24 Basic Accounting Principles Business Owners Must Have
Basic accounting principles underly generally accepted accounting standards (GAAP), which are “principles-based”. The Financial Accounting Standards Board (FASB) codified “authoritative” Accounting Principles in ASC 105. Both FASB accounting standards and “non-authoritative” sources including accounting practices, provide the basis for generally accepted accounting principles (GAAP), which is used by both privately and publicly-held non-governmental accountants in preparing financial statements for the public. GAAP is often used in financial reporting to present company financial statements to management, banks, and investors. Some small privately-held companies prepare their financial statements on a non-GAAP cash basis, primarily for tax reasons.
Publicly-held companies in the U.S. submit GAAP-basis, audited financial statements to the Securities and Exchange Commission (SEC) as company filings. These public issuers follow additional SEC guidelines for financial reporting. If publicly-held companies report non-GAAP earnings, they must also reconcile them to GAAP earnings.
Basic Accounting Principles
Accounting principles to use as guidelines are described in this section.
Each business or non-profit enterprise is considered to be a separate economic entity. Therefore, transactions for the entity should be restricted to only those that apply to a particular economic entity and will not include transactions that apply solely to the owner.
Period of time
When recording a transaction and preparing financial statements, transactions are dated and summarized by the period to which they relate. Financial statements are often produced for monthly, quarterly, and annual periods of time. Usually, financial statements for the current period of time also show the prior year(s)’ same time period for comparison purposes to detect trends (horizontal financial analysis).
Transactions are generally recorded on a going concern basis that assumes the business will continue operating. Unless otherwise indicated and disclosed, the assumption is that a company has the resources required to stay in business for the foreseeable future. The adequacy of cash flows, liquidity position, and ability to obtain additional financing impact the going concern status of a business enterprise. An auditor’s financial statement opinion will address this going concern assumption when the financial condition of the company is at risk, with the possibility of bankruptcy, shutdown, or liquidation due to probable business failure. If the auditing firm has substantial doubt about an economic entity’s ability to meet its financial obligations and operate for at least the next 12 months, then uncertainty about the business entity’s going concern status is expressed in an extra explanatory paragraph in the auditor’s opinion relating to the financial statements. Management must also disclose going concern issues in the Notes to Financial Statements.
Economic entities record a transaction to reflect the cost of the purchase on that date. Later transactions are recorded at their cost on each date of purchase. Historical cost applies to fixed asset (equipment) purchases and many other categories. Historical cost is no longer the only acceptable basis for GAAP. Fair value accounting (“mark-to-market”) has more recently been applied to specified asset and liability accounting areas like certain investment securities. For more information, research the FASB Accounting Standards Codification® of GAAP - ASC 820 on Fair Value Measurements and Disclosures that apply to specific accounting topics. Also, employee benefit plans generally report plan investments at fair value, using ASC 820 as guidance.
Monetary Unit Assumption
Transactions are recorded at the current (transaction date) value of the US dollar or another monetary unit that is the functional currency (the main currency used by a business). The indexed value of the US dollar or other functional currency (to show inflation over time) is not applied to increase the historical cost of assets. The monetary unit assumption principle implies a stable monetary unit over time.
Revenue Recognition Principle
Accountants record revenues in the period of time to which the revenues relate and contract obligations are performed. Revenue may be recorded upon shipment of items. Software subscription revenue will relate to the month in which the software product is used. If SaaS software is sold on an annual basis and cash is received as a lump sum upfront for the year, then a series of accounting entries will be made to spread out the revenue by recording one-twelfth of the revenue each month and reducing the deferred revenue liability. Service revenue is recorded in the time period performed or spread over 12 months if the service is continually performed as time elapses.
Costs and expenses are recorded in the same period as the revenue to which it relates. Examples are cost of goods sold and sales commissions which have a direct link to revenues. If there is no direct relationship to revenue, then costs and expenses should be allocated based on time or another appropriate method to match revenue. Accrual accounting is used to record a transaction to implement the matching principle.
Information should be recorded and disclosed in financial statements or other financial information using the principle of materiality as a guide. The essence of materiality is: Would the recording of a transaction or disclosure of information cause the person relying on the company financial statements (perhaps for an investment decision) to make a different decision if the amount is not recorded in a certain way or included in a disclosure? Materiality implies significance. One use of materiality is to record a transaction for an equipment purchase as an expense rather than a depreciable asset if the amount is below a minimum accounting policy amount like $500. Auditors may calculate the percentage of total assets or revenues to determine materiality in an audit for purposes of making audit adjustments or requiring management disclosures in financial statements.
Preparing financial information may be time-consuming and has financial costs. The cost-benefit principle ensures that the cost of preparing financial statements doesn’t outweigh the benefit of that information to financial statement readers. In making a cost-benefit decision in accounting, include materiality considerations. Cost (as in cost-benefit) is a “pervasive constraint” on providing useful financial information, according to the FASB’s Conceptual Framework 8, section QC4.
