Accounting principles are guidelines and rules in recordkeeping that ensure the completeness, consistency, and comparability of the output of accounting – the financial reports. As many small business owners do their accounting on their own, understanding the principles is critical for properly recognizing assets, liabilities, equity, expense, and income.
Understanding accounting principles also helps small business owners in understanding the “whys” of the accounting process. With it, accounting becomes less challenging and more purposeful.
Accrual Principle of Accounting
The accrual principle sets the rules for when to recognize income and expense. According to the accrual principle, the entity must recognize an income when it is earned, irrespective of when it is received. Similarly, an expense should be recognized when incurred, whether already paid or not. The accrual principle of accounting ensures that income and expenditure are recognized on the correct period.
To illustrate, if a service company accepts customer credit, there is a gap between the render of service and the receipt of payment. It makes more sense to record income at the time of service because it is when the company gains the right to compensation. With the accrual principle, reports fairly represent the accounting events transpiring for a certain period.
The matching principle is an extension concept of the accrual principle. It dictates companies to report expenses in the same period as their related income. Simply, if an income account and an expense account have a cause and effect relationship, they must be recognized together in the same accounting period.
For example, assume a company that pays an agent a commission 15 days after a sale transaction. Accounts such as the commission expense often confuse record keepers of when to record the expense. But the matching principle clears this confusion by providing that the company should record a commission expense on the same period as its origin sales transaction.
Economic Entity Principle
The economic entity principle states that the business is an entity separate from the owners. Under the principle, the activities of the company must be recorded separately from the activities of the owner/s. It also serves as a foundation for keeping business finances separate from the owners’ personal finances. Any dealings of the owners with the business must be reported clearly to emphasize the entity principle.
The materiality principle provides that the business may forego an accounting standard if, in employing it, the net impact to the company is negligible. The materiality threshold is generally at 5%. Items representing at least 5% of total assets should be disclosed.
However, it is crucial to note that neglecting a particular standard should not result in a misleading interpretation of the financial statements. For example, accounts that would change a net income to a net loss is material no matter how small the amount may be.
Going Concern Principle
Going concern is an underlying assumption that the business will continue to operate for the foreseeable future. Reporting under the going concern principle affects the valuation and disclosures of the business’s accounts. For instance, under the going concern assumption company’s assets are valued at cost rather than at current or liquidating value. Other disclosures should also indicate the business’s intention to continue existing plans and activities.
If the business has doubts about its ability to continue as a going concern, it must disclose such conditions (e.g., loan defaults, continuous losses) in its financial statements.
Accounting Solutions for Small Business’s Accounting Needs
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