GAAP, short for Generally Accepted Accounting Principles, is like your financial rulebook. And if you’re an entrepreneur, understanding and maintaining GAAP compliance can be super important.
But, it’s crucial to note – not every business needs to follow GAAP, especially if you’re a small startup that’s just getting started.
Where GAAP really comes into play is when you’re expanding your horizons. This might be when you’re trying to attract investors, dreaming of taking your business public one day, or going through an external audit.
Before we dive deep into each of these scenarios, let’s start with the basics.
What is GAAP Accounting?
GAAP is is a set of standardized practices, rules, and procedures in the United States – almost like a big playbook for accounting professionals. U.S. GAAP standards have been overseen by the Financial Accounting Standards Board (FASB) dating back to 1973.
So, what’s the goal of GAAP? It’s all about making sure that there’s a standard set of accounting rules.
This standardization makes life a lot easier for investors and anyone else checking out financial reporting. With consistent reporting methods comes clear, easy-to-understand information for everyone.
Plus, using the same “playbook” makes it easier to compare different companies, spot trends over time, and make smart decisions. It’s like comparing apples to apples, rather than apples to oranges.
Why is GAAP Compliance Important?
GAAP compliance is crucial for audits, acquisitions, raising capital, and going public.
Think about it like this. Let’s say you’re pitching your startup to potential investors.
With your GAAP-approved financial statements in hand, you’re showing them your company’s worth in a language they understand. This can really boost their confidence in your business and help secure an investment.
Same goes for when you’re trying to get a loan.
Banks want to see GAAP compliance in your financial statements, like your balance sheet, income statement, and cash flow statement, to figure out if lending money to your startup is a good idea. This is because GAAP makes your financial activity more accurate and reliable.
Moving onto acquisitions.
When you’re in the market to sell your company, buyers are going to take a close look at your financials first, in order to figure out how much your company is really worth.
If you’ve been adhering to GAAP, they can trust the financial information you provide. But if there are discrepancies in your accounting, they might question the validity of your numbers and offer a lower purchase price or even back out of the deal entirely.
Fast forward a bit, and imagine you’re ready to make the switch to a public company – that is, sell shares of your company to the public.
Going from a private company to a public company requires you to check a lot of boxes. For example, the U.S. Securities and Exchange Commission (SEC) mandates GAAP compliance if you go public to protect potential investors.
Now, let’s talk GAAP audits.
Like we said above, if you’re a public company or an investor-backed startup in the private sector, GAAP compliance is necessary. And when it comes time for your first external audit – a kind of financial health check done by an outside company – your financial documents need to meet GAAP standards.
If your financial records are GAAP-compliant, the audit process should be easier. If not, you may be in for a rough ride.
If you’ve been recording revenue as soon as a customer places an order, instead of when you actually deliver the product or service (which is the GAAP reporting process), auditors will catch this.
Just remember – not every business needs to comply with GAAP. If you’re small-scale or none of these scenarios really fit the bill for you, sticking with simpler accounting methods might be all your business needs for now. (More on when to use GAAP accounting in the next section!)
When to Use GAAP Accounting
Not all businesses need to follow GAAP accounting, especially in the early stages.
As businesses grow, they typically progress through three stages of accounting, each increasing in complexity:
- Cash Accounting
- Accrual Accounting
- GAAP Accounting
Cash accounting is the simplest form of accounting. You record income when you receive cash and expenses when you pay them. It’s great for budding small businesses because it directly reflects your cash flow.
However, it doesn’t give you a complete picture of your financial situation, as it doesn’t account for your accounts payable or accounts receivable (money you still owe or are owed).
Accrual accounting is a step up in complexity, recording income and expenses when they are earned or incurred, regardless of when cash changes hands. This gives a more accurate picture of financial performance over specific periods of time, but it can be more complex to manage.
GAAP accounting is the most complex of the three. It uses accrual accounting and also a specific set of accounting rules for handling various complex transactions.
Small businesses or sole proprietors often start with just cash accounting because it’s more straightforward and doesn’t require as much paperwork. But as their businesses expand, they typically need to step up to accrual accounting and then full GAAP compliance. This eventual shift is usually necessary to meet the needs of banks, investors, and certain regulations.
Not sure whether you should make the switch between the different stages of accounting? That’s totally normal. Each business has a unique financial situation that comes with a set of different needs. Read more on this below in our FAQ section!
Reach out to our team today for a free consultation. You’ll come away with personalized solutions for your accounting needs.
Understanding the 10 GAAP Principles
1. Economic Entity Rule: A business’s transactions are separate from the owner’s personal dealings. For example, if you, as an ecommerce business owner, purchase a laptop for personal use, this cost should not be included in your business’s accounting records.
2. Monetary Unit Rule: Only transactions that can be measured in money are recorded. So, the value of the 5-star reviews your SaaS product has received isn’t quantified and included in the accounts, even though it contributes to brand reputation.
