If you’re a new business owner—or, thinking about starting a business—you may not realize that there are rules and regulations about how to keep your financials.
Even if you know the basics of accounting, you cannot simply log information as you see fit. Instead, the Financial Accounting Standards Board (FASB) establishes a set of generally accepted accounting principles (GAAP) so that businesses in the United States can maintain uniformity with their financial information.
Since 2009, FASB has been the “single official source of authoritative, non-governmental US generally accepted accounting principles.” FASB relies on assistance from the American Institute of Certified Public Accountants to establish these principles.
Are you looking to learn more about accounting principles so you can use them in your small business?
Below, you’ll find a complete breakdown of GAAP principles and terms to help get you started.
Cash vs. accrual basis of accounting
Before we can jump into the principles, it’s first important to recognize two primary differences in accounting methods. When compiling financial data, business owners have the option to do so using the cash or the accrual basis of accounting. These methods make clear distinctions regarding how owners log business transactions.
Under the cash basis of accounting, business owners record income when they receive it. They then record expenses as they pay them. The cash method does not take into account any accounts receivable or accounts payable. With this method, you strictly apply payments from clients or sales once you receive the cash-in-hand, and you record expenses when you spend the money. .
Accrual accounting is an entirely different approach from cash accounting. Instead of recording income and expenses as they clear your bank, you register them at the time that you agree to sales or purchases even if sales will be invoiced at a later date or purchases are made on credit. The accrual method takes accounts payable and receivable into consideration.
So, the difference is that the cash basis method recognizes revenue and expenses only when the cash enters or leaves your bank account, while the accrual basis accounts for contracted revenues and costs that haven’t been received yet.
GAAP does not recognize cash basis as an accepted accounting practice. The accrual basis is not only easier to track and log, it also provides a better picture of a business’s financial health. Knowing that GAAP does not accept the cash basis reporting standard will help you better understand the principles that GAAP does cover.
What principles does GAAP cover?
GAAP is the American standard for financial reporting. The rules cover a wide range of principles and philosophies, including:
- Ways to recognize revenues, expenses, assets, and liabilities on financial statements
- How to measure and report profits and losses
- How to present information on financial statements
- What information business owners must include on financial statements
Currently, public companies are the only businesses required to abide by GAAP. However, if you’re a small business owner who hopes to one day take your company public, you’ll want to start abiding by GAAP standards. Additionally, investors tend to want to see businesses abide by GAAP. So even if you own a non-profit or private company, understanding and practicing GAAP is within your best interest.
Let’s take a look at some of the most relevant GAAP accounting principles. Making the switch from non-GAAP to GAAP standards can be challenging. Understanding GAAP principles can help smooth the transition and ensure you maintain compliance while doing so.
The matching principle instructs business owners to account for revenues and expenses on the income statement at the same time. As a result, any liabilities will appear on the balance sheet at the end of the accounting period. The matching principle is an example of accrual basis accounting.
The cost principle, sometimes referred to as the historical cost principle, requires business owners to record the cash amount of the asset when it’s obtained. This principle reflects the fact that GAAP doesn’t account for inflation. The original cost of the asset is the same amount recorded in financial documents.
Revenue recognition principle
This accrual-basis principle states that business owners should recognize revenues as soon as they sell a good or service. This principle essentially considers “Accounts Receivable” and “Income” the same thing. Business owners must recognize income even if they have not received it yet.
Going concern principle
This principle primarily concerns liabilities. It states that a company should continue to exist into the foreseeable future, long enough to meet its commitments and obligations. Abiding by this principle means that a company does not intend to liquidate any time soon. If an accountant believes this is not the case, he or she must still abide by other GAAP principles but disclose this information to all relevant parties.
Full disclosure principle
Similar to the going concern principle, the full disclosure principle states that business owners should disclose information on financial statements if it’s necessary or relevant. Owners can do so in the notes of the report.
What happens if you go to record a transaction, only to realize that there are two different ways to do so. This principle is the ultimate decider, stating that owners should choose the option that will result in lower net income.
This principle gives accountants and bookkeepers a bit of leeway in their record keeping. It says that these parties can violate GAAP if the amount is insignificant. There’s no black and white meaning of significant. For instance, $1,000 could represent a substantial portion of revenues in your first accounting period. But for Google or Apple? Not so much.
