The COVID19 pandemic has stimulated the creativity of many Americans who were bored with the shelter-in-place restrictions. This has resulted in a boom of new businesses, primarily sole proprietorships, and the owners’ need to become familiar with accounting, marketing, and other concepts they may have been hitherto unfamiliar with.
Whether you outsource your accounting or do it yourself, there are five basic principles of accounting that govern the accounting process. They are as follows:
1. Revenue Recognition Principle
Revenue is defined as the gross influx of income for a business, whether the payment is cash, receivables, royalties, interest, dividends, or another source. The term cash includes credit card sales and personal checks. This principle states that all revenue must be recognized and recorded.
2. Historical Cost Principle
This principle states that when a tangible asset is acquired for a sum of money, its cost must be recorded on the date it was received. This principle doesn’t apply to intangible concepts such as location or goodwill.
3. Matching Principle
This concept is primarily used with accrual accounting and states that expenses incurred in a period should be matched to the revenue received in the same period. There are caveats to the matching that pertain to the cost of goods sold, depreciation, and loss or damage to inventory, but generally, both expenses and revenue should be recorded in the period in which they occurred or were generated.
4. Full Disclosure
Every business should have at least monthly financial statements that reveal the real state of the industry. They’re not meant to hide information or be pro forma statements but should be accurate at the time the statements were prepared. It’s now common to append financial statements with notes so that full disclosure remains.
5. Objectivity Principle
Financial statements should be factual and free of bias. They contain quantifiable numbers that can be verified by evidence rather than opinion. This rule’s exception is value-based accounting, which may have some preference due to value’s inherent subjectivity.
No matter the size of your business, all business owners should be familiar with these terms and principles. Financial statements are always required when applying for a loan, and they’re invaluable tools for expansion. Knowledge of these principles will help you sound more professional when speaking to your banker and other professionals.