Nerdy takeaways
- Using basic accounting principles makes your business financials more consistent, accurate and reliable.
- Familiarizing yourself with these concepts can help you better understand the GAAP standards that publicly traded companies must adhere to (and that many small businesses follow).
- While you might not deal with these principles on a daily basis, understanding them allows you to make sense of how transactions are recorded and how particular accounts, like revenue and expenses, are handled in your books.
Basic accounting principles standardize businesses’ financial practices. Following these defined rules makes your business’s financials more consistent, accurate and reliable. This lets you compare financials from one period to the next and gauge your business’s health.
Using the best accounting software automates bookkeeping tasks. That means you won’t have to deal with these principles often. But knowing them helps you understand what’s going on behind the scenes.
Here are the nine most important accounting principles for small-business owners.
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1. Accruals
You can use two main accounting methods: accrual- and cash-basis accounting.
Accrual basis: This method records income and expense transactions when you incur them. For example, you’d factor in accounts receivable as soon as you send out an invoice, as opposed to when someone actually pays it.
Cash basis: This method records income and expense transactions only when you receive or make a payment. That means you don’t factor in accounts receivable. Instead, you’d wait until an invoice is paid to record it as income.
Many small businesses start with cash-basis accounting. But we recommend accrual-basis accounting, because it gives you a more holistic picture of your business’s financial position.
2. Consistency
This principle means once you choose an accounting method (accrual or cash), you stick with it. This lets you accurately compare performance across accounting periods.
The Internal Revenue Service (IRS) also requires consistency for filing small-business taxes. If you want to change your accounting method down the road, you need IRS approval.
3. Going concern
Going concern assumes your business is in good financial condition and will operate for the foreseeable future. Under this principle, companies may spread an expense out over a period of time instead of recognizing it all at once.
Of course, going concern doesn’t apply if there’s evidence that the business can’t pay back a loan or meet its obligations. At that point, the company might need to start considering the liquidation value of assets.
4. Conservatism
The conservatism concept means businesses should recognize expenses sooner than revenue. This can result in more conservative financial statements. For cash flow purposes, it's also better to overestimate your expenses rather than income.
For example, businesses should only recognize revenue when there’s a signed invoice or purchase order. Businesses recognize expenses, on the other hand, when there’s a reasonable possibility they’ll be incurred.
🤓 Nerdy Tip
Some concepts, like conservatism, overlap with the rules that publicly traded companies have to follow. These are referred to as the generally accepted accounting principles (GAAP). Ultimately, GAAP ensures businesses’ financial reporting is consistent. Small businesses don’t have to follow GAAP, but often do to maintain logical financial records. 5. Economic entity assumption
This one is all about keeping business and personal finances separate. 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 bookkeeping much more difficult. And if your business is a corporation or limited liability company (LLC), it can compromise your liability protection.
6. Materiality
Businesses should record any financial transactions that could materially affect business decisions. It's better to record too much than too little, especially in the event of an audit.
Accounting and bookkeeping apps make it easy to record every small transaction. Most of them sync directly with your business bank and credit card accounts.
7. Matching
This means you record revenue and expenses related to it at the same time. Matching helps reveal any cause-and-effect relationships between income and purchases. For example, let’s say you pay commission to an employee who completes a sale in March. You should also record the commission payment in March.
Get a FREE review of your books
NerdWallet Small Business helps you get your business in shape for taxes, loans, and growth. Stop worrying about accounting and speak with a real, human expert from our partner, Xendoo.
8. Accounting equation
This equation helps you understand how accounting software records 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, your accounting software debits your cash account when you receive cash.
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 instance, your software credits the owner's equity account when the company issues shares of common stock.
To learn more about how debits and credits work, see this explainer on double-entry accounting.
9. Accounting period
An accounting period could be a calendar year, fiscal year, six months or three months. At the end of each period, businesses fill their investors in on how they're performing.
Financial records from an accounting period should only include transactions from that period. That may be obvious. But it ultimately ensures the business can accurately compare performance across periods.
Three major reports are at the center of this concept:
- Profit and loss statement: Also called an income statement, this report shows a business’s revenue and expenses over a particular period of time, like a quarter.
- Cash flow statement: This key report helps summarize how cash is flowing in and out of a business over a specific time period.
- Balance sheet: This report is a snapshot of a business’s assets and liabilities as of a particular date.
» MORE: Best free accounting software
