If you plan to take your startup public someday, it’s never too early to get your house in order. And one major thing public companies have to be aware of is GAAP accounting.
While GAAP compliance is only required of publicly traded companies, following these accounting rules could make it easier to report your business’s financial information consistently. It could also help your company get approved for financing.
What is GAAP in accounting?
GAAP, also called US GAAP, stands for Generally Accepted Accounting Principles. It’s a set of rules and procedures for financial reporting laid out by the Financial Accounting Standards Board (FASB).
In general, GAAP accounting sets out the rules and standards companies should follow to ensure their accounting is accurate, consistent, and honest. Guidelines include which financial statements to submit, what information needs to be in the statements, and how that information should be presented.
To put it plainly, these are the general rules for accounting in the US.
GAAP is mainly practiced in the US, and only public companies operating there are required to comply with it. Most other countries use International Financial Reporting Standards (IFRS).
The main difference between IFRS and GAAP is that IFRS generally allows companies more flexibility, while GAAP requires stricter adherence to its rules.
The cash flow statement is one example of this contrast between accounting methods. With IFRS, companies can report their dividends and interest on a few different financial statements, depending on how they would prefer to classify them. With GAAP, you must report interest paid or received in the operating section of your income statement.
GAAP accounting principles
There are 10 main principles of GAAP:
- Principle of Regularity: The accountant will follow GAAP rules at all times. This means remaining GAAP compliant for all financial documents, not just some documents.
- Principle of Consistency: The accountant promises to follow the same rules for each accounting period and the whole process. Doing this makes it easier to compare financial results from one period to another. If any changes are made, the accountant must explain why.
- Principle of Sincerity: The accountant agrees to do their best to report accurate and impartial statements. They won’t over- or undervalue things or report any information they believe to be inaccurate.
- Principle of Permanence of Methods: This means the accountant will use similar procedures from one period to the next. For example, they won’t change inventory or depreciation methods each year.
- Principle of Non-Compensation: Positive and negative finances will both be reported transparently. For instance, the accountant won’t try to hide a loss from investors.
- Principle of Prudence: The accountant promises to report facts, not speculation. For example, they won’t report what they think the value of an asset might be worth next period — only its current value.
- Principle of Continuity: This means the accountant will report information (especially assets and liabilities) with the assumption that the business plans to stay in operation.
- Principle of Periodicity: Accounting entries are reported during standard financial periods, such as fiscal years or quarters.
- Principle of Materiality: The accountant will report all financial information. They won’t leave out certain accounts or statements.
- Principle of Utmost Good Faith: This principle assumes all transactions recorded are honest, and accurate information is communicated to the accountant. After all, if a business isn’t honest with their accountant, their financial statements likely won’t be accurate.
Your business might already follow some of these accounting principles. Even if your company isn’t officially GAAP compliant, you should aim to keep accurate financial data and be consistent with your bookkeeping.
Why is GAAP important?
GAAP is important for a few major reasons, chiefly the standardization and accuracy of financial reporting.
The basis of GAAP was established after the stock market crash of 1929. Leading up to the crash, companies could report their financial data in whatever form they chose. By standardizing accounting practices, the newly formed US Securities and Exchange Commission (SEC) hoped to avoid another crash.
Today, the expectation is that when you look at a publicly traded company’s income statement, the information will be presented the same way each financial period.
Pinterest offers a great example of how important GAAP is. The image-sharing platform offered two earnings numbers in 2019. They shared that they had earnings of $17m in a press release, but also had to mention GAAP-compliant losses of $1.36B.
Why such vastly different numbers?
The company chose to present its EBITDA (earnings before interest, taxes, depreciation, and amortization), a popular non-GAAP metric. Their business revenue had grown quickly — 51% in 2019.
But when you factor in all of the tax payments, interest, depreciation, and amortization they had to pay, that revenue quickly dwindled. EBITDA indicates that Pinterest was profitable before costs like taxes, but GAAP shows all the costs the company had incurred.
Both statements help shareholders understand Pinterest’s financial health and offer useful information for investors.
The benefits of GAAP
While some companies believe GAAP regulations can be too strict, there are many benefits to using the standards.
For one, GAAP helps protect investors and consumers by ensuring accurate and consistent financial reporting. Without it, companies could report whatever and whenever they want.
Following GAAP also gives companies comprehensive guidelines of what to do. Companies know which financial documents they need to prepare and how and where to report specific entries.
According to Armine Alajian, certified public accountant (CPA) and founder of Alajian Group, an accounting firm for startups, “Improper classification of income and expenses is one of the most common problems I encounter with clients who are non-GAAP compliant. This can lead to inaccurate financial records and hinder decision-making processes.”
But if your business follows GAAP, your financial records will be more accurate, meaning you can make better-informed decisions.
GAAP vs. non-GAAP accounting
The SEC only requires publicly traded companies to report GAAP-compliant financial statements. Private companies generally do not need to follow GAAP.
Reporting non-GAAP metrics in financial statements has become more popular in recent years. Audit Analytics found only 59% of companies reported non-GAAP metrics in 1996. By 2016, this figure had jumped to 96%.
Some businesses argue that non-GAAP measures help give a more holistic view of a company’s financial statements. They say this is especially true when technology and interest rates are so volatile.
On the other hand, the SEC believes most non-GAAP measures can be misleading. On top of that, a study from the Massachusetts Institute of Technology (MIT) found that between 2010 and 2015, non-GAAP-reported earnings were 23% higher on average than GAAP earnings. There was also a strong correlation between non-GAAP earnings and higher CEO pay.
Making the switch to GAAP
Often, switching to GAAP can help you discover issues that may be affecting your business negatively.
Marguerite Pressley Davis, founder of Finance Savvy CEO, a financial literacy company, has helped many founders become GAAP compliant. “The biggest accounting issue we run into [with non-GAAP-compliant companies] is how they recognize revenue.”
She finds a lot of companies will recognize revenue too soon, recording the sale before any of the work has been completed. This leads to all of the revenue being recorded right away, while the costs aren’t noted until weeks or months later.
GAAP uses accrual-based accounting, which helps your expenses and income match up better. With accrual accounting, you recognize income when it’s earned, unlike cash basis accounting, which recognizes income when you receive the money. Likewise, you also record expenses in the period they are incurred, rather than when your bill is due.
When you switch to GAAP, you’ll have a more accurate idea of your costs, which can help your business set prices that will help with growth.
A middle ground for small businesses
Small businesses don’t have to be completely GAAP compliant, but some of the principles and reporting methods can still be useful.
Most accounting software, like QuickBooks, can help you follow GAAP requirements, such as accrual-based accounting.
To become fully GAAP compliant, your business needs to have periodic outside audits conducted by a certified public accounting firm, which can be expensive.
Instead, work with a CPA to get your balance sheet and income statement up to GAAP standards. That way, when you apply for financing, you can show lenders detailed financial reports that accurately reflect how your business is doing.