There are ten rules that govern the accounting profession. These guidelines are known as the generally accepted accounting principles—often referred to as “GAAP” for short.
Your business needs to follow these standards whenever you’re preparing financials.
If you’re a small business owner without an accounting background, there’s a good chance that you’re not too familiar with these principles. Over the years I’ve seen so many companies make mistakes because they’re not following GAAP.
The primary purpose of GAAP ensures that every business applies the same methodology for consistent financial reporting. These standards also protect businesses, investors, and customers from fraud.
As a business owner, you already have a full plate handling your daily operations. That’s why it’s so important that you have a bookkeeper who is qualified, trained and knows these guidelines.
But just because you have someone in place to apply these principles to your books, it doesn’t mean that you can just ignore them. You need to have a basic understanding of these standards as well. You can use this guide as a reference for a quick summary and explanation of each bookkeeping principle.
Economic Entity Assumption
This principle is also known as the separate entity assumption. The alternative name makes it easier to understand how it gets applied.
Basically, this standard states that all business and personal transactions must be separate from each other.
Monetary Unit Assumption
The monetary unit assumption rule asserts that all your business activities must be recorded in one currency. This will be extra work for those of you who accept foreign transactions and operate internationally.
This principle also dictates that the purchasing power of currencies remain static, meaning that inflation is not taken into consideration over time. So even if your business has been operating for 20 years, you can’t account for inflation on your financial reports.
Specific Time Period Assumption
Balance sheets, income statements, and all other financial documents must always report information as of specific dates and date ranges under the specific time period assumption.
Without this principle, financial reports wouldn’t make sense when they’re being reviewed and analyzed.
All balance sheets should indicate the “as of” date, while profit and loss statements will include a date range.
The value of items changes over time. But the cost principle says that the value of an asset doesn’t change its cost on the financial reports.
For example, let’s say you buy a building that has increased in value over the last few years. The asset must still be reported as the purchase price.
The easiest way to remember this principle is that you can’t confuse value and cost.
Changes in value will be reflected in depreciation entries or in a gain or loss of an asset’s sale. But if you want to know the valuation of your company without selling assets, you can’t rely on your financial statements.
Full Disclosure Principle
As the name implies, businesses must disclose all information related to their financial statements under this accounting principle.
You are required to divulge all knowledge related to your statements in the notes of a report.
The purpose of the full disclosure principle is to ensure that investors or stockholders are not misled by certain aspects of a financial report.
Going Concern Principle
The going concern principle is also known as the non-death principle. It assumes that all businesses must function without a defined ending date.
If an entity plans to operate for the foreseeable future, the accountant can justify deferring specific expenses to a later accounting period. The assumption is that the entity will still be operating during that later time.
Accountants are required to disclose information if they think a business is deferring their expenses and planning to liquidate the company.
Lots of small business owners operate on a cash basis for tax reasons. This means that they report revenue when it’s received and report expenses when the money is spent. However, this system does not follow the generally accepted accounting principles.
Under the matching principle, businesses must report their finances on an accrual basis.
Sales and the expenses that incurred to produce those sales need to be reported in the same period. This gives a better picture of a company’s profitability and performance compared to cash statements.
Revenue Recognition Principle
This bookkeeping standard is like the matching principle because it involves accrual accounting.
Businesses need to report revenue when it was earned, regardless of when payment was received. Basically, this means that income should be reported at the time of the sale when you send an invoice and not when payment is received.
The materiality principle allows accountants to use their best judgment whenever they record transactions and fix errors.
It’s common for the materiality principle to be applied when an accountant is doing tax returns or reconciling the books. If they discover that the numbers are off by a small amount in relation to the overall size of the company, they can consider the error immaterial.
An immaterial difference can be ignored. However, material discrepancies need to be addressed.
There is no dollar amount, percentage, or threshold used for the materiality principle. It’s up the accountant to use their professional opinion to decide.
Principle of Conservatism
The principle of conservatism is another example when accountants can use their best judgment to decide.
At times, there are multiple ways to record a transaction that would be considered acceptable. In these instances, it’s up to the bookkeeper to choose the option that is the most suitable for the company that they’re working with.
With that said, this doesn’t mean that they can just ignore GAAP.
Even if you have a bookkeeper, accountant, or both, every business owner needs to know the generally accepted accounting principles.
Your knowledge of these standards will give you a better understanding of how and why things are being done a certain way. Plus, it will make it easier for you to communicate with your bookkeeper.
Make sure you find someone who will follow these guidelines when preparing your financial statements. Knowing that GAAP is being applied properly is one of the top benefits of outsourced bookkeeping services.