You didn’t get into business to be an accountant, so why do you need to know these accounting concepts? Well, understanding basic accounting concepts can help you make better predictions about your company’s future based on past trends in sales and costs. This will help you make smarter financial decisions in the long run.
Understanding basic accounting principals will also help you make quick but informed operational decisions on a day-to-day basis. This will save you time and money — two of your most valuable resources as an entrepreneur. Even if you’re using business accounting software, it’s important to have a foundational understanding of these concepts.
Finally, having a basic understanding of accounting concepts will ensure you have productive conversations with your financial advisors when planning strategically for your company’s future.
Here are the nine most important accounting concepts you need to know.
If you’re looking to understand basic accounting concepts, this is a critical one. There are two main accounting methods that you can use — cash basis and accrual basis accounting. Many small businesses start out with cash basis accounting, but accrual basis financial statements give you a much better understanding of your business’s financial position than cash basis statements. Plus, Generally Accepted Accounting Principles, or GAAP, require public companies to use accrual accounting.
Accrual basis financial statements match income and expenses to the periods in which they are incurred. Cash basis statements, on the other hand, only reflect income and expenses when they are received or paid.
Let’s say you invoice a customer for services rendered on March 15 and you give the customer 30 days to pay the invoice. If the customer is a good customer, the check will arrive on April 15, or maybe even a few days earlier.
On accrual basis financial statements, the income will appear in March, as an increase in sales and a corresponding increase in accounts receivable. On cash basis financial statements, the income wouldn’t appear until April when it hits your bank account.
Similarly, let’s say you had to pay a subcontractor to fulfill the services for which you invoiced the customer. The subcontractor billed you on March 31 for services rendered that month and they gave you 45 days to pay the invoice. This means you will pay them on May 15.
On your accrual basis financial statements, the expense will appear in March — the same month as you invoiced your customer. On your cash basis financial statements, the expense won’t appear until May.
The ability to match income and expenses to the period in which they are incurred can help you more accurately identify expenses and trends in your business. This is why accrual basis financial statements are superior to cash basis financial statements for business management purposes.
Bottom line: Know the difference between accrual basis vs. cash basis.
This second accounting concept is closely related to the first. The consistency concept says that once you choose an accounting method, you should stick with it for all future financial records. This allows the company to accurately compare performance in different accounting periods. The Internal Revenue Service also requires consistency for the purpose of filing small-business taxes. If you choose an accounting method and later want to change it, you must get IRS approval.
Bottom line: Stick to one accounting method.
3. Going concern
The "going concern" concept says you should assume that your business is in good financial condition and will remain in operation for the foreseeable future. This concept allows companies to sometimes defer the recognition of certain expenses into future accounting periods. Of course, the accountant or auditor is free to come to a different conclusion if there’s evidence that the business can’t pay back its loan or other obligations. In that case, the company might need to start considering the liquidation value of assets.
Bottom line: Assume the business entity is in good standing and will continue.
Under the conservation concept, revenue and expenses are treated differently. Businesses should recognize revenue only when there’s a reasonable certainty that it will be recognized, for example by a purchase order or signed invoice. However, businesses should recognize expenses sooner, when there’s even a reasonable possibility that they will be incurred. This weighs in favor of more conservative financial statements. It’s better for cash flow purposes to overestimate your expenses rather than your income.
Bottom line: Expenses should be realized sooner than revenue.
5. Economic entity
This is one of the most important concepts for small businesses — you should avoid commingling business with personal funds. Business financial statements should reflect only business transactions. For example, you should avoid putting personal expenses on a business credit card. Failure to follow this concept can make your virtual bookkeeping much more difficult and even land you in legal trouble if you’re a corporation or limited liability company. In those cases, you can preserve limited liability protections only by separating business and personal finances.
Bottom line: Don’t commingle personal and business finances.
This concept is pretty simple and just means that businesses should record any financial transactions that could materially affect business decisions. Even if this results in minor transactions being recorded, the idea is that it’s better to give a comprehensive look at the business. In fact, business accounting software makes it very easy to record every small transaction, since it automatically syncs up with your bank accounts and credit cards.
Bottom line: Record all important transactions on the books.
The "matching" concept says that you should record revenue and expenses related to revenue at the same time. The purpose is to let you see any cause-and-effect relationship between income and purchases. For example, let’s say you pay a commission to a salesperson for a sale that you record in March. The commission should also be recorded in March.
Bottom line: Record expenses related to revenue in the same period as the revenue.
8. Accounting equation
There is a basic accounting equation that will help you record transactions:
Assets = liabilities + owner’s equity
As the formula indicates, assets go on the left side of the equation and are debited. In the same way, assets go on the left side of your general ledger. For example, if you receive cash, your cash account would be debited in your accounting software. Liabilities and owner’s equity go on the right side of the equation and are credited. Similarly, these items go on the right side of your general ledger. For example, if the company issues shares of common stock, that amount would be credited to the owner’s equity account.
Bottom line: Assets = liabilities + owner’s equity.
9. Accounting period
"Accounting period" is the final concept you should understand. Under this concept, only financial records pertaining to the time period at issue should be included. To understand this point, you first need to understand the three financial statements that are important for a company: profit and loss statement, balance sheet and statement of cash flows.
The profit and loss statement and statement of cash flows cover a particular time period, such as a quarter or a calendar year. A balance sheet is a snapshot of a business’s assets and liabilities as of a particular date. If you were making a profit and loss statement for the first quarter of 2019, for example, you wouldn’t cover transactions that occurred before or after the quarter. This ensures that the company can accurately compare performance in different time periods.
Bottom line: Only record transactions for the period under review.
Understanding these basic accounting concepts can you help you succeed in business.
You don’t need advanced accounting knowledge to effectively run your business. However, equipping yourself with an understanding of these basic accounting concepts (and investing in some useful accounting books) can help you review your transactions and financial statements with greater confidence. The additional value you will get from your conversations with your financial advisors will make the effort to understand these concepts well worth your while, too. If you’re in need of accounting software that can help you understand and easily implement these concepts, try QuickBooks Online.
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