When many people think of small business accounting, they think “boring.” They picture an emotionless drone in a poorly lit room entering numbers into a dusty journal or perhaps an outdated computer. It is the antithesis of marketing and sales, which is considered the “sexy” part of business.
While accounting may not be the most exciting area of business, it is certainly far removed from the caricature that many portray. Accounting involves critical thinking and strategic decision-making and can have a tremendous impact on the current and future success of your business.
Conservative Choices in Accounting:
Generally Accepted Accounting Principles “GAAP”
Generally accepted Accounting Principles, known as “GAAP,” represent the policies, standards, conventions and rules used by accountants to record financial accounting transactions and to prepare financial statements. GAAP is extensive and covers many complex areas of accounting. The Securities and Exchange Commission (“SEC”) has the authority to establish GAAP in the United States. The SEC, however, usually delegates the establishment of GAAP to the private sector. Since 1973, the Financial Accounting Standards Board known as “FASB” has been granted this authority. Prior to FASB, The Accounting Principles Board (and before them the American Institute of CPAs) had this authority.
Conservative Versus Liberal Accounting Policies
For the record, this has nothing to do with politics! Whether a company tends to implement conservative or liberal accounting policies doesn’t provide a clue as to who the owners vote for in elections. The difference arises in the choices that businesses make when choosing between different GAAP alternatives. In many cases, there is more than one valid way to account for a financial transaction and still comply with GAAP. Conservative versus liberal in an accounting context refers to the impact that these choices between valid GAAP alternatives have on a company’s earnings.
Conservative accounting choices tend to result in lower current reported earnings. Liberal accounting choices tend to result in higher current reported earnings.
It’s in the Timing
The difference between conservative and liberal accounting choices comes down to timing – when do you recognize revenues and expenses.
With conservative accounting choices, revenues tend to be recognized later and expenses tend to be recognized sooner. This decreases your current revenues and increases your current expenses. This has the effect of lowering your current reported earnings.
With liberal accounting choices, revenues tend to be recognized sooner and expenses tend to be recognized later. This increases your current revenues and decreases your current expenses. This has the effect of increasing your current reported earnings.
Over the long-term, however, these differences tend to reverse. There is no free ride. If you use liberal accounting polices, this will boost your current earnings at the expense of future earnings. Conservative accounting policies provide higher earnings in the future, but you have to settle for lower earnings now.
Areas Where Small Businesses Make Accounting Choices
Below are five key areas where companies choose between conservative and liberal accounting policies. The selection of choices below is restricted based on the particulars of the transaction which goes beyond the scope of a single article. Each area will be addressed in detail in future articles. Keep this in mind.
Go to the article: Making Conservative Choices in Accounting
