There are four basic accounting principles, four accounting assumptions and four accounting constraints in accounting rules that businesses use to record and report their financial transactions.
These set of rules is called GAAP
(Generally Accepted Accounting Principles)
GAAP is the foundation we use to help in handling the different accounting concepts we face as business owners.
These rules are accounting standards and guidelines to help us make our financial statements (income statement, cash flow statement, balance sheet) more consistent, comparable, meaningful, and informative. It’s important to have an accurate picture of total sales, a credit balance, total accounts receivable, net income, total credit sales and receivable balance. Not every U.S based company is required to comply with GAAP, with the exception of publicly traded companies (or those that plan to someday).
Who Sets GAAP?
GAAP standards are issued by the FASB (Financial Accounting Standards Board) in response to the 1929 stock market crash. After that time, the FASB eventually came to be and in 1973, these new standards were adopted. The board wanted to create a standardized set of accounting practices in order for more transparency of financial records between publicly traded companies. Accounting principles are generally accepted only when enforced by law and the Securities and Exchange Commission (SEC) who regulates public companies, requires public companies to use GAAP. Private companies have also, for the most part, adopted these rules, largely due to pressure from lenders and investors so they have access to the information they need to make sound decisions.
4 Basic Accounting Principles:
- The Historical Cost Principle – This principle states that we are required to record most of our assets at their original costs with no adjustments for increases in market value. This accounting principle makes sure we don’t put our own perceived value on our assets.
- The Revenue Recognition Principle – This accounting principle is the basis for accrual accounting. It requires us to record revenue when the goods have been sold or the service has been provided.
- The Matching Principle – This basic accounting principle requires us to use accrual basis accounting. It also requires us to match our expenses with our revenues, which is double-entry bookkeeping. A very common example of this accounting principle is to report employees’ wages in the week the employees worked not in the week they are paid.
- The Disclosure Principle – This accounting principle requires us to disclose all pertinent financial information about our business in an understandable form. This information is presented in the main body of our financial statements, in the footnotes of our financial statements, or as supplementary information.
Four Accounting Assumptions:
There would be no way to cover all the principles, assumptions, and constraints that makeup generally accepted accounting principles on this one page, but I did want to mention a few assumptions that I think are very important to our small businesses…
- The Business or Economic Entity Assumption – This assumption requires companies to keep all of our business transactions separate from our personal transactions. One of the first things you should do when you start your small business is open up a separate checking account and only use it to pay and record all of your business transactions.
- Monetary Assumption – This assumption requires us to record and present every transaction in a monetary unit such as the dollar.
- Time Period Assumption – This accounting principle assumes that all of our business transactions can be recorded and separated into different time periods such as months, quarters, and years.
- Going Concern Assumption – Assumes that our business will continue operating and will not be closed or sold in the foreseeable future.