Ever talk to an accountant and had absolutely no idea what they were saying even though they were clearly speaking the same language as you? Most people think accounting is all about numbers, and while important, in order to be effective, accountants also need to understand the founding principles and concepts of their craft.
The terminology, concepts, and principles can seem daunting at first…and probably even after you’ve learned them, but it’s said that “knowing is half the battle,” so you have to figure out the other half on your own. So here are a couple of things to know in no particular order to seem like you’re knowledgeable about accounting.
1. The Accounting Equation: Assets = Liabilities + Owner’s Equity
The accounting equation is at the core of every financial statement you’ll see. It essentially states that a company’s assets are equivalent to its liabilities plus its owner’s equity. Breaking that down a bit more, everything a company owns such as cash, the physical building, and machinery, are all classified as assets, are made up of things that are bought by borrowing money, any recurring costs, and all other overhead costs, which are called liabilities, in addition to the owner’s investments, aka the owner’s equity.
2. Double-Entry Accounting: Recording Transactions In Two Accounts
This is a method of recording transactions in at least two different accounts to ensure accuracy and consistency. Basically, you have to write transactions in both the debit and credit accounts in a ledger, where the total of all debts must equal the total of all credits.
3. Debits And Credits: Recording Changes
Debits and credits make up double-entry accounting. Debit increases an asset account, it can decrease a liability or an owner’s equity account. Credit on the other hand does the opposite, as it decreases an asset account, while raising liabilities or owner’s equity. It’s imperative to understand the relationship between debits and credits in order to understand financial statements.
4. Accrual Accounting: Recording All Transactions
Accrual accounting is a method of recording transactions when they’re incurred, regardless of when payment is made or received. This means that expenses are recorded as they happen instead of when any form of payment is made. It also means that revenues are recorded when they’re earned instead of when payment is received.
5. The Matching Principle: Matching Expenses With Revenue
The matching principle says that expenses should match with related revenues in the same accounting period, generally this accounting period is within the same year. In a more simplified manner, when a company earns revenue, there should be a record of a related expense, even if the payment for the expense hasn’t been made yet, and it has to happen within the same accounting time frame.
6. Conservatism Principle: Choosing The Least Favorable Option
The conservatism principle seems overly pessimistic as it’s a concept that recognizes expenses and liabilities as soon as possible when the outcome is uncertain, but only recognizing revenues and assets when they’re guaranteed. This also means if there’s uncertainty about an asset, an accountant should lean towards not recording it, while if there’s uncertainty about an expense you should lean towards recording it. Having said this, it is still up to the accountant to decide what to do, using their best judgment to gauge the situation.
7. Materiality Principle: Recording Significant Transactions
This principle states that accounting standards can be ignored if the net impact of a transaction is so minute that it wouldn’t make a difference for any user of the statement. This could also be interpreted as only recording significant transactions as long as the end user isn’t misled by the information. As long as it doesn’t impact the credibility of the statement, accountants can avoid spending valuable time and money on reporting immaterial information.
8. Relevance Principle: Include Information That Impacts Decision-Making
This principle states that information that impacts the users’ decision-making process should be included in financial statements. Information that is relevant can be defined as understandable, timely, and necessary for informed decisions to be made. As a general rule, if the information bears weight on a decision, it must be included.
9. Reliability Principle: Verifiable And Accurate Information
As the name implies, this principle concerns the reliability of the financial information on a financial statement, which is made up of verifiable and accurate data. This information must be based on evidence and free from bias. The data must be useful for its users which may include auditors, managers, and stakeholders, as they will be making decisions based on the information gathered.
10. Comparability Principle: Providing Information For Comparison
This principle declares that financial statements should provide information that can be compared to other statements written from different accounting periods and from other companies as well. This means there has to be a level of standardization present in the financial statements.
The Wrap Up
These are the basic accounting concepts and principles that every non-accountant should know. By understanding these concepts, you’ll have a better understanding of financial statements and make more informed decisions when reviewing them. Doesn’t matter if you’re an entrepreneur, a junior finance associate, or just dabbling in accounting, these concepts provide a great foundation for learning more about accounting.