Basics of Accounting Part III

Hello, readers! Welcome back to the Hoods Tax & Accounting blog! If this is your first time here, welcome! We’re delighted to be able to share up-to-date information about taxes, bookkeeping, and accounting. Our blog is also dedicated to educating you about tax-advantaged savings accounts, tax provisions, programs, and more! We aim to provide you with the tools needed to meet your short and long-term goals. Our seasoned professionals are experts on the tax code, eligible deductions, and QuickBooks—all necessary fundamentals for saving you money! The Hoods Family has been around since 1988 and our comprehensive accounting and tax planning services are among the best in the Lowcountry. If you’re in need of tax preparation, accounting, QuickBooks training, or business consulting services, do not hesitate to schedule an initial consultation! As we approach the end of the year, tax season steadily approaches. We recommend preparing early to maximize your savings and refund. We do offer contactless services using a combination of over-the-phone consultations and digital drop-offs, for safety and convenience. You can read more about our hours and submit a request for a meeting using our website!
 
Our last series, Bookkeeping Basics, explained bookkeeping fundamentals in an easy-to-understand format. From understanding different kinds of accounts to the nature of double-entry, our series broke down bookkeeping into its requisite parts. What’s the difference between a debit and a credit? Does single or double-entry bookkeeping suit your business better? How do you prepare financial documents? What are the bookkeeping best practices which will take your business to the next level? The answers to these questions and more can be found in our previous posts. Bookkeeping is one of the most essential building blocks of any successful business and the precursor to accurate accounting. Therefore, we recommend giving this series a read before delving into our Accounting series. 
 
Now, in part one, we discussed why accounting is a primary function in the management of a business of any size. We detailed what exactly accountants are responsible for, as well as how they execute these responsibilities. Like bookkeeping, accounting is separated into distinct types. We provided an overview of the differences between these types of accounting and how to determine which type is suitable for your business. In addition to answering a few common questions about accounting, we shone a light on the benefits of hiring a professional accountant. In part two, we started parsing through the nitty-gritty details of accounting principles. Accounting principles are the general guidelines by which accountants perform their duties; and each principle is underpinned by a practicality. While the most commonly recognized accounting principle is the accrual principle, in our last article we covered the consistency principle, the full disclosure principle, the conservatism principle, and more. Today, we’ll continue our discussion on accounting principles and finish out this series by answering a couple of questions and providing a few best practices for accurate accounting. The aim of this series is to provide a solid foundation for understanding how accounting works and to stimulate an interest in further learning. If you haven’t already, make sure to give the first two parts of this series a read! Without further ado, let’s learn!
 
Accounting Principles
 
Who decides on accounting principles? The Financial Accounting Standards Board, otherwise known as the FASB, dictates the standard accounting principles used by accountants in the United States. These principles are called the “generally accepted accounting principles,” or GAAP. Accounting principles aren’t arbitrary, nor did they arise out of thin air. Rather, as the name suggests, these principles were previously followed by the general majority of accountants and, after a number of years, became a matter of practice. Now, all publicly traded companies must abide by the GAAP. For small businesses, however, most principles are not mandated. In fact, many accountants rely on their own training, experience, and the specific needs of the business they’re servicing to determine which accounting principles to apply. That said, as we established in the last part of this series, consistency is key. Accounting principles should be maintained over long periods to ensure the clearest picture of a company’s financial history can be obtained by looking at financial reports. 
 
