Accounting Principles - The Fundamentals For All Small Business

Ever wondered why some small businesses hit a roadblock and struggle to stay afloat? It often boils down to one thing – “the numbers”. You know, keeping tabs on the money spent, understanding where they stand financially – the whole accounting shebang. For many, accounting can feel like staring at a mountain when you've only got climbing shoes for a hill.

Many entrepreneurs grapple with the same challenge. Accurate recording of transactions feels like decoding hieroglyphics, reading financial statements seems like deciphering an ancient manuscript, and decision-making from the numbers side of things…hmm… well, that's a whole new adventure.

Often, the issue is the lack of accounting savviness. This leads to procrastination, confusion, and errors in the financial aspect of their operations. I’m not going to sugarcoat it. Accounting isn't a walk in the park. It can be as tricky as trying to figure out what's under the hood of a car for a novice like me. Many times, I wish the mechanic would just get to the point and resist trying to confuse me more. This is not my intent here. I’m going to keep it basic, no unnecessary jargon, just what you need to take you from point A to B in your accounting journey for your business.

First and foremost, we need to cover the fundamental terms. These terms will be the building blocks of understanding your business transactions; in most cases, it is referred to as “The Principles of Accounting.”

Business Entity Principle

Kicking things off with the "business entity principle." This principle is a fundamental starting point, and it's pretty straightforward. Essentially, it means treating your business as a separate entity, whether you're a solo entrepreneur or running a limited liability company.

Here's the deal, every transaction related to the business needs to be recorded. Transactions that are strictly personal and have no impact on the business are irrelevant in your business books. However, if you ever dip into the business resources for a personal transaction, that's a game-changer and as such it must be recorded.

Let’s say you decide to treat yourself to a new car. If the money for that car comes from your personal funds and not a dime from the business, you're in the clear and there is no need to jot it down. But, and here's the twist, if you use the business funds to snag that same car or, vice versa, use your personal funds to cover a business expense, you've got to get it down in the records.

In a nutshell, any transaction, whether it's 100% for the business or straddles the line with your personal life, needs a spot in the record books.

Going Concern

This principle I refer to as the "can-the-business-continue-to-exist test."

At some point, you will hear your investors, accountants, and potential partners say or ask the question if the business is a going concern. What they are essentially asking is, "can our business keep on keeping on or is the business financially sustainable”? The financial reports you will prepare for your business will operate on the assumption that it's here to stay for the foreseeable future, with no plans to shut it down or throw in the towel.

This is precisely why recording all business transactions is paramount. It helps avoid uncertainties stemming from inconsistent revenue, unsteady cash inflow, or an over-reliance on short-term credit finance. It makes sense to consider the going concern principle as a health check for your business, ensuring it's not just surviving but thriving.

Historical Cost

For every transaction recorded, there's a key rule – it needs a clear, agreed-upon monetary value. That value is often the historical cost of the transaction, meaning the original cost when the deal went down. This cost is the go-to number you'll find in your books.

Let's say you purchased a laptop for your operations.  The exact amount you paid when you first got your hands on the new tech becomes the cost listed in your financial records.

Accrual Concept

In the realm of the accrual concept, timing is everything. It's all about capturing transactions as they happen, not just when the cash is in play.

Generally, transactions should find their place in the books when they're incurred, not necessarily when your wallet sees the light of day. Let's take insurance, for example. You may pay your premium well in advance, long before you enjoy the coverage. Similarly, a supplier might grant credit, allowing you to grab the goods before settling the bill.

The catch here is that the moment cash exchanges hands might not align with when the transaction unfolded. Recording it on the date or period it occurred gives a more accurate snapshot of your financial standing.

It's worth noting that some businesses opt for the cash method, where transactions are only logged when cash changes hands. The drawback, however, lies in the risk of incomplete and misstated accounts.

Dual Aspect Concept

The dual aspect concept, also known as "double-entry accounting," is the linchpin for ensuring precision and completeness in recording transactions.

Every transaction has two sides – debit and credit. These two aspects are like partners, always moving in sync. For every debit, there must be a credit and the total debits must equal the total credits for each transaction.

For example, when you make a cash sale, the sale is recorded as both revenue (credit) and an increase in cash (debit). These dual aspects – credit for the revenue and debit for the cash – create a balance in your books.

Other Concepts - Prudence, Consistency, and Materiality

As you navigate your business operations, the principles of prudence, consistency, and materiality play vital roles in sound record-keeping.

Being prudent is all about exercising objective judgment in your transactions. For instance, if there's uncertainty about the collectability of a receivable, a prudent approach may involve recognizing potential losses.

Consistency means using the same accounting methods and principles consistently over time. When you're consistent, your financial statements become comparable and provide a reliable snapshot of your business's performance. Whether it's inventory valuation or depreciation methods, sticking to a chosen approach ensures reliability.

Materiality is about focusing on what truly matters. In the context of record-keeping, it's understanding that not every detail needs the same level of attention. Materiality allows you to prioritize significant transactions or events, ensuring that your records capture the essential aspects without getting bogged down in minutiae. While precision is vital, focusing extensively on this minor detail might distract you from more significant financial considerations.

Each entry in your financial records is not just a number; it's a narrative, telling the story of your business journey.

Try not to become overwhelmed by accounting principles, see them as your helpful guide. Let these principles give you the power to understand your business finances better. Use them to make smart decisions that shape where your business is going. They're not just rules; they're tools to make your business journey smoother.

The views reflected in this newsletter are those of the author and do not necessarily reflect those of Aegis Business Solutions, its partners, or any affiliated companies.

Found value? Share with friends. Stay tuned for more basic bookkeeping nuggets in the next article. Feel free to suggest future topics. Until next time. Cheers to your ongoing success 😊