Accounting can make or break a business, and accountants need a set of principles to help them stay on track. In the United States, businesses are guided by Generally Accepted Accounting Principles (GAAP), which are established and adhered to by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA). By following GAAP, businesses of all sizes can keep clean books and facilitate audits. This article will explore these principles, what they entail, and their purpose.
Ideally, all transactions of a business should be recorded in the period in which they occur and not when the cash flows associated with them are reflected. Essentially, you need to keep track of when the product reaches the consumer, even if payment is supposed to be made at a later date. Failure to comply with this principle could lead to an artificial acceleration of deferred transactions and confusion of accounts.
This principle advises accountants to record expenses and debts immediately. On the other hand, income and assets should only be recorded when the accountant is certain. However, this should not be done over an extended period as it may give the wrong impression of the company’s finances.
According to this principle, a company should use its current financial management methods consistently until another method is agreed upon. Before agreeing to switch to the new method, it must have been tested and shown to be better than the existing one. If a company decides to adopt another financial management option, it must eliminate the old one and completely adopt the new method. Jumping from one aspect of accounting to another can lead to confusion and losses.
An accountant is required by accounting principle to record all items as they arise in cash or its equivalent. This cost is not adjusted for market inflation or expected changes in value. Some companies are gradually abandoning this principle and moving towards fair value adjustments to help reduce inconsistent recordings.
The business should be considered a separate entity in all businesses, including those run as sole proprietorships. Homeowner and business finances should not be confused. Failure to follow this rule may result in financial loss and confusion.
Financial information about the company should be disclosed to investors and lenders without omission. To follow this principle, footnotes which are often part of the financial statements are included. Disclosure of all information gives the investor or lender the tools to decide whether or not to do business with you.
Continuity of exploitation
Following this principle aligns with the owner’s intent to continue its operations, missions and visions for the foreseeable future. An accountant should be able to tell from the accounts the financial health of the business, which allows him to make the going concern assumption. Ideally, they shouldn’t be planning to close shop anytime soon. This principle also allows investors, shareholders or employees to know whether or not they should invest in the company.
In the matching principle, an accountant should ideally match all expenses with the corresponding income. Expenses are included in the statement from the time they are used or expire if they are not directly related to business income. Costs to which the business cannot immediately attribute a future benefit should be immediately allocated to the financial statement segment.
Following the monetary principle, accountants can only make entries in a known currency. For the United States, this means that transactions must be recorded in US dollars. A company cannot record aspects such as customer service, skill levels or motivational speeches because they are not quantifiable. This principle also assumes that the currency used is stable over time, so it is not adjusted to market instability or inflation. It gives accountants the correct data to determine the state of the business, what actions they can take and what they cannot.
Accountants should only record transactions that can be proven. Data from third-party entities such as promissory notes, bank statements or receipts contain more water than those generated internally. The accounting department could lose its credibility if it does not adhere to this principle.
Regardless of whether the money is paid at that time or not, once a product is sold or a service is rendered, revenue must be recognized. According to this principle, income should be recorded when it is earned and not necessarily when it is received. To control the aspect of fraud, the regulatory councils have provided different details on what to include in a company’s revenue recognition.
Period of time
This principle requires companies to report their financial activity over short periods, such as weeks, months or the fiscal year. The time used should be shown as a title on every financial statement produced by the business. This allows businesses to see their financial journey, what they’re doing wrong, and what they can invest in to drive growth. Not adhering to this principle means that a company could fly blind, which is a dangerous move by any measure.
in good faith
Also known by its Latin name, “uberrimae fidei”, it is the bare minimum for running a business. According to her, companies should aim to be honest and transparent in all their business dealings and engagements with different parties. In addition, they must avoid misleading or withholding information that could influence decisions.
Although publicly traded companies are not required to follow these principles, it is wise to do so. Adhering to these principles in a business of any size lays the foundation for your financial journey, and auditors often demand GAAP-compliant statements. Therefore, it is ideal to follow all or more of them to help create a trustworthy, reliable and financially sound environment that will keep the business going.