The practice of accounting is probably one of the oldest in relation to business. For as long as people have traded goods and services for money, they have needed accounting standards to maintain records and keep track of their accounts.
Despite its age and utility, accounting can seem like a foreign language, an intimidating concept for laymen and small business owners alike. But like any foreign language, you’ll find yourself more versatile and aware of your environment after mastering it. To get started, let’s examine the eight basic principles of accounting.
1. Revenue Principle
The revenue principle states that income should be recorded when ownership of a good or service passes from the buyer to the seller. One important note: the principle doesn’t refer to the transfer of cash or even when that cash is collected, but instead refers to when the entire transaction is complete.
This is also known as the “realization principle.”
2. Expense Recognition Principle
The expense recognition principle could be thought of as complementary to the revenue principle. Loosely defined, expenses are recognized as costs that are needed to produce or deliver goods. The principle states that expenses used to make goods and services should be recorded at the same time that those goods or services are sold. Regardless of when an invoice is received, the cost or expense for the goods or services is incurred as soon as the business uses the stated goods or services.
3. Matching Principle
The matching principle states that the collection of revenue from a good or service should be matched with its corresponding expense at the time of revenue collection. For example, if you own a deli and sell sandwiches, you must have bread, meat and condiments on hand to fulfill orders. Although these expenses will be purchased prior to you earning revenue from them, the matching principle states that you shouldn’t account for those expenses until you’ve earned the revenue that they’re supposed to bring in. In this case, you match the expense and the revenue to the items.
4. Cost Principle
The cost principle states that you should record and retain the original cost of an asset for the life of your ownership of that asset. An original cost provides an objectively verifiable cost amount to use when computing depreciation or other fluctuations in value. For example, if you own the building your business is in, the cost you would place in your ledger is what you had originally paid for the building or its “historical cost.” The value of the property may increase or decrease over time, but its historical cost will remain the same.
5. Objectivity Principle
The objectivity principle states that any data used in accounting should be factual and verifiable, and not subjective or based on subjective opinion. Publicly traded companies are forced to adhere to a variant of this principle when issuing an annual report.
6. Continuity Assumption
The continuity assumption, or “going-concern principle,” assumes that a business will continue to operate indefinitely. This assumption affords you the ability to continue to forecast revenues and evaluate the value of goods and services. If you work under the assumption that a business will not continue to operate, then your inventory loses its resale value, making it almost impossible to create a revenue forecast, budget or plan ahead for any other contingencies.
7. Unit-of-Measure Assumption
This principle assumes that a business’ native currency is the appropriate unit of measure to use for accounting purposes. For example, if a business operates in the United States, then the unit-of-measure assumption would determine that the U.S. dollar is the correct currency to use for all accounting purposes, including revenues, expenses and budgets.
8. Separate Entity Assumption
Also, known as the “business entity assumption,” this principle assumes that, from an accounting perspective, a business entity and its activities are separate from its owner(s). This applies to any type of company, including single-owner sole proprietorships as well as partnerships and corporations, which can have many owners. This assumption allows for accounting documents and financial statements related to the business to exist separately from the business owner(s) personal statements.
In order to best manage your accounting needs, you may want to hire an accountant who has experience with these principles and the day-to-day needs of a small business. You can also look into using accounting software that can greatly ease the burden of tracking and maintaining your finances. However, if you decide to manage your accounting practices, make sure you have a strong grasp on the principles listed above so you can best understand how to keep your business viable.