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Every business that’s based in the US needs to comply with Generally Accepted Accounting Principles. These are a set of commonly used business accounting principles that are recommended by the Financial Accounting Standards Board (FASB).
Businesses are expected to comply with these rules so there can be general consistency, clarity, and easy comparability between financial information from different organizations.
Similarly, the set of rules followed across the European Union is referred to as the ‘International Financial Reporting Standards,’ also known as IFRS.
In this post, we will highlight some common accounting principles that are crucial to your business:
The Matching Principle
This matching principle is at the heart of adjusting entries and accrual accounting. According to the matching principle, a company must record an expense in its books in the same period as which the related revenue transaction was recorded. However, if there is an expense category that does not relate to revenue that is already recorded, it no longer falls under the provisions of the matching principle. In this case, the expense will be recorded in the same time period when it was incurred.
A classic example of the matching principle is how companies deal with the cost of goods sold. This expense is always matched with sales in a specific period; the two have a cause-and-effect relationship.
Revenue Recognition Principle
The revenue recognition principle is an important provision of GAAP; it lays down conditions for recognizing revenue and how to account for it. In most cases, revenue is very easy to recognize. Companies typically record revenue whenever a sales transaction takes place—when the customer pays for a service/product.
However, according to the GAAP revenue recognition policy, companies must report revenues irrespective of the cash collection, that is, the moment the sale is made. When the cash is later collected, it can be accounted for with the help of the relevant adjustment entries.
According to Investopedia, the revenue recognition policy should ideally be the same throughout the industry for standard accounting practices. Even within a company, the policy should remain consistent throughout the years. This is to avoid inconsistencies or the emergence of seasonal trends when the accountant analyzes historical finances.
According to the cost principle, the cost of an item should not change in the financial statements. This is why this principle is also known as the historical cost principle.
Each time you account for an asset, it must be recorded at the initial cash value at which it was acquired. This cost is also known as the historical cost of the asset. According to this principle, you must not account for the asset based on improved market value or inflation-adjusted value.
The historical cost is important for a number of reasons. When the market value of an asset appreciates, it often results in misreporting and impairs comparability. This may make your accounting data less reliable.
Any appreciation or depreciation in values is then adjusted in separate accounts. This principle usually applies to fixed assets.
Time Period Assumption
Time period assumption is also known as period assumption or accounting time period assumption. This principle requires the accountant to divide the life of their business into equal and pre-defined time periods. All the internal and external financial statements must then be prepared based on these time periods.
The exact length of the accounting period depends on the individual requirements and nature of the business and how often the business requires the financial statements to be spaced out.
In most cases, the accounting period is either four months, six months, or a year—in other words, quarterly, bi-annually, and annually. Setting the time period is important because it gives the company a framework to measure and analyze its performance. Businesses can use this time period to further evaluate their performance and compare their returns across several periods.
The good news is that each of the above-mentioned business accounting principles can be adhered to with accounting software like QuickBooks. QuickBooks helps you stay on top of your financial and accounting compliance. Other than that, QuickBooks is easy-to-use, secure, and highly customizable to suit your business needs and size.