Full Disclosure Principle
Full disclosure means that significant information is communicated to financial statement users. Full disclosure includes notes to the financial statements and reflects materiality.
Industry Accounting Practice
Accounting principles include unique applications for certain industries, some of which are included in specific industry guides. Widely recognized practices in an industry may be a type of “non-authoritative” accounting guidance, providing a source for generally accepted accounting principles.
Conservatism and Neutrality
Conservatism has long been a principle of accounting for recording transactions relating to estimates and uncertain future events. Conservatism results in recording unpredictable expenses and liabilities earlier than uncertain revenue and assets. An example transaction would relate to the future outcome of an existing lawsuit or threat of a lawsuit. When establishing financial accounting standards, the FASB may use neutrality (unbiased) rather than conservatism as a decision basis.
The Objective and Qualitative Characteristics of Useful Financial Information
The FASB’s Conceptual Framework Statement 8 (as Amended in August 2018) includes the objective of financial statements and qualitative characteristics that also underly generally accepted accounting principles.
According to the FASB Conceptual Framework, “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.”
The Qualitative Characteristics of useful financial information include Fundamental Qualitative Characteristics of relevance and faithful representation:
What information is useful to investors and making a difference in financial statements. It includes predictive and confirmatory value, like that used in forecasting revenues, then judging the accuracy of the predictions. Materiality, like relevance is based on what makes a difference in the usefulness of financial information but is based on company knowledge and facts.
Faithful representation means complete, neutral, and free from error (to the maximum extent possible). Complete includes portraying an economic phenomenon with descriptions and explanations to aid user understanding. Neutral means information presented without bias. Free from error means no errors in the process of determining the information, but the financial information can include estimates (for example, asset impairment estimates to write down the cost basis of an asset).
The Qualitative Characteristics of useful financial information include Enhancing Qualitative Characteristics of comparability, verifiability, timeliness, and understandability, which should be applied iteratively to get the best result.
Comparability (and Consistency)
For comparability, financial information that includes a comparison to another period of time, date, or business entity helps users make decisions by understanding similarities and differences. The FASB addresses consistency in this section, defining it as using the same methods to account for the same items for different periods of time and across business entities in the same time period. Per the FASB Conceptual Framework, “Comparability is the goal; consistency helps to achieve that goal.”
Verifiability means reaching consensus by different qualified people, either by direct observation (like counting cash) or indirectly by using the same methods to process inputs to create outputs.
Timeliness means having the financial information and company financial statements prepared soon enough to be useful.
According to the FASB Conceptual Framework, “Classifying, characterizing, and presenting information clearly and concisely makes it understandable.” The information also needs to be complete to be understandable.
Other Basic Accounting Principles
Although not included explicitly in Qualitative Characteristics of Useful Financial Information, objectivity may be considered a basic accounting principle. It encompasses verifiability (evidence to support) and neutrality (absence of bias), in addition to independence to create useful company financial statements / financial information.
Reliability means that accounting records and company financial statements should be accurate to the extent possible and use the best available accounting practice.
How Accounting Principles Are Reflected in the Financial Statements
All financial statements need to be useful, relevant, faithful representations which are verifiable, reliable, and unbiased, and understandable. Financial statements are prepared with the assumption that the economic entity is a going concern unless otherwise indicated by significant evidence. A cost-benefit constraint is used when preparing financial statements. Financial statements need to be issued on a timely basis, with comparison to other time periods, to be most useful. They should be prepared on a consistent basis for items within different time periods and across business entities.
The accounting principles of Going Concern and Period of Time apply to the recording of assets and liabilities on the balance sheet. Prepaid assets like insurance are spread over the time period (monthly) to which they apply if paid in advance for a year. Expenses are accrued as liabilities to apply to specific Periods of Time to which they relate. Historical cost is generally used to record assets unless the FASB financial accounting codification or industry accounting practice provides specific guidance that is different.
Revenue Recognition and the Matching Principle are reflected in the income statement, as revenues and costs or expenses are recorded. The Period of Time principle also applies. Conservatism is reflected when recording accruals relating to the impact of possible future events like expected or unresolved litigation.
Statement of Cash Flows and Statement of Retained Earnings
Net income (loss) from the Income statement is a flow-through item that is the first line in an indirect Cash Flow Statement. Net income (loss) also flows through to retained earnings, which is shown in the Statement of Retained Earnings. The accounting principles applied to the income statement carry over to these financial statements.
Notes to the Financial Statements
The Full Disclosure principle is reflected in the Notes to the financial statements. Materiality is reflected in those items which must be disclosed if they would result in a different decision by the user if not included in the financial statements. Relevance and Reliability are also reflected. The accounting principles of Conservatism and Neutrality (lack of bias) determine disclosures and what is recorded in the company financial statements. The Notes to the financial statements (and the auditing firm’s opinion) would disclose any Going Concern issue.
Knowing basic accounting principles and their relationship to GAAP and company financial statements gives you a better understanding when preparing financial statements. The financial statements that you create should be more understandable and useful to the users to help them make better decisions.