Understanding GAAP
In the world of business finances, the Generally Accepted Accounting Principles (GAAP) are a set of rules and guidelines that companies use during the financial reporting process. GAAP helps companies prepare their financial statements in a consistent and accurate way. This means that all companies follow the same rules when recording their income, expenses, assets, liabilities, and equity.
Why is GAAP important? Well, it makes it easier for people to compare and understand financial information from different companies. For example, if you’re a potential investor, you can look at the financial statements of two companies and see if they’re doing well or not.
GAAP also ensures that companies are transparent and honest with their financial reporting. Companies must disclose important information in their financial statements, like how much they owe to others or how much money they make from sales. This helps investors and other users of financial statements understand the business’s financial position and make informed decisions.
Another important thing is the timing of when companies record their transactions. GAAP provides guidelines for when and how companies should record their income and expenses. This helps ensure that financial statements are accurate and reliable.
When companies follow the same rules, disclose important information, and record their transactions correctly, it is easier for investors and others to understand and make decisions based on a company’s financial information.
Who Uses GAAP?
Publicly traded companies (public companies) are businesses that sell shares of their stock to the public – like Tesla, Microsoft, Amazon, and Google – to name a few. They are required by law to follow GAAP accounting practices. This is because they have many shareholders who invest in their company, and these shareholders need accurate and reliable information to make informed decisions about buying or selling the company’s stock.
Private companies, on the other hand, are not legally required to use GAAP. However, many private companies still choose to follow these accounting principles. And we’ll learn why in the next section.
Government entities like city governments or state agencies also use GAAP. Because they handle public funds, they must show how they use taxpayers’ money. GAAP helps ensure that government financial statements are transparent and accurate, allowing citizens to see how their money is being spent.
Why Is GAAP Important for Startups?
Following Generally Accepted Accounting Principles is vital for businesses, investors, and the public. GAAP helps ensure:
Trustworthiness of Financial Statements
One of the cornerstones of business is trust. Investors, creditors, and other stakeholders rely heavily on a company’s financial statements to make informed decisions. And reliable financial statements provide a clear picture of a company’s financial situation. By adhering to GAAP and having auditors check the accounting records, startups can reduce the risk of mistakes in their statements and ensure that their financial data is reliable and trustworthy, which in turn, helps build relationships with stakeholders.
Standardization Across Businesses
Imagine having to learn a new language every time you visit a different city. Confusing, right?
It’s easier when everyone speaks the same language and follows the same rules. That’s standardization, and it’s what makes it possible to understand and compare the financial statements of different companies. GAAP ensures that all companies follow the same assumptions and rules when preparing their financial statements and creates a level playing field that makes benchmarks meaningful.
Financial statements that comply with GAAP help investors and other stakeholders understand how the business is doing and make sound investment decisions.
Regulatory Compliance
No startup wants to wade through the murky waters of legal complications. Adopting GAAP can act as a protective shield, ensuring that a company meets all legal and regulatory requirements and thereby avoiding potential financial penalties.
Many people have heard about companies like Enron, WorldCom, and AIG, or individuals like Bernie Madoff, who got in trouble with the Securities and Exchange Commission (SEC). But you may not know why.
The Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) are responsible for setting and enforcing accounting standards – GAAP. And the companies and individuals listed above failed to comply with GAAP.
Besides the SEC and FASB, there are also organizations that influence GAAP, such as the American Institute of Certified Public Accountants (AICPA) and the Governmental Accounting Standards Board (GASB). These organizations provide guidance and recommendations on accounting principles and practices.
It’s important to note that GAAP differs from the International Financial Reporting Standard (IFRS) and the International Accounting Standards Board (IASB). While GAAP applies to businesses in the United States, IFRS applies in many other countries. Even though there are some similarities between the two, there are also differences in certain accounting rules and standards.
Guided Decision Making
The financial choices a startup makes are instrumental in defining its future. GAAP acts as a compass, providing a consistent frame of reference to understand the financial implications of operational decisions.
One principle within GAAP that contributes to guided decision-making is the Principle of Prudence. This principle ensures that accountants present financial information based on concrete facts and avoid speculation. By being cautious and conservative in their reporting, accountants provide a more accurate picture of the company’s financial situation. This helps businesses make decisions that are grounded in reality rather than assumptions.
Attracting Investments
For startups, securing investments can be the difference between success and stalling. When a startup adheres to GAAP, it signals to potential investors a commitment to financial transparency, professionalism, and sound business practices. This can be the very factor that tips the scale in favor of an investment.
Key GAAP Concepts Startups Should Know
Without getting too in-depth, let’s look at some essential GAAP concepts that every startup should be familiar with.
1. Accrual Accounting:
One important GAAP concept is accrual accounting. There are two main methods of accounting for business: cash-based accounting and accrual accounting.
With cash-based accounting, a business records money when it is received or paid. But with accrual accounting, companies record their financial transactions when they are earned or happen, regardless of when the funds are received or paid. It’s like booking a hotel room or ordering a pizza for delivery; you’re charged the moment you reserve or place an order instead of when you check out or receive your pizza.
Accrual accounting helps businesses track their income and expenses more precisely. By recording money when it is earned, companies can better understand how much money they are making over a specific time period. This allows them to plan and make smarter financial decisions.
2. Consistency Principle
The Consistency Principle helps ensure things are done the same way every time – using the same methods and practices when recording financial information. So, for example, if a business uses a particular method to record income and expenses one year, the same method should be used the next year too. This prevents any “creative” changes that could skew financial results.
