Nerdy takeaways
- Using basic accounting principles makes your business financials more consistent, accurate and reliable.
- Familiarizing yourself with these concepts can help you better understand the GAAP standards. Publicly traded companies must adhere to these, and many small businesses follow them.
- You might not deal with these principles on a daily basis. But knowing them helps you make sense of how your accounting software works.
Basic accounting principles standardize businesses’ financial practices. Following them makes your business’s records more consistent, accurate and reliable. This lets you compare financials from one period to the next and gauge your business’s health.
Our picks for the best accounting software automate bookkeeping tasks for you. That means you won’t have to deal with these principles often. But knowing them helps you understand what’s going on behind the scenes.
Here are the nine most important accounting principles for small-business owners.
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1. Accruals
You can use two main accounting methods: accrual and cash-basis accounting.
Accrual basis: This method records income and expense transactions when you incur them. For example, you factor in accounts receivable as soon as you send out an invoice. You don't wait until someone actually pays it.
Cash basis: This method records income and expenses only when you receive money or make a payment. That means you don’t factor in accounts receivable. Instead, you’d wait until a client pays an invoice to record it as income.
Many small businesses start with cash-basis accounting. But we recommend accrual-basis accounting. Ultimately, it gives you a more holistic picture of your business’s financial position.
2. Consistency
Once you choose an accounting method (accrual or cash), you stick with it. This lets you accurately compare performance across accounting periods.
The Internal Revenue Service (IRS) also requires consistency for filing small-business taxes. If you want to change your accounting method down the road, you need IRS approval.
3. Going concern
Going concern assumes your business is in good financial condition and will operate for the foreseeable future. This allows companies to spread an expense out over a period of time instead of recording it as one lump sum.
Of course, going concern doesn’t apply if there’s evidence that the business can’t pay back a loan or meet its obligations. At that point, the company might need to start considering the liquidation value of assets.
4. Conservatism
The conservatism concept means you should recognize business expenses sooner than revenue. This can result in more conservative financial statements. It's also better to overestimate your expenses rather than income. It helps you stay on top of your cash flow.
You should only record probable gains when they actually happen. For example, let's say you're trying to sell a large piece of equipment. You wouldn't record the sale until it happens. But you shouldn't wait to recognize probable losses. Instead, you take them into account when they're likely to happen.
🤓Nerdy Tip
Some concepts, like conservatism, overlap with the rules for publicly traded companies. These are the generally accepted accounting principles (GAAP). The set of rules ensures businesses’ financial reporting is consistent. Small businesses don’t have to follow GAAP. But they often do to maintain logical financial records.5. Economic entity assumption
This one is all about keeping your business and personal finances separate. Business financial statements should reflect only business transactions. For example, you should avoid putting personal expenses on a business credit card.
Ignoring this concept can make your bookkeeping much more difficult. And it can compromise your liability protection if you own a corporation or limited liability company (LLC).
6. Materiality
You should record any financial transactions that could significantly impact business decisions. It's better to record too much than too little, especially in the event of an audit.
Accounting and bookkeeping apps make it easy to record every small transaction. Most of them sync directly with your business bank and credit card accounts.
7. Matching
This means you record revenue and expenses related to it at the same time. Matching helps reveal any cause-and-effect relationships between income and purchases.
For example, let’s say an employee completes a sale for your company in March. But you don't pay them commission until April. You should record the commission expense in March so that it aligns with the sale.
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NerdWallet Small Business helps you get your business in shape for taxes, loans, and growth. Stop worrying about accounting and speak with a real, human expert from our partner, Xendoo.
on Xendoo's website
8. Accounting equation
This equation helps you understand how accounting software records transactions:
Assets = liabilities + owner’s equity
As the formula indicates, assets go on the left side of the equation. Your accounting software debits them, which increases the asset balance. In the same way, assets go on the left side of your general ledger. For example, your accounting software debits (or adds to) your cash account when you receive cash.
Liabilities and owner’s equity go on the right side of the equation. Your accounting software credits them. This increases those accounts' balances. Similarly, these items go on the right side of your general ledger. For instance, your software credits (or increases) the owner's equity account when the company issues shares of common stock.
Debits and credits work differently depending on the account. To learn more about them, see this explainer on double-entry accounting.
9. Accounting period
An accounting period could be a calendar year, fiscal year, six months or three months. At the end of each period, businesses fill their investors in on how they're performing.
Financial records from an accounting period should only include transactions from that period. That may be obvious. But it ensures the business can accurately compare performance across periods.
Three major reports are at the center of this concept:
- Profit and loss statement: Also called an income statement, this report shows a business’s revenue and expenses over a particular period of time, like a quarter.
- Cash flow statement: This key report helps summarize how cash is flowing in and out of a business over a specific time period.
- Balance sheet: This report is a snapshot of a business’s assets and liabilities as of a particular date.
» MORE: Best free accounting software