3. Time Period Rule: A business’s financial life can be split into time chunks, like months or years. For instance, your online store might break down its earnings into quarterly reports, providing a clear view of how your income changes with seasons.
4. Cost Rule: Assets are logged at their original cost, not what they might be worth now. This means that even if the market price of your SaaS company’s servers increases, in your books, they remain valued at the purchase price.
5. Full Disclosure Rule: All information that might affect your business finances must be shared. If your ecommerce store is involved in a pending lawsuit that could affect its financial situation, this should be disclosed in your financial reports.
6. Going Concern Rule: This assumes that a business will keep running indefinitely. So even if your SaaS business is going through a rough patch, for accounting purposes, it’s assumed to be continuing operations for the foreseeable future.
7. Matching Rule: A business must record expenses in the same time period that it gained the related revenues. For example, if your online store spends on advertising in February and gets increased sales in March, the advertising cost is recorded in March’s books.
8. Revenue Recognition Rule: Revenue is logged when it’s earned, not when the cash is received. So, if your SaaS company makes a sale in January, but the customer pays in February, the revenue is recorded for January.
9. Materiality Rule: Any information that could sway an investor’s decision must be shared. If your ecommerce business has a significant increase in returned products, even though this isn’t directly a part of your financial statements, it should be disclosed due to its potential impact.
10. Conservatism Rule: When there are two possible solutions, pick the one that won’t exaggerate assets or income. So, if there’s uncertainty about the value of your SaaS company’s intellectual property, for your accounts, you would choose the lower estimated value.
We get it. This is a lot of info! And you’re not alone if you’re feeling a bit in over your head right now – entrepreneurs often struggle to fully grasp GAAP-compliant accounting principles.
But don’t worry, GAAP isn’t an insurmountable mountain. With help from a savvy accountant, you can get the hang of it. And trust us, getting started with GAAP will pay off big time as your business grows!
How Accounting Software Can Help with GAAP Compliance
Accounting software such as QuickBooks or Xero can play a key role in your journey toward GAAP compliance. These tools, while not explicitly designed for GAAP, are capable of generating GAAP-compliant financial statements.
QuickBooks and Xero can be particularly useful for SaaS and ecommerce businesses aiming for GAAP compliance. For instance, a SaaS company could leverage these tools to accurately track recurring revenue. On the other hand, an ecommerce business might find them handy for managing inventory and cost of goods sold, aligning with GAAP requirements.
But bear in mind, as your business grows and accounting processes become more complex, you will need a higher level of accounting expertise than a software tool. This ensures you’re not just plugging numbers into the software, but rather, truly understanding and correctly handling your financials in line with GAAP.
Our GAAP Compliance Services
At Acuity, we’re well-versed in helping growing businesses navigate the complexities of accounting best practices, like GAAP compliance.
Our team of accounting controllers can take charge of GAAP accounting, ensuring that all of your accounting processes closely follow its financial standards.
And our services are designed to grow with you – from cash accounting through GAAP accounting. We have entrepreneurs start with our bookkeeping services, and as their business grows and accounting practices become more complex, they can leverage our controller team’s expertise.
Plus, when you’re ready, our CFO team can elevate your financial management even further. If you’re ready to bridge the GAAP with Acuity, explore our pricing packages or book a free consultation with our team to get started.
Frequently Asked Questions
GAAP and IFRS (International Financial Reporting Standards) are different sets of accounting standards. IFRS was developed by an independent, not-for-profit organization called the International Accounting Standards Board (IASB).
GAAP is based on legal authority, and IFRS is based on a generalized principle, but they’re very similar. However, GAAP is U.S.-based accounting, so if you operate a multinational company that’s based outside of the United States, you likely have to consider IFRS.
In terms of what we offer to our clients at Acuity, we evaluate whether we can provide IFRS statements on a case-by-case basis.
Our team of accounting controllers has the expertise you need for GAAP compliance!
Here’s a little bit about what they can help with:
- GAAP accounting (of course)
- Prep for taxes and investors
- Deferred revenue and revenue recognition
- Establishing accounting best practices
- Complex financial reporting
- Weekly cash flow planning
The choice between cash and GAAP accounting depends on your business’s size and growth plans.
Let’s say you’re running a startup SaaS company. Initially, when your user base is small, cash accounting might serve your needs perfectly. This straightforward method lets you record income when you receive payments and expenses when you pay them, directly reflecting your cash flow.
But as your SaaS business grows – say you start landing larger contracts or wanting to attract investors – the financial landscape becomes more complex. This could be the time to consider a switch to GAAP accounting.
For instance, if you’re charging subscription fees, GAAP accounting allows for revenue recognition over the life of the subscription, aligning your revenue reports with service delivery.
Remember, every business has unique needs and growth trajectories, so it’s crucial to consider your own business’s stage and plans when choosing an accounting method.
If you’re unsure about the right time to switch, we recommend consulting our team of financial experts for personalized guidance.