You do not need to be an accountant to be able to run a business. However, every entrepreneur will benefit from gaining an understanding of the basic accounting principles. Knowing the principles that lie behind how financial statements are prepared will help a business owner make sense of their accounts. It will also help them understand the financial reports of other businesses. Here is an explanation of twelve of the fundamental accounting principles the business owners need to know.
Prudence, or conservatism, is the accounting principle that drives your accountant sometimes to appear to be a bit of a pessimist! But the principle comes down to taking a conservative, cautious view of the financial affairs of a business. Prudence is what dictates that your accountant makes a provision for bad debts when you have no evidence to suggest that any of your sales invoices will not be paid. Prudence is erring on the side of caution and presenting a realistic picture of the financial state of a company.
The matching principle refers to matching revenues with related costs in the relevant period. If you sold an item, the cost of which is not yet in your accounts, for example, your accountant will accrue for that cost. In this case, the accrual would account for an expense for which you have not yet received a vendor invoice in the correct period. Likewise, if you have paid in advance for a product or service, then your accountant will treat that as prepayment. Prepaying cost defers it until the item or service is used in the business.
3. Deferred Income, Inventory, and Work-in-Progress
Deferred income, inventory, and work-in-progress are all related to the matching principle. Stock will be held on the balance sheet until it is used. Work carried out on a project that has yet to be billed can also be treated as a type of inventory, called work-in-progress. And, if you invoice customers in advance, then the income will only appear in your profit and loss account when the product or service is delivered.
4. Monetary Unit Assumption
The monetary unit assumption sounds very grand, but it is based on pure common sense. This accounting principle is merely stating that all your transactions will be recorded in the same currency. So, if you purchase goods in a foreign currency, the cost will be converted to your home currency at the exchange rate prevailing when the purchase was made. In other words, the monetary unit assumption ensures that you are not mixing up your apples and pears!
5. Economic Entity Assumption
The economic entity assumption says that every business shall be treated as a separate entity from its owners. This rule is what makes your accountants insist that you keep separate business and personal bank accounts. In law, a company is treated as a separate entity. A company can enter into contracts, and a company can be sued.
6. Accounting Periods
The time period assumption is what dictates that your accounts are produced for particular periods. This accounting concept is why it is essential to close off your accounts at the end of each month and year. Your profit and loss account will include the revenue and costs for a period, usually a month or a year. Your balance sheet will be stated as at a specific date. Month-ends and year-ends ensure that that your historical accounts are cast in stone and cannot, under normal circumstances, be amended. Your accounting periods should be strictly adhered to for both income and expenses. For example, you cannot mismatch income and expenditure by bringing back sales from the subsequent period into the current period to increase the profit.
7. Fixed Assets and Depreciation
The depreciation of fixed assets is another example of the matching principle. Assets are capitalized because they have a value to the business over time. Fixed assets are then depreciated, which means that they are gradually written off over their useful life.
8. Accruals Accounting Vs. Cash Accounting
The accounts of larger businesses will usually be prepared using the accruals principle, which recognizes the costs and revenues when they occur. So a vendor’s invoice, for example, will be debited to the profit and loss account when the invoice is received. Whereas in cash accounting, the invoice would not be debited to the profit and loss account until the invoice has been paid. Cash accounting is usually only used for small businesses.
Consistency refers to the consistent treatment of transactions in the accounts. This consistency will apply to different types of transactions and through the various accounting periods. So, if you defer the income on one annual support contract, for example, you must use the same accounting treatment for all like support contracts. You cannot swap and change how you treat your income deferral from one accounting period to the next. A business can change its accounting policies from time to time. However, you cannot change accounting policies like income deferral merely to get to the bottom line that you want to see!
The materiality principle is used by an accountant to decide if something is significant enough to warrant action or reporting. If the value of an item in the books is sufficient to distort the “true and fair view” of the finances of the business that the accounts provide, when it is deemed to be material. So, a minor error in the books of a large corporation, for example, would be regarded as immaterial, and so it would be ignored.
11. Going Concern Principal
The going concern principle is the assumption that the business is going to continue trading. Things like accruals, prepayments, and deferred income only make sense if the company continues in business. If the company is not going to continue trading, then the accounts would need to show the current realizable value of the business rather than its value as a going concern.
12. Historical Cost Principal
Finally, everything shown in a profit and loss account represents the historical cost of an item when it was purchased. Some types of assets and liabilities in the balance sheet, however, may be subject to revaluation. An item that you bought in a foreign currency will have been converted at the exchange rate at the time of purchase in the profit and loss account. However, if you hold a foreign currency bank account, the money in that account will be revalued at the end of each accounting period to reflect the current exchange rate. Some types of investments may also be adjusted to reflect their current value.
Understanding the above accounting concepts and principals will not make you an accountant. It takes years of training and studying to become a certified accountant. But, if you understand the basics, you will be better equipped to interpret your accounts, and it will help you know why your accountant may ask you to make final adjustments to your annual financial statements.