As a small business owner, you wear a lot of hats. You’re managing operations, raising money from investors, generating sales and building brand awareness all at once—and with limited resources. You’re probably time-poor and if you’re not a numbers person, it may be tempting to outsource your accounting as soon as your budget allows. However, as the business owner, you need to have a finger on the pulse of operations and an intimate understanding of how your numbers impact the business. Unless you’re great at communicating with your accountant or have already managed the books for long enough to understand the financial side of the business, accounting is one thing you should keep in-house.
If you’re new to accounting, there are a few standards and procedures you should know. Generally Accepted Accounting Principles (GAAP) are essentially the commandments you need to live by while managing your books. These principles are the framework professional accountants use and will help you as you begin to compile your reports. While this list doesn’t cover all the rules and principles, it does go over those which may be most pertinent to you as an entrepreneur. Here is our list of eight basic accounting principles for small business owners:
Separate Entity Assumption
It’s important to keep your business transactions separate from your personal transactions. Even if you’re operating as a sole proprietor, your business accounting and personal accounting should be done separately for legal purposes. When you need to go back and review old expenses,—and you certainly will at one point or another—keeping the two worlds clearly divided will work out in your favor.
Basically, this assumption dictates that your business’ domestic currency is the currency you need to use as a unit of measurement. For example, if you operate using U.S. Dollars and receive payment in Euros, Yen, Pesos or any other currency, you should calculate the exchange rate and record payment in U.S. Dollars.
Time Period Assumption
You can—and should—split up your accounting activities into smaller, defined periods of time. As the business owner, you need to set the intervals by which you will compile and report on your data. Whether you choose to track operations on a weekly, monthly or quarterly basis, your reports should show your defined intervals so they can be easily referenced in the future. For example, the heading of your cash-flow statement would read, “Week Ending Saturday, June 11, 2015” and would contain all cash flow activities for that week.
Revenue Recognition Principle
The revenue recognition principle says that you should record revenue when the revenue is earned, regardless of when you actually receive payment. For example, let’s say you sell your product in May with a net-60 day invoice term. You’ll recognize the revenue in May even though you may not see a check until June or July.
Similarly, if payment is received in advance of revenue being earned, it should not be recognized until the earning event. For example, if your business is a SaaS model where a customer purchases a year-long subscription for services in one lump sum, the revenue should be recognized over the term of the service; that is, 1/12 of the lump sum each month over the 12-month contract in this case.
The expense principle is essentially the reverse of the Revenue Recognition Principle above. It says that an expense incurred will be recorded when the purchased goods or services are received and used, regardless of when that expense is paid. For example, if you hire a temp for your business, the expense of that temp should be recorded starting on the first day of their service. It doesn’t matter that you’ll likely receive and invoice and pay their agency later in the month. On the flip side, you could make a large purchase such as an expensive new printer, and recognize the cost of that item over the useful life of the printer.
The matching principle dictates that business owners should match revenue with incurred expenses at the time of a sale.
Think about it this way: You’re an ice cream company and you purchase all the raw goods to make a large batch of ice cream. In one week you sell 1,000 pints. For that week, you’ll match the expense of making those 1,000 pints with the revenue you received from selling them.
As another example, you’ll want to match sales commission expenses during the period in which the sales were made, not when the commissions were actually paid out.
The Cost Principle
Generally, the amounts recorded on your books should be recorded at the original purchase price. For example, a computer will be carried on your balance sheet as an asset—recorded at the price for which you bought it. You would not record the original price of the item if you happened to purchase it on sale. Record a purchase at the actual dollar amount you spent. Any asset—like a building—whose value fluctuates based on the market, will always be recorded at the historical price.
Another example of this that is particularly important if you’re growing your business using venture capital is how you think about equity. Equity should be carried based on the historical amount invested, not the adjusted value of the company. Some items are required to be carried at fair value, the rules for which can get quite complex.
There are a few loopholes to the principles listed above. If you’re a large, corporate business, you may not need or want to recognize the cost of a printer over time. You’d probably rather record it all in one lump sum on the day you received it. The materiality principle allows business owners to choose not to apply specific rules if the result is not materially different than that which would be required under the rules. Generally, it’s good practice to adhere to the guidelines as outlined, but there will likely be a few exceptions based on the relative size of your business.
GAAP in the United States is a complex set of guidelines, and there may be specific rules which contradict these high-level guidelines. It is always prudent to consult an accounting or legal professional for conclusions based on the facts and circumstances of your business and the transactions executed.