against revenue when they are used up; this ensures that the expense is recognised in the period benefited.
Monetary unit perspective principle
The Monetary Unit Perspective Principle is a basic accounting concept that dictates measuring and recording your small business’ transactions.
When you are counting money in your business, ask yourself what each transaction is worth when it happens. This will help you decide what should be recorded on your financial statements. It can also affect how much profit your business’ reports to your investors or banks.
The Materiality Principle is a concept that applies different rules to different sized items. This rule helps small businesses decide what should be counted as part of an income statement, balance sheet accounts and other financial statements.
Income statements are only concerned with the most important parts of business transactions.
When making decisions about how to count money in your business, look at the size of the transaction. You should only record transactions that are important or relevant to your business’ finances.
Time/Accounting period principle
The Time/Accounting Period Principle is a rule that states how the time of an event should affect what you report on your financial statements
A transaction will be recorded differently depending on whether it happens in one financial year or another. If the transaction occurred between 1 April 2020 and 31 March 2021, it would be reported on 2020’s financial statements. Transactions happening after 31 March 2021 would be reported on 2021’s financial statements, and so on.
For example, if you own a small business and sell something in early January 2020 for $100, this will not be counted as part of your revenue until your annual report for 2020 is published. Transactions from 2020 must be recorded in the year that they occur.
Full disclosure principle
The Full Disclosure Principle states that small businesses should make every effort to record all transactions accurately. This rule is fundamental because it helps keep small businesses accountable for their money.
Losses and gains should be recorded as soon as they are known. If you know that your business has lost $200, you must record these losses on the day of the loss. If your business makes a $200 profit on a transaction, this too needs to be recorded on the same day.
Going concern principle
The Going Concern Principle states that “a business is assumed to be able to continue in operation and meet its obligations as they become due for an indefinite period of time.” This means that if a small business has been operating for more than one year, the owner does not have to prove that their small business will exist in the future.
In order to prove this, a small business would need to show that they have enough financial support for the long term. Overall, this rule means that a small business does not have to prove that it will stay open forever
Revenue recognition principle
The revenue recognition principle is a key part of accrual accounting. It is a rule that requires small businesses to say how much money they made in a certain period of time. This is done by looking at how much money they received and then seeing if it matches up with the work that was done.
The principal says that you should only recognise money as being earned when the customer has actually received it. That means that if someone pays you in advance, you shouldn’t count that as income until you’ve actually delivered whatever it is you’re selling.
In order for revenue to be counted in an accounting period, the associated activity must be completed. It must be likely that payment for that revenue will be received. The revenue and its associated costs should also be reported in the same accounting period.
The Matching principle is the concept that, when you record revenue, you should also record all the related expenses at that time. This means that you charge inventory to the cost of goods sold at the same time you record revenue from the sale of those inventory items. This is how accrual accounting works – cash-basis accounting does not use this principle.
Conservatism is the idea that you should record expenses and liabilities as soon as possible, but only record income and assets when you are sure they will happen. This makes financial statements more conservative, which can mean that businesses have lower profits because they aren’t recording some income and assets right away. However, this principle can also lead to a business recording losses sooner rather than later.
This concept can be taken too far if a business is dishonest about its finances and makes it look like it’s doing worse than it actually is.
If there are two options for how to report an item, the accountant will choose the one that will result in less net income or less assets. This is called conservatism. This helps the accountant break ties between two options. Accountants are supposed to be unbiased and objective when they work.
Basic accounting principles such as the cost principle help small businesses keep their finances accurate and transparent. Small businesses should keep these principles in mind when they are doing their books. Not only will following the cost principle help small businesses to record transactions correctly, but it will also keep them responsible and accountable for their money.
As you can see, there are many different accounting principles. These are just a few of the most important ones. If you have any questions about these accounting principles, feel free to ask our friendly team! Alternatively, if you need help with small business accounting on the Gold Coast, contact Grow Advisory Group to arrange a free, no-obligation meeting.
We look forward to helping you with any and all your accounting needs.
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Disclaimer: The information contained in this blog is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from an accountant and/or financial adviser.