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Diving into the bedrock of financial wisdom, we've gathered insights from top accountants on a fundamental question for business owners. From the importance of cash flow management to the importance of integrity, here are the four key accounting principles every entrepreneur should grasp, shared by professionals including a CPA and a tax specialist.
Cash Flow Management Is Essential
Matching Principle Guides Financial Accuracy
Accrual Accounting Reflects True Earnings
Integrity Ensures Accurate Financial Reporting
We believe that one of the most important accounting principles every business owner should understand is the concept of “Cash is King.” This principle highlights the importance of cash flow management, which is crucial for the survival and growth of any business, regardless of its size or industry.
Cash flow refers to the movement of money in and out of a business. It's different from profit, which can sometimes mask underlying cash flow issues. A business might show a profit on paper but still face financial difficulties if it doesn't manage its cash flow effectively. This often happens because profits are recorded when earned, not necessarily when cash is received.
Understanding cash flow is essential because it ensures you have enough liquidity to meet your financial obligations, like paying suppliers, employees, and other operational expenses. If a business can't meet its short-term liabilities due to poor cash flow management, it can lead to severe operational disruptions or even insolvency.
Experienced accountants such as ourselves play a vital role in helping businesses manage their cash flow. We prepare detailed cash flow forecasts that project future cash inflows and outflows, helping business owners plan for upcoming expenses and identify potential cash shortfalls in advance.
Creating and maintaining a budget is also essential for tracking performance against financial goals. We help our clients set realistic budgets based on historical data and market conditions, ensuring that cash flow is aligned with strategic objectives. Regular analysis of financial statements, like the balance sheet and income statement, provides insights into cash flow trends and financial health. We identify patterns and potential issues, offering recommendations to optimize cash flow.
As a technology-focused firm, we partner with a number of innovative accounting app solutions which can automate many aspects of cash flow management, from tracking and generating invoices and payments to sending payment reminders and generating real-time, custom reports.
Our clients can build their own bespoke “app stack,” choosing multiple software solutions that integrate seamlessly with one another and improve overall accuracy and efficiency. By utilizing these tools, business owners can gain better control over their finances and make data-driven decisions.
Neil Allcroft, Tax Specialist, HB&O
There are various accounting principles that underlie how accounts are prepared. Depending on what you read, there are anywhere from five accounting principles to upwards of fourteen.
Like all things I do, especially in finance, I like to keep it simple. For this reason, I focus on five which I believe cover the key accounting concepts and ensure that financial information is accurate and useful. These five principles are accruals, conservatism, historical cost, substance over form, and matching.
Of these, I believe matching to be the most important for all business owners.
Why?
It’s where most business owners who know little about finance go wrong and can easily make wrong decisions.
The matching principle states that income and costs relating to the same thing/event/item/project should be matched and accounted for in the same period. This is vitally important as there can often be a lag between costs being incurred and income being invoiced.
For example, let’s assume we are a business that repairs damaged houses for insurance purposes. Typically, what will happen is that after the work is agreed upon for a house, the contractor will carry out the work. In doing so, the contractor will incur costs—labor, materials, and possibly other subcontractors—in advance of the work being invoiced upon completion. The costs and income may therefore straddle more than one accounting period/month.
If these costs and wages are incurred in one period, e.g., June, and accounted for in that period, and then the income is accounted for in July when invoiced, this will show a completely false picture.
Why?
Well, June will show no income and all of the costs for the project, and July will show all of the income and no costs, thereby showing a loss in one month and a profit in another. If accounted for under the matching principle, a smaller profit would be shown in both months. This is why work-in-progress must be accounted for accurately at the end of every month, thereby matching the costs with the income.
Without this, wrong decisions can be made, and indeed I have seen it many times. Recently, a business contacted me stating they were going to cease trading as they were loss-making. In fact, they had significant work-in-progress that had not been accounted for, and that is why they were showing losses. When properly accounted for, the business was profitable.
Matching is essential.
Craig Alexander Rattray, Growth Strategist, Know Your Numbers
I think every business should understand the concept of accrual accounting. Basically, this means that you record an expense when you incur it and you record revenue when you earn it, even if bills aren't paid immediately. This concept makes it much easier to figure out how much money your business actually earned during the year, regardless of when the checks were cashed.
Eric Novinson, Founder, This Is Accounting Automation
Integrity is key.
This brings about honesty, good ethics, and sound business principles. I am a true believer that integrity applied to accounts that then show a true and fair value ensures that all stakeholders are receiving the correct information.
Integrity in businesses leads to perpetual growth and protection from calamities. Good will lead to a mirror of nice customers and nice suppliers. With integrity, you will pay on time, and you will not overcharge.
Within accounting, integrity will lead to the correct taxes being paid and avoid compliance breaches and fraud.
Buhir Rafiq, CPA - Accounting Practice M.D, Total Books Accountants Ltd