The Basics of Accounting Part II

​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!
 
We recently wrapped up a three-part series on Bookkeeping Basics, which explained bookkeeping fundamentals in an easy-to-understand format. From understanding different kinds of accounts to the nature of double-entry, our series breaks 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 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. 
 
Today, we’re continuing our exploration of the art of accounting. In part one, we discussed why accounting is an essential function of managing 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. If you’re interested in learning the basics of accounting, definitely check out our last article!
 
Today, we’re expanding our understanding of accounting by breaking down the principles which guide the practice. Accounting uses precise data and formulas to assess the financial health of a business. Like any mathematical endeavor, there are hand-and-fast rules to accounting. Professional accountants spend years in specialized degree programs and certifications to learn how to perform these calculations correctly. Today, we hope to impart a few of the overarching principles which govern accounting and give you a sense of confidence in your accounting skills. 
 
Accounting Principles
 
The accrual principle is actually one we’ve discussed before. If you read part one, you already know the difference between accrual accounting and cash-basis accounting. Well, as you might guess, accrual accounting is backed by the accrual principle. This principle is based upon the assumption that transactions will be recorded in the accounting period when they are incurred, not when the cash associated with the transaction actually exchanges hands. For example, if Company A agrees to produce $3,000 worth of products for Company B, this transaction would be recorded immediately, not when the products are delivered or when the invoice for the products is paid. Make sense? This principle assumes reporting transactions immediately is more accurate. The IRS requires most businesses to perform accounting according to this principle because they also believe this method is more accurate. 
 
The supporting principle to accrual accounting is the matching principle. The matching principle relies upon the assumption revenue should be recorded alongside corresponding expenses. For example, if Company A sold 32 units of product, in addition to recording revenue, they would also record a deduction in inventory. You might find the matching principle familiar and, if you remember our breakdown of double-entry bookkeeping in our Bookkeeping Basics series, then you would be right! The matching principle is the basis for double-entry and is not used for other types of bookkeeping, such as cash-basis. 
 
The conservatism principle is similar to the accrual principle in that, with this method, you record expenses and liabilities as soon as they occur. However, the conservatism principle differs from the accrual principle in that, with this method, you would wait to record revenues and assets until you are sure they will occur. For example, using the previous example, Company A would not record the $3,000 worth of revenue until Company B paid the invoice, but they would record the expenses accrue in producing $3,000 worth of products. This principle is considered conservative as profits are routinely understated on financial statements. While you never want to overstate profits, understating profits can lead outside entities or investors to incorrectly assess your company as underperforming. The advantages of such a principle are a better projected financial future, as profits are pushed to later dates. 
 
The consistency principle isn’t as much a method for the recording of business’s financial performance, but rather a fundamental building block for multi-year accuracy when evaluating a business’s financial performance. This principle assumes you should maintain a single accounting method for as long as possible. Frequently jumping between different methods of accounting can make it difficult to assess the long-term growth or decline of a business. Following the consistency principle means you’ll only switch to another accounting method if, and only if, a better method comes along. 
 
The cost principle assumes businesses should record assets, liabilities, and equity investment at the price they paid to purchase. The advantages of aligning yourself with the cost principle are a simplified entry of financial data and the figures entered are verifiable. However, the disadvantages of the cost principle are its lack of accuracy. The cost principle assumes the value of assets remains the same as when you first purchase them and, if you’ve ever bought a car, you know the value of an asset can depreciate over time. Likewise, assets can appreciate over time, too. For example, if Company A invested $5,000 in Company B in 1999 and, by 2021, Company B increased its worth by 20%, this investment would have increased by $1,000. However, with the cost principle, the accounting for Company A will not take this increase into account. As you can see, this would result in skewed figures for both assets and liabilities. More and more, businesses are moving away from the cost principle, in favor of adjusting initial purchases prices to their fair values periodically. 
 
Now the going concern principle is the answer to the cost principle. The going concern principle assumes a business will continue to operate and, thus, can reasonably forestall the acknowledgment of certain expenses like depreciation. These expenses will have to be accounted for eventually, but the going concern principle offers a bit of leeway for business owners. 
 
The economic entity principle could be considered a basic business doctrine. This principle is the basis for keeping business and personal transactions separate. For tax purposes, mixing the assets and liabilities of two or more businesses is unadvised. Financial statements should reflect the independent financial state of a single business entity. In the event of an audit, messy records can lead to problems. Even a single business with multiple divisions might benefit from keeping records of expenses and revenue separate. 
 
The full disclosure principle, as you might assume, puts forth the idea it’s the responsibility of a business to provide context for financial statements where necessary. Any information which might affect how a recipient may interpret the contents of financial statements should be accompanied by clarification. Examples of full disclosure might include an explanation of a change in accounting principle, an explanation for a non-monetary transaction, or an explanation of a high volume of transactions with a single party. When financial statements are created for management purposes, full disclosure is generally not necessary. The full disclosure principle applies most often when submitting financial statements to entities outside of the business, such as the IRS. 
 
 
If you can believe it, these are only a handful of the accounting principles which govern accounting! We hope we’ve given you an easy-to-understand breakdown of these principles. In the next part of this series, we’ll continue learning about accounting principles. We’ll answer a few more of your most frequently asked questions about accounting, too! Hoods is here to make bookkeeping and accounting approachable. Since both of these practices have the ability to make or break a business, we want to make sure each small business has the very best basis for success! 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! Until next time, thank you for reading! 

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