The first principle we’ll discuss today is the materiality principle. This is quite a vague, hard-to-pin down concept, as its effect is based almost entirely on perception. Simply put, the materiality principle stipulates that any transaction which might alter the decisions of those interpreting financial statements must be recorded on said financial statements. Conversely, any transaction which is deemed inconsequential or “immaterial,” can be left off of financial statements, as long as this would not result in anyone being misled. Now, determining whether a transaction is material or immaterial is a subjective task, relying on the judgement of the accountant. Failing to record a significant, material transaction can have consequences. Therefore, the Securities and Exchange Commission provides a tentative definition for materiality: “an item representing at least 5% of total assets should be separately disclosed in the balance sheet.” Still, smaller transactions may still be considered significant. For example, if Company A failed to report a loss of $30, would this be considered misleading? Well, if this $30 loss resulted in their reported net profit actually being a net loss, then yes. Therefore, it’s not necessarily about the size of the transaction, but rather the weight of the transaction. If you’re abiding by the materiality principle, be sure to ask yourself: What impact does this transaction have on the overall positive or negative implications of the financial statement?
 
The second principle we’ll discuss is the monetary unit principle. This principle is based upon the assumption that business should record only those transactions linked to a set value of currency. For example, if Company B invested $5,000 into a new piece of equipment, this would be recorded as such. However, if Company B invested time and resources into improving an aspect of their business, this wouldn’t necessarily be recorded. The purpose of the monetary unit principle is to avoid overvaluing certain assets and liabilities. The monetary unit principle plays into a much larger principle—that of verifiability. To be verifiable, accounting results must be reproducible, meaning an outside accountant could derive the same results from using the same historical data. Speaking of historical data, this is the basis for the reliability principle, which states all recorded transactions should be capable of being proven. This is why accountants and bookkeepers alike are always encouraging you to keep receipts! The reliability principle dictates the practice of auditing. To successfully survive an audit, you must have evidence to support transactions. 
 
The revenue recognition principle is one of the most important principles, as a failure to accurately report revenue can land you and your business in hot water. This principle stipulates revenue must be recorded when it is “earned.” Now, this principle becomes complicated by factors such as a company’s size, location, and public or private status. However, in a broad sense, revenue is earned when a company has fulfilled its performance obligations. For example, if Company C has entered into an agreement with Company B to provide a service, the revenue from this agreement will only be earned when the service has been completed, not when the cash is exchanged. As you might’ve already noticed, this principle does not apply to those who practice cash-basis accounting. Financial institutions are releasing more and more regulations concerning revenue recognition in order to standardize the process and provide investors with greater transparency into a company's financial performance. 
 
Finally, there’s the time period principle, which is based upon the assumption that a business should report their financial transactions over a set period of time (i.e. fiscal quarter, fiscal year, etc.). Reporting in this way is essential for trend analysis. 
 
Questions & Best Practices
 
When were accounting principles first standardized? In the 15th century, with the advent of the T-ledger, double-entry bookkeeping became the first standardized accounting principle. More recently, the American Institute of Certified Public Accountants made efforts to standardize accounting in the U.S. Should you try to follow as many accounting principles as possible? No, this isn’t recommended, especially since a few accounting principles are directly opposed to one another. One of the biggest critiques of the GAAP is that it is not mandated, but this gives companies quite a bit of leeway to decide for themselves the best accounting methods. We recommend consulting with professional accountants and asking for their opinion on which accounting principles are applicable for your business. 
 
Like bookkeeping, it’s important to track all expenses and keep evidence of every transaction. If you’re performing your accounting yourself, you’ll need to regularly set aside time to perform necessary duties. Professional accountants make an effort to automate accounting functions where possible. Always keep business finances separate from personal finances, for tax purposes and overall clarity. As well, make sure to keep backups of all financial records. 
 
 
As you can see, accounting is a complex art, dictated by its own set of standards. A professional accountant will be able to navigate these choppy waters with ease and provide you with the results you desire. Consider Hoods for your accounting needs! We offer bookkeeping, accounting, and business consulting services. As well, we offer tax preparation, payroll, and QuickBooks training! If you have any questions or are interested in a consultation, do not hesitate to reach out. We do offer virtual consultations over Zoom, as part of our effort to accommodate everyone in these trying times. We look forward to hearing from you! Thank you for taking the time to read our Basics of Accounting series and we hope you’ll return for future learning! Until next time!