Stakeholders like investors, banks, or potential business partners typically want to compare a company’s financial performance from one period of time to the next. For example, a lender will want to see how much money a business has made or how much it has spent over a certain period of time.
With consistent information, accurate comparisons are possible.
3. Materiality
Ever heard the saying, “Don’t sweat the small stuff?” In accounting, materiality determines what’s ‘small’ or ‘big’ enough to matter. It helps accountants determine what financial information should be included in a report. If a piece of financial information could impact a stakeholder’s decision, it’s material and must be reported.
Let’s look at an example.
A fixed asset is a tangible piece of property, plant, or equipment (PP&E) that a business owns or manages with the expectation that it will continue to help generate income over its useful life. In most cases, fixed assets are subject to depreciation, which is reported on financial statements.
For this example, let’s assume you own a plumbing business and purchase a pipe wrench for $120.
The pipe wrench is a tangible piece of equipment that will help your business generate income, technically making it an asset. But, because the cost of the pipe wrench is so low, the amount of depreciation to be reported would be negligible. In this case, a business could simply record the pipe wrench purchase as an expense in the year it was purchased rather than as an asset with depreciation over its useful life of 10 years.
4. Going Concern
Startups operate on the assumption that they will continue to exist and stay in business for a while. The ‘Going Concern’ principle embodies this belief unless substantial evidence points toward potential closure.
As a result, when preparing financial statements, accountants assume that a business will continue to operate for at least the next year. And this assumption allows them to defer or spread out some expenses over time.
Deferring expenses helps give a more accurate picture of the company’s financial health. For example, businesses experiencing or planning for growth often invest significantly in equipment and possibly facilities for their expansion. If these expenses are reported in the year they occur, it can give the impression that a company suffered a substantial financial loss.
However, deferring the cost over the equipment’s useful life instead of recording it all at once makes it clear that the expenses are part of normal operations or growth instead of poor business decisions.
Under GAAP, businesses must disclose any concerns about their future viability. If a company is worried it might not be able to keep going, it has to let everyone know in its financial reports. This disclosure is necessary because it can significantly impact investors, lenders, and other stakeholders.
5. Full Disclosure Principle
Transparency is the name of the game. If there’s any financial information, risks, or uncertainties that stakeholders should know about, the full disclosure principle ensures it’s out in the open, either in the financial statements or the accompanying notes.
In other words, full disclosure means businesses must show and explain all the important details about their operations and financial records. By disclosing all the crucial facts, like how much money the company makes and how they spend it, investors and regulators can understand how well the business is doing.
Accountants play a significant role in following this principle. They make sure to include everything in the financial documents or accompanying notes.
6. Cost Principle
The Cost Principle comes into play with asset valuations when determining a company’s net worth. Net worth is an organization’s total assets minus total liabilities. And in general, there are many ways to define the value of assets. If you have purchased a home, you’re familiar with appraised value. If you’ve sold or purchased a car, you’re familiar with fair market value.
But when it comes to accounting, the cost principle says that we should use the asset’s original price (purchase price).
Here’s why. Market values fluctuate. That car you purchased 10 years ago doesn’t have the same market value today.
Using the original purchase price as the value of an asset makes it easy to compare a company’s net worth from one year to the next by offering a clear and unambiguous value for financial reporting. This helps keep financial records consistent and fair.
The Cost Principle also says that the cost of providing financial information should be less than the benefit we get from it. This means accountants should ensure it is not too expensive to create financial documents and reports. It’s essential to balance the cost with the benefits we get from having this information.
Following the Cost Principle helps us understand how much money a company spent on something and how much it is worth.
Components of a GAAP-Compliant Financial Statement
Financial statements help us understand how much money a company makes and spends, how much it owes, and how much it owns. GAAP ensures that the statements are accurate, consistent, and reliable.
A set of GAAP-compliant financial statements has three main components: the income statement, the balance sheet, and the cash flow statement.
The income statement shows how much revenue the company earned and expenses incurred during a specific period of time and can be used to calculate its net income or net loss. One important aspect of GAAP-compliant Income Statements is that they use the accrual basis of accounting. This means that revenue and expenses are recorded when earned or incurred rather than when the money changes hands. This helps to provide an accurate picture of the company’s financial performance, even if payment for goods or services has yet to be received or paid.
The balance sheet shows the company’s assets, liabilities, and shareholders’ equity. Balance sheet statements provide a snapshot at a specific point in time. The balance sheet helps us understand the net worth of a business.
The cash flow statement shows how the company’s cash position changed during the reporting period. By looking at the Cash Flow Statement, we can see the sources and uses of cash. Additionally, it can help us determine if the business has enough money to pay its bills and can generate enough cash to keep running smoothly. This is called liquidity. When a company has good liquidity, it means it has enough money to keep going.
Conclusion
GAAP isn’t just a set of complicated financial guidelines that public companies must follow. For startups, it’s a roadmap to trustworthiness, transparency, and sustainable growth. As the financial world evolves, the foundational pillars of GAAP remain steady, guiding startups toward success. To all budding entrepreneurs, it’s worth investing time and resources in understanding and implementing GAAP—it could very well be your ladder to success.
Further Reading
For those keen on delving deeper into GAAP for startups, check out these resources.
Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports by Thomas Ittelson.
Financial Intelligence for Entrepreneurs by Karen Berman and Joe Knight.
Beginners’ Guide to Financial Statements by the Securities and Exchange Commission (SEC).
Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports by Howard Schilit.
The Accounting Game: Learn the Basics of Financial Accounting – As Easy as Running a Lemonade Stand (Basics for Entrepreneurs and Small Business Owners) by Darrel Mullis and Judith Orloff.
Happy learning!
