40 Basic Accounting Principles that you need to know to understand Small Business Accounting
Business owners need to know general accounting principles before they can move on to more complicated accounting practices. The following are the 40 Basic Accounting Principles that you must know to understand small business accounting:
- The guidelines that accountants and businesses use to practice accounting are called Generally Accepted Accounting Principles (GAAP).
- GAAPs are adapted, changed and updated by the Financial Accounting Standards Board (FASB). The Securities and Exchange Commission (SEC) also has authority to change the rules, but they generally leave it up the FASB.
- Non-publicly traded private businesses (companies that are not listed in any stock exchange) have no legal obligation to follow GAAPs. However, banks and lenders usually require it, and it’s aptly named “generally accepted” for a reason.
- The three financials that small businesses use to evaluate their economic condition are the balance sheet, the income statement, and the cash flow statement. (There will be a separate blog post on these financials).
- The formula used to create the balance sheet is Assets = Liabilities + Equity (or Equity = Assets – Liability). Accounting is often called “double entry accounting” because when there is a change on one side of the equation it must also be reflected on the other side of the equal sign (=).
- Assets are anything that the business owns that has monetary value, such as cash, inventory, machinery, etc. These can even include intangible assets such as patents, trademarks and goodwill.
- Liabilities are debts or anything that the business owes to someone else. Creditors have claim on the assets until the liabilities are paid.
- Equity is the portion of the assets that exceeds liabilities. This is the portion that is not subject to creditor’s claims. (Homeowners should understand this well. A mortgage is a liability that gives the lender claim on a portion of the house. As long as that liability exists, the lender can foreclose. The portion that the home owner actually owns is called equity).
- Assets, liabilities and equity are divided into sub-categories called accounts.
- Accounts for assets include cash, accounts receivable, prepaid expenses, inventory, and fixed assets (assets that will last more than a year and help the business generate revenue).
- Accounts for liabilities include accounts payable, notes payable (loans), withheld taxes (from employees’ wages due to the IRS), accrued payroll taxes, and deferred revenue (cash collected now for a service in the future).
- Equity accounts depend on the legal structure of the business. The most common small business entity is the Limited Liability Company (LLC), which can be a single-member LLC or a multi-member LLC. Equity accounts for a sole proprietorship or single-member LLC include owner’s equity and owner’s withdrawals. Equity accounts for a partnership include Partner A Equity, Partner A Withdrawals, Partner B Equity, Partner B Withdrawals, etc., where “A”, “B”, etc. are the partners. Equity accounts may have different names. For a corporation they’re common stock, dividends paid and retained earnings.
- Less frequent changes in equity occur through owner contributions or owner withdrawals. More frequent changes in equity occur through earning revenue or incurring expenses.
- Revenue and expenses are also sub-categories of equity, and they have their own sub-accounts.
- Net Profit is when revenue exceeds expenses.
- Revenue accounts include sales, interest income, rental income, and service fees.
- Expense accounts could include cost of goods sold, salaries and wages, rent, utilities, advertising and marketing, travel, meals and entertainment, depreciation and others depending on the business.
- The collection of all asset, liability, equity, revenue and expense accounts is called the general ledger.
- The changes in revenue and expense account balances are reflected on the income statement. The income statement is sometimes called the profit and loss statement or P&L. Its a separate statement that indicates whether the business made a profit or incurred a loss. (Again, there will be a separate post on the financials).
- The period of time reflected on the income statement is generally a month or a year. Some businesses review their financial statements on a quarterly basis.
- Businesses can record their expenses and revenues on an Accrual Basis or a Cash Basis.
- Accrual Basis Accounting is when the business records their expenses and revenues at the time they actually incur the expense or earn the revenue. Yet, actual payment often comes later than when it is earned (by 2-3 months for some businesses).
- Cash Basis Accounting is when the business records expenses and revenue at the time cash is paid.
- Cash Basis is much more simple since it doesn’t require accounts receivable or accounts payable. In other words, Accrual Basis does include accounts receivable and accounts payable. Cash Basis also gives a less accurate picture of the business’ performance during any given point in time (for most businesses).
