The 10 Most Important Basic Accounting Principles Defined

1. Economic Entity Assumption

Ever wonder why your accountant harps on you about keeping your business transactions separate from
your personal transactions? This isn’t because your business accountant wants to make their job easier
(although, yes, separate transactions definitely do help!).

The reason they won’t budge on this? The economic entity assumption principle. It basically means that
a business is an entity unto itself, and should be treated as such (which is also why this is sometimes
called the “separate entity assumption”). If you know this basic accounting principle definition, you’ll
better under the reason why your accountant insisted you open a separate business bank account when
you opened your business. This is business 101.

Even in a sole proprietorship, where your business activity appears on your personal tax return, the
economic entity assumption still applies. This is because, legally, your business can exist independently
of you. And, another plus is that this will make your life easier if you ever decide to incorporate down
the road.

2. Monetary Unit Assumption

The monetary unit assumption principle dictates all activity be recorded in the same currency. This is
why you have to go through the extra effort to complete your business bookkeeping for foreign
transactions.

Another assumption under this basic accounting principle is that the purchasing power of currency
remains static over time. In other words, inflation is not considered in the financial reports of a business,
even if that business has existed for decades.

3. Specific Time Period Assumption

An accounting balance sheet always reports information as of a certain date. Profit and loss statements,
also called income statements, encompass a date range. All financial statements have to indicate the
time period for the activity reported in order for them to be meaningful to those reviewing them.

In short: Dates are really, really important. Always check your financial statements for dates. A balance
sheet will indicate the report is “as of” or “at” a certain date. Profit and loss statements will indicate
they are for a specific date range.
4. Cost Principle

The cost principle in accounting outlines that the cost of an item doesn’t change on the financial
reporting. So, even if you’ve bought something within the year that’s skyrocketed in value—let’s say a
building, for instance—even though its relative market value has changed, accountants will still always
report the asset at the amount for which it was obtained.

Knowing this basic accounting principle definition teaches something pretty important for small business
owners in general: It’s important not to confuse cost with value. The value of things does change over
time, and this is reflected in the gain or loss on sale of assets as well as in depreciation entries. If you
need a true valuation of your business without selling off your assets, you’ll need to bring in an expert in
business valuations rather than relying on your financial statements.

5. Full Disclosure Principle

The full disclosure principle is the generally accepted accounting principle that grabs the most headlines.
Under this basic accounting principle, a business is required to disclose all information that relates to the
function of its financial statements in notes accompanying the statements. This principle helps make
sure stockholders and investors are not misled by any aspect of the financial reports.

6. Going Concern Principle

Also referred to as the “non-death principle,” the going concern principle assumes the business will
continue to exist and function with no defined end date. Knowing this basic accounting principle will
help you understand why you defer the recognition of expenses to a later accounting period. If an
accountant is concerned the business might be forced to liquidate, they have to disclose this under
GAAP principles.

7. Matching Principle

For tax purposes, many small businesses choose to operate on a cash basis, meaning revenue is
reported when cash is received and expenses are reported when cash is spent (or when your business’s
credit card is charged). But, many businesses are required to report all financial information on an
accrual basis, largely due to the matching principle.

Under the matching accounting principle, sales and the expenses used to produce those sales are
reported in the same accounting period. These expenses can include wages, sales commissions, certain
overhead costs, etc.
Even if your tax return is on a cash basis, your accountant might prepare your financial reports on an
accrual basis. Accrual basis reports reflect the matching principle and provide a better analysis of your
business’s performance and profitability than cash basis statements.

8. Revenue Recognition Principle

Under the accrual basis of accounting, revenue is reported when it’s earned, regardless of when
payment for the product or service is actually received. Similar to the matching principle, the basic
accounting principle of revenue recognition accurately reports income, or revenue, when the sale was
made, even if you bill your customer or receive payment at a later time.

9. Materiality

The materiality principle is one of two basic accounting principles that lets the accountant use their best
judgment in recording a transaction or addressing an error.

We often see the materiality principle at play when an accountant is reconciling a set of books or
completing a tax return. If the account is off by a relatively small amount in relation to the overall size of
the business, the discrepancy may be deemed immaterial. Immaterial discrepancies can be disregarded,
but material discrepancies must be addressed. Similarly, immaterial expenses can be recognized at the
time of purchase, but material expenses must be depreciated over time.

It’s important here for the accountant to be empowered to use their professional opinion. Since
businesses come in all sizes, an amount that might be significant—or material—for one business may be
insignificant—or immaterial—for another.

10. Conservatism

The principle of conservatism is the other principle that lets the accountant use their best judgment in a
situation. When there’s more than one acceptable way to record a transaction, the principle of
conservatism instructs the accountant to choose the option that’s best for the business they’re working
with.

It’s important to understand this basic accounting principle is only invoked when either way the
accountant can record the transaction is acceptable. It doesn’t allow the accountant to completely
disregard other accounting principles.
How These Accounting Principles Will Improve Your Relationship with Your Accountant

So, not every business is required by law to comply with GAAP. However, most accountants will insist on
following them, regardless of whether your business is bound by law to comply with GAAP. And as your
business tax deadline approaches, we can imagine the idea of getting an audit is incredibly scary—so
adherence to these basic accounting principles ensures there’s never a question about the integrity of
your financial statements.

Also, think of these principles like a language. You may not work with the same accountant or
bookkeeper throughout your business’s entire lifetime, but understanding these principles will help you
communicate with whoever is in this position, as you’ll always understand the language they speak, the
decisions they make, and why.

All in, understanding the basics of these accounting principles will help demystify some of those
requests your accountant makes, or help you understand why a process is set up as it is. Plus, you’ll be
armed to identify when something seems amiss in your financial records, so you can address issues as
they arise rather than when they become insurmountable.

Accounting formulas should be next on your checklist for understanding the inner workings of
accounting.