You’ve started a small business, and it’s going well. At least, you think it is. You look at your Accounts Receivable and see that you have a couple of payments outstanding. You look at your Accounts Payable and see that there are bills coming up. Wait, have you made a profit or not?
It’s at this point when most small businesses hire an accountant, virtual bookkeeper or a part-time financial controller to explain what’s going on in your business and advise you on expenditures. Chances are that any of these people will apply a set of principles known as GAAP, or General Approved Accounting Practices to the task for which you’ve hired them.
In fact, you should insist upon it, and here’s why:
- Following these principles gives you, the business owner, a more accurate picture of your finances.
- If you should be audited, your books must be in order and following these practices set the path for a favourable outcome, not to mention that it’s easier to follow them all along than to reconstruct your books after the fact.
- If you should require a loan or an infusion of investment capital, it will be imperative in the application process.
Now that you’re convinced of the prudence in having your accountant follow GAAP, what exactly are the principles? There are several, but four are held to be inviolate:
Cost Principle
The first is that purchases are recorded at their actual cost, rather than at market value. This ensures more accurate accounting and lessens the potential for market fluctuations to interfere with accurate accounting.
Revenue or Accrual Principle
The second is that revenue be reported when it is earned, rather than when it is received. This principle is not as easily understood, however, its purpose is to show work that has been completed, not future work.
Matching Principle
An expense must be reported in the same accounting period as the revenue associated with it. This should be self-explanatory, and will avoid the scenario above where the business owner is unsure whether a profit was made on a particular revenue-producing event.
And finally,
Disclosure Principle
If any of the four principles we’re discussing is more important than another, this one could be considered the most important. It states that all relevant financial information should be disclosed in a company’s books. More business owners have found trouble by violating this principle than any other. Even if honesty weren’t a consideration, how can you make sound financial judgments about your own business if relevant information is missing? For the purposes of audit, investment or applying for a business loan, it cannot be emphasised too strongly.
Having your books in good order will assist in many aspects of your business, not the least of which is acquiring operating capital through a small business loan on a timely basis.
We hope you have enjoyed the first of our Business Basics Articles and will be looking forward to more.