- Your accountant and other business advisers will explain whether your business should use the Cash Basis or Accrual Basis.
- Some accounts receivable won’t ever get paid. This means the company’s assets and revenues will be overstated. The most common method of estimating the collectability of receivables is called an aging schedule. This divides receivables into categories based on how old the receivable is.
- Accounting doesn’t always give a 100% accurate picture of the company’s performance. Accounting is meant to give the best representation possible. There are many practices that a business can use to “maximize” their revenue, or at least the appearance of it. For example: a business may decide to record the purchase of supplies under accounts payable until the supplies are used. Since accounts payable is an account of liabilities and not equity, the lump sum doesn’t appear as an expense. Then when they use the supplies, they reduce accounts payable and increase expenses gradually over time. This makes their revenue appear higher initially, but it’s ultimately the same once the supplies are used.
- There are legal ways to “fudge” the numbers and there are illegal ways. The practice given as an example above (recording supplies as they’re used and not as they’re purchased) is a legitimate practice. Corrupt management in some companies have ways of “fudging” the numbers illegally to make a company’s performance appear better than it is. Sometimes this can be avoided with internal auditing. This is the whole basis for some chapters in the book Financial Intelligence. There are also many examples of this in Financial Accounting: A Mercifully Brief Introduction.
- Fixed assets (such as machinery, computers, vehicles, etc.) decrease in value over time and as they are used. This is called depreciation.
- A company could record the purchase of a fixed asset as an expense up front (not the suggested practice), or they can record the purchase of a fixed asset as a change in assets (subtract cash and increase fixed assets). Then over time assets are reduced and a different account called accumulated depreciation (which is a contra asset account) is increased. This is done by estimating the useful life of the asset and choosing an appropriate rate of depreciation.
- GAAP sanctions several depreciation methods. Two common methods are the straight-line method and the accelerated method.
- The straight-line method of depreciation is when an asset is depreciated by a fixed amount regularly over time.
- The accelerated method is when the bulk of the asset is depreciated sooner in time. This is the better method when the value of the asset is expected to rapidly decline after it is purchased.
- Under GAAP rules, assets are recorded at their original cost, even if their market value changes over time (yet another reason why account doesn’t give a 100% accurate representation of the company’s economic condition).
- As explained in Tax-Free Wealth, depreciation can be a significant legal tool for tax savings (there will certainly be another blog post on this).
- When a business uses accrual basis accounting, the cash flow statement tells them how much cash they actually have in their possession to work with. Their revenues may be higher or lower than their current cash since they have accounts receivable and accounts payable. (Again, there will be another post on the three financials).
- Before preparing financials, there are usually adjustments made to the general ledger. These may include such actions as writing off accounts receivable that are deemed noncollectable, recording depreciation and adjusting inventory.
- At the end of the year, closing journal entries are made to bring the income statement accounts to zero. On the balance sheet this is done by transferring revenues to owner’s withdrawals or it becomes retained income for the next year.
- Your accounting software will automate much of the above for you so that you don’t have to manually enter every transaction twice or do any calculations. Yet, it is important to know what your accounting software is doing. (There will be another blog post on accounting software). Also, your accountant will make adjustments as needed.
- Some business owners purposely have businesses that operate at a loss since this can off-set their overall income from other businesses and act as a significant tax advantage (see Tax-Free Wealth).
Once you understand these principles, then you’re ready to move on. Just reading them is not sufficient, they must make sense to you. More clarification will come with other posts, such as the post on accounting software and the post on bookkeeping that will be on this blog in the near future.
This article was not written by an accountant. Consult with an accountant or other qualified professional to perform accounting for your business.
Major source for this article: Financial Accounting: A Mercifully Brief Introduction by Michael Sack Elmaleh. Buying this book or a similar book would be beneficial to anyone who wants to learn accounting since the end-of-chapter examples and exercises can help to solidify the material in your mind.
For an explanation on why an accounting article is posted on a marketing blog, read September is Accounting Month.
If you have any questions on this article (or answers to questions), leave a comment below.