What Is Accounting Practice?
Accounting practice is the process and activity of recording the day-to-day financial operations of a business entity. Accounting practice is necessary to produce the legally required annual financial statements of a company. There are different accounting methods that companies can choose to use, and there are principles that companies must abide by. Generally accepted accounting principles (GAAP) refer to a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public companies in the United States must follow GAAP when their accountants compile their financial statements.
- Accounting practice is the recording of the day-to-day financial operations of a business entity necessary to produce the legally required financial statements.
- Public companies in the United States must follow GAAP in their accounting practice.
- Two popular accounting methods are cash accounting and accrual accounting.
Understanding Accounting Practices
Accounting practice is necessary so that a company can produce the annual and legally required financial statements: the income statement, the comprehensive income statement, the balance sheet, the statement of cash flows, and the statement of stockholders equity.
Various accounting methods are used by companies for their accounting practices. The two primary methods are cash accounting and accrual accounting.
For cash accounting, revenue and expenses are recorded as they are received and paid, and transactions are only recorded when cash is spent or received. For example, in cash accounting, a sale is recorded when the payment is received, and an expense is recorded only when a bill is paid. This method is the most typically used method for small businesses. However, if a business generates over $5 million in sales for the year, it must choose the accrual accounting method, according to the Internal Revenue Service.
Accrual accounting is based on the matching principle, which is intended to match the timing of the realization of revenues and an expense. By matching revenues with expenses, the accrual method gives a more accurate picture of a company's true financial position. Under the accrual method, transactions are recorded when they are incurred rather than when payment is actually made. This means a purchase order is recorded as a revenue even though the funds are not received immediately. The same goes for expenses in that they are recorded when the payment may not yet have been made.
Accounting principles are rules and concepts applied to accounting activities. GAAP refers to a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public companies in the United States must follow GAAP principles when compiling their financial statements. GAAP is a combination of authoritative standards (set by policy boards) and the commonly accepted ways of recording and reporting accounting information. GAAP aims to improve the clarity, consistency, and comparability of financial information. Some examples of GAAP principles are the following:
The Revenue Recognition Principle
This principle applies to the revenue entered on the income statement. Revenue is the gross inflow of cash and receivables of an enterprise from the sale of goods of services or the yielding of any interest, royalties, and dividends.
Historical Cost Principle
The historical cost principle requires that the price paid for an asset at the time of its acquisition is the basis for its treatment in subsequent accounting periods. If the asset is acquired at no cost, the item will not be recorded as an asset. For example, a company's reputation is a valuable asset, but it is not recorded in the accounts.
The matching principle requires that a company report an expense on its income statement for the period in which the related revenues are earned. Additionally, a liability should be entered on the balance sheet for the end of the accounting period. The matching principle is associated with the accrual method of accounting and it requires entry adjustments.
Full Disclosure Principle
According to this principle, the financial statements should convey information and not conceal it. Financial statements should disclose all relevant information. Because of the principle of full disclosure, companies append notes to their financial statements.
According to the objectivity principle, the accounting data should be definite, verifiable, and free from the personal bias of the accountant. Each transaction recorded in the accounts should have evidence to support it, for example, in the form of receipts, cash memos, or invoices.
Special Considerations for Accounting Practice
As the physical and digital worlds have integrated over time, today's accounting information systems are typically computer-based methods with special accounting software.
Accounting practices and their attached systems produce financial reports used internally by management to assess performance and for strategic planning. Financial reports are also used by external stakeholders including investors, creditors, and tax authorities. When paired with accounting practices, accounting information systems support all accounting functions and activities including auditing, financial accounting and reporting, and tax management and accounting.
Accounting practice culture often sets individual standards, behaviors, and attitudes. These ways of doing business can manifest into good and bad norms on aggregate. In the worst cases, accounting practice can lead to financial scandals. High profile scandals include Enron in 2001; Sunbeam, WorldCom, and Tyco in 2002; and Toshiba in 2015.