Accounting

Understanding the 5 Basic Accounting Principles

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If you want to keep your financial records accurate and organized, it’s important to follow basic accounting principles. You could own any type of business and you’d still be operating using the same accounting principles. That’s why as a business owner, understanding these basic accounting terms and concepts is an important aspect of running your business properly. Read on to learn how to follow the basic accounting principles and maintain your business’s financial integrity.

What are the Basic Accounting Principles?

generally accepted accounting principles gaap

The principles of accounting are the rules that organizations follow to report their financial information. The five accounting terms ensure certain practices are carried out according to best practices, as well as state and federal law. Depending on the size of your business, they can be used as references for stakeholders or any other managing entities.

In addition to these accounting concepts, there are also the Generally Accepted Accounting Principles, also known as GAAP. In the United States, the Financial Accounting Standards Board (FASB) has set these accounting principles for all publicly traded companies. Unless you own a publicly traded company, you should not have to worry about being held to these standards.

Now that you have a firm grasp of what these accounting terms are, let’s go into the specifics of each.

1. The Revenue Principle

Also called the revenue recognition principle, this is the concept that a business should only recognize revenue when it has mostly completed the earnings process. Basically, that means a business should only record revenue at the point of sale when the buyer takes possession of the item or the service is complete. This is regardless of whether the customer has paid the invoice. This principle allows businesses to keep track of their accounts. It also helps prevent businesses from counting their profits before the earnings process is complete. We’re looking at you, accounts receivable.

2. The Expense Principle

This basic accounting principle identifies the point in time that a company can log a transaction as an expense. Also known as the expense recognition principle, the concept states that an expense occurs at the time that the business accepts the good or service from an entity. Regardless of whether a bill went out to the business or they paid for the transaction, this principle says that the expense happens once the customer receives goods or the organization performs the service.

3. The Matching Principle

Under the matching principle, each item of revenue should match an item of expense. Let’s say for example that you sell apparel. When a customer buys a pair of jeans, you must also count the expense of the materials to make them. The expense to make the pair of jeans must match the revenue earned from selling them. When businesses apply the revenue, expense, and matching principles, they are operating under the accrual accounting method.

4. The Cost Principle

The cost principle is the concept that a business should not use the resell cost to record the cost of an item in the books. Instead, the business should use the historical cost. Let’s say that your business owns the office space that it operates out of. You should list the historical costs of the property as the cost, instead of the fair market value of the property. Bear in mind any overhead costs you might be forgetting when factoring in this accounting term.

accounting concepts

5. The Objectivity Principle

The objectivity principle is the concept that your books should only contain verifiable data that you can back up with objective evidence. There should never be the subjective measurement of values, even if that data is better than the verifiable data. Foregoing this rule could lead to confusion between different parties who may not find the subjective information easy to understand. It is always better for other people to be able to verify your claims.

Why Knowing Accounting Principles is Important

While each of the five accounting principles seems justified for good practice, following basic accounting principles is a good foundation for your business’s financial planning and budgeting. For example, without the revenue principle, you may be depending on future payments to pay your bills. With this caliber of accounting, a business can easily go under.

Another important argument in favor of the basic accounting concepts is for company cohesion. Depending on the size of your organization, you could have different employees in charge of each of the five principles. Without a plan in place, it would be nearly impossible to come to the same conclusions about your financial health at the end of every month. This inevitably would wreak havoc if kept unchecked. Therefore, these are just two of the reasons establishing the accounting principles at your business connects to your success.

Closing Thoughts

The basic accounting principles offer a streamlined approach to reporting financial documents. Each of the five accounting concepts plays a part in the bigger picture at stake: your business’s financial health. By establishing these principles early in your organization, you can ensure a more organized and productive experience with your cash flow. That way, you’re not tracking down missing funds or recording unverifiable data. Your business, and your bottom line, will thank you when you adopt these accounting principles.