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principle states that amounts in your accounting system should be quantified, or measured, by using historical cost. If you have a business and the business owns a building, that building – according to the cost principle – shows up on your balance sheet at its historical cost. You don’t adjust the values in an accounting system for changes in a fair market value. You use the original historical costs.
Objectivity principle
The objectivity principle states that accounting measurements and accounting reports should use objective, factual, and verifiable data. In other words, accountants, accounting systems, and accounting reports should rely on subjectivity as little as possible.
An accountant always wants to use objective data (even if it’s bad) rather than subjective data (even if the subjective data is arguably better). The idea is that objectivity provides protection from the corrupting influence that subjectivity can introduce into a firm’s accounting records.
Continuity assumption
The continuity assumption – accountants call it an assumption rather than a principle for reasons unknown to me – states that accounting systems assume that a business will continue to operate. The importance of the continuity assumption becomes clear if you consider the ramifications of assuming that a business won’t continue. If a business won’t continue, it becomes very unclear how one should value assets if the assets have no resale value. This sounds like gobbledygook, but think about the implicit continuity assumption built in to the balance sheet for the hot dog stand at the beginning of the day. (This is the balance sheet that shows up in Table 1-4 earlier in this chapter.)
Implicit in that balance sheet is the assumption that hot dogs and hot dog buns have some value because they can be sold. If a business won’t continue operations, no assurance exists that any of the inventory can be sold. If the inventory can’t be sold, what does that say about the owner’s equity value shown in the balance sheet?
You can see, I hope, the sorts of accounting problems that you get into without the assumption that the business will continue to operate.
Unit-of-measure assumption
The unit-of-measure assumption assumes that a business’s domestic currency is the appropriate unit of measure for the business to use in its accounting. In other words, the unit-of-measure assumption states that it’s okay for US businesses to use US dollars in their accounting, and it’s okay for UK businesses to use pounds sterling as the unit of measure in their accounting system. The unit-of-measure assumption also states, implicitly, that even though inflation and occasionally deflation change the purchasing power of the unit of measure used in the accounting system, that’s still okay. Sure, inflation and deflation foul up some of the numbers in a firm’s financial statements. But the unit-of-measure assumption says that’s usually okay – especially in light of the fact that no better alternatives exist.
Separate-entity assumption
The separate-entity assumption states that a business entity, like a sole proprietorship, is a separate entity, a separate thing from its business owner. Also, the separate-entity assumption says that a partnership is a separate thing from the partners who own part of the business. This assumption, therefore, enables one to prepare financial statements just for the sole proprietorship or just for the partnership. As a result, the separate-entity assumption also relies on a business to be separate, distinct, and definable compared with its business owners.
A Few Words about Tax Accounting
I’m not going to talk much about tax accounting or tax preparation in this book, but one of the key reasons why you do accounting and use a program such as QuickBooks is to make your tax accounting easier. That’s obvious. So a fair question is this: How does what I’ve said so far relate to income tax return preparation?
This question is a tough one to answer. Tax laws typically don’t map to generally accepted accounting principles. Generally accepted accounting principles aren’t the same thing as income tax law. If you use good basic accounting practices as you operate QuickBooks, however, you get financial information that you can use to easily prepare your tax returns, especially if you get some help from your certified public accountant (CPA).
If you want, you can also use income tax rules to fine-tune your accounting and bookkeeping. This practice, which is technically known as an other comprehensive basis of accounting (OCBOA), is generally considered to be an appropriate way to perform accounting for small and medium-size enterprises.
Chapter 2
Double-Entry Bookkeeping
IN THIS CHAPTER
❯❯ Checking out the fiddle-faddle method of accounting
❯❯ Grasping how double-entry bookkeeping works
❯❯ Looking at an (almost) real-life example
❯❯ Figuring out how QuickBooks helps
The preceding chapter describes why businesses create financial statements and how these financial statements can be used. If you’ve read Book 1, Chapter 1, or if you’ve spent much time managing a business, you probably know what you need to know about financial statements. In truth, financial statements are pretty straightforward. An income statement, for example, shows a firm’s revenue, expenses, and profits. A balance sheet itemizes a firm’s assets, liabilities, and owner’s equity. So far, so good.
Unfortunately, preparing traditional financial statements is more complicated and tedious. The work of preparing financial statements – called accounting or bookkeeping – requires either a whole bunch of fiddle-faddling with numbers or learning how to use double-entry bookkeeping.
In this chapter, I start by describing the fiddle-faddle method. This isn’t because I think you should use that method. In fact, I assume that you eventually want to use QuickBooks for your accounting and, by extension, for double-entry bookkeeping. But if you understand the fiddle-faddle method, you’ll clearly see why double-entry bookkeeping is so much better.
After I describe the fiddle-faddle method, I walk you through the steps to using and understanding double-entry bookkeeping. After you see all the anguish and grief that the fiddle-faddle method causes, you should have no trouble appreciating why double-entry bookkeeping works so much better. And I hope you’ll also commit to the 30 or 40 minutes necessary to learn the basics of double-entry bookkeeping.
The Fiddle-Faddle Method of Accounting
Most small businesses – or at least those small businesses whose owners aren’t already trained in accounting – have used the fiddle-faddle method. Take a peek at the financial statements shown in Tables 2-1 and 2-2. If you’ve read or reviewed Book 1, Chapter 1, you may recognize that these financial statements stem from the imaginary hot-dog-stand business. Table 2-1 shows the income statement for the one day a year that the imaginary business operates. Table 2-2 shows the balance sheet at the start of the first day of operation.
TABLE 2-1 A Simple Income Statement for the Hot Dog Stand
TABLE 2-2 A Simple Balance Sheet for the Hot Dog Stand
With the fiddle-faddle method of accounting, you individually calculate each number shown in the financial statement. The sales revenue figure shown in Table 2-1, for example, equals $13,000. The fiddle-faddle