Monetary unit assumption
This principle states that the US dollar is “king.” It forbids accountants from logging transactions in any other currency other than US dollars. This principle also allows accountants to ignore the effect of inflation when reviewing statements, as it assumes that the dollar’s purchasing power has not changed over time.
Economic entity assumption
This assumption is particularly relevant for freelancers and self-employed individuals. It mandates that these individuals separate business transactions from personal transactions, even though, legally, a sole proprietorship and a business’s owner are considered the same entity.
Time period assumption
This principle permits accountants to estimate amounts because they are working within short time periods, so long as the time intervals are distinct. Business activities are both continuous and complex. Accountants can provide estimates to help streamline the accounting process.
Now that you have a better understanding of GAAP let’s take time to review some of the terms you may come across as you work on implementing these accounting principles in your business.
Accounts payable relates to money that you owe vendors and creditors. These are accounts you’re expected to pay for purchases owed. They are considered liabilities.
Accounts receivable is money you’re expecting from clients and customers for services rendered or products sold. They are considered assets.
Amortization is the process of spreading out the cost of an intangible asset over a certain period, usually the entire lifespan of the item. It also refers to the repayment of a loan or other debt that’s divided up into multiple installments over time.
The assets of a business include all of its bank accounts, accounts receivable, products purchased for inventory, office furniture, machinery and equipment, real estate, and anything else that has value and is owned by the business.
A balance sheet is a snapshot of a company’s financial standing at the end of a specific period. It contains a statement of the liabilities, assets, and capital owned by the business, as well as net income. Companies typically produce balance sheets at the end of every accounting period and year.
The cash you have in your accounts, plus all of your assets and investments, is known as capital. The two major types of capital are debt and equity.
Debt involves borrowed funds from loans or other financing options that you take out and expect to repay. Equity relates to selling off interest in the company in exchange for money. A buyer who purchases equity is seen as making an investment in the business.
Cash flow represents both money coming in and going out of your business accounts. There are different types of cash flow, including operational, investment, and financing. Without the right amount of cash flow, your business will fail. You can primarily find this information on the statement of cash flows.
Debits and Credits
When using the double-entry bookkeeping method, your debits and credits always cancel each other out. You debit your expense account and credit your bank or other cash accounts.
In the event that you’re depositing funds into your bank account, you debit the cash account and credit the income or deposit category it relates to. For example, if you were paid $1,000 from a client invoice, you record this transaction by debiting your bank account and crediting the specific client’s receivable account.
Depreciation involves matching the expense of a long-term asset with the period of time that the business will use it for. It represents the recovery of cost over time. Depreciation applies to computers, furniture, machinery, and equipment used to start and run a small business.
The formula for depreciation takes into account the useful life of the product, the salvage value, and purchase price. The difference between depreciation and amortization is that depreciation relates to tangible assets, whereas amortization pertains to intangible assets.
Double-entry bookkeeping system
The double-entry method of bookkeeping requires accountants to make two entries for every transaction. This means that every transaction requires an opposite and corresponding entry into another account. This means that you can find each transaction in two accounts. The double-entry bookkeeping method is the most common strategy used by accounting software, large corporations, and CPAs.
A liability is anything that relates to a debt or financial obligation. Owners record liabilities on the company’s balance sheet. Liabilities include accounts payable, income taxes, wages, and other accounts owed.
Profit and loss
An income statement, also known as a profit and loss statement, summarizes the business income, expenses, and total cost during a specific period. It shows the profit that the business earned during this time as well as the loss incurred, and it gives a positive or negative figure.
Single-entry bookkeeping systems
Unlike the double-entry bookkeeping system, which requires corresponding transactions, the single-entry system is far more straightforward. As the name indicates, accountants only log the transaction in one account.
Your checkbook is an example of the single-entry method. You record debits and credits as your balance increases and decreases. Your checkbook shows a single transaction — how much money you sent. It does not track the “end result” of the transaction, only that you made the payment.
Get your finances in order
As a small business owner, financial transactions and accounting records are perhaps the most integral components of your company’s success.
They not only provide you with the capital that you need to grow, they also help demonstrate the financial health of your business.