Small Business Doctor

The way in which we account for business transactions is based upon the accounting principles known as Generally Accepted Accounting Principles or GAAP. US GAAP is the name of the accounting standard, and IFRS is a different standard used around the world. These business transactions are recorded within the accounting books, and are subsequently summarized by the financial statements.

I. Accounting Principles

There are seven Generally Accepted Accounting Principles. These principles form not only the policies for accounting but also serve as guidelines for accounting professionals as they do their work.

Accrual Principle

Under the accrual principle, we record expenses during the period in which the benefit received from those expenses occurs. It doesn’t matter when the cash was paid for those expenses. Similarly, we recognize income during the period in which the product or service was received by the customer not whenever we received payment for that product or service.

The rationale behind the accrual principle is that we want accounting to track the economic basis of a company’s transactions. If a small plumbing contractor pays insurance for his work van at the start of the year in January and it covers him through June, we would want to apportion that insurance expense to each of those six months and not assign this expense solely to January. It’s paid for in January, but the benefit of that expense extends through all six of those months.

Matching Principle

The matching principle is that revenues should be matched with the expenses that helped to generate them. The matching principle builds upon the accrual principle.

Monetary Principle

The monetary principle is that only events that can be recorded in a monetary value should be recorded in the financial books and presented in the financial statements. This does not mean that non-quantitative facts, such as having a good reputation, are unimportant to a business. It simply means that accounting is concerned with measuring monetary values.

This is important, because companies, especially tech startups, will sometimes try to present to potential investors non-monetary information like user engagement as though that were at least as important as cash flows. While internal metrics like user engagement are indeed important, they do not rise to the level that financial statement facts present.

Periodicity Principle

The periodicity principle simply states that we divide up a company’s operating cycle into periods like months, quarters, or years for reporting purposes. This helps the users of financial statements better make comparisons between companies.

Consistency Principle

The consistency principle states that accounting policies and principles should be consistently applied from one period to the next. An implication of this principle is that once a company adopts a policy or method, that policy or method should continue to be used going forward unless there is a valid reason to change it.

The consistency principle helps the users of financial statements better make comparisons of a company’s performance over time.

Conservatism Principle

Otherwise known as the Prudence Principle, the conservatism principle emphasizes caution while practicing accounting. All estimated losses should be recorded before those losses actually occur, while estimated gains should never be recorded before they actually occur.

The goal of the conservatism principle is to ensure that financial statements do not overstate assets or income. It is a check and balance against innate desire of the managers and owners of a company to make the company appear better than it actually is.

Going Concern Principle

The going concern principle is the assumption that a company will continue to operate indefinitely. The implication is that its assets are not intended to be liquidated in fire sale anytime soon.

It is from the going concern principle that accounting practices like the depreciation of assets over their useful lives are derived. It is part of the auditor’s task to assess the validity of the going concern assumption.

II. Accounting Standards

Accounting standards are the rule books set by regulatory agencies to standardize the way that financial transactions are recorded and presented. There are two main accounting standards.

US GAAP

US GAAP is the accounting standard primarily used here in America. There’s a massive amount of individual guidelines. US GAAP is overseen by the Financial Accounting Standards Board (FASB).

IFRS

International Financial Reporting Standards (IFRS) is a competing accounting standard. IFRS is overseen by the International Accounting Standards Board (IASB). IFRS is a more principles-based accounting standard that does not have as many individual guidelines as US GAAP.

III. Accounting Books

A company’s accounting books are where financial events are recorded. These books were once originally books, but are now almost always records inside of a database.

Journals

Journals are the books of original entry. Journals are where financial transactions are recorded in chronological order.

This is an example journal entry. This journal entry says that on August 3, 2015 $250 of inventory was purchased for cash.

Ledgers

Ledgers summarize those transactions and categorize them by individual account. Ledgers are the books of final entry.

The ledger would, for example, sum all of the journal entries like the one above that affected the Cash Account. It would provide you with the total balance of the Cash Account.

Trial Balance

Trial Balance is a statement that lists all of the ledger accounts and their balances at some specific point in time, usually when the bookkeeper is in the process known as “closing the books.” The Trial Balance statement is used to ensure that total debits are equal to total credits, which ensures that the accounting entries are in balance.

IV. Financial Statements

The financial statements are formal presentations of a company’s financial activities and position. These documents are essential for decision-making by the users of financial statements.

Balance Sheet

The Balance Sheet presents a snapshot at a specific point in time of a company’s assets, liabilities and equity. The Balance Sheet is sometimes referred to as the Statement of Financial Position. Assets will equal the sum of liabilities and equity.

A balance sheet looks like this:

Income Statement

The Income Statement shows a company’s revenues, expenses, and resulting profit or loss over a specific period of time. The Income Statement is sometimes referred to as the Profit and Loss Statement.

An Income Statement looks like this:

Cash Flow Statement

The Cash Flow Statement shows how the changes presented in the Balance Sheet and Income Statement affect cash and cash equivalents. The Cash Flow Statement is sometimes referred to as the Statement of Cash Flows.

A Cash Flow Statement looks like this:

Statement of Comprehensive Income

The Statement of Comprehensive Income includes all changes to equity during a specific period except for those derived from investments by owners or distributions to owners. The Statement of Comprehensive Income combines the Income Statement with Other Comprehensive Income items.

Statement of Changes in Equity

The Statement of Changes in Equity shows all changes to the Equity section of the Balance Sheet during a specific period. The Statement of Changes in Equity includes all changes from Net Income, Other Comprehensive Income, and transactions with owners.

Notes to Accounts

The Notes to Accounts include additional information to help interpret the financial statements. This is where you can find explanations of a company’s accounting policies, significant estimates, and other disclosures like that.