In these instances, GAAP accounting is essential—yet many small business owners are unsure how to create GAAP-compliant financial statements, or even about GAAP compliance in general.
Is GAAP compliance on your radar? The good news is that we can help. At Acuity, we advise many growing businesses that have sophisticated investors or require a GAAP audit, and we’re no stranger to the challenges that come with it. Here, we’re clearing the air when it comes to GAAP by covering commonly asked questions and revealing exactly why (and when) GAAP accounting rules come into play.
What is GAAP Accounting?
GAAP, otherwise known as the “Generally Accepted Accounting Principles,” is a set of accounting rules, standards, and procedures that are maintained by the Federal Accounting Standards Board (FSB) that was established back in 1973. These principles were created to help standardize all aspects of accounting with the ultimate goal of providing “useful information to investors and other users of financial reports and educate stakeholders on how to most effectively understand and implement those standards.” In other words, having a consistent set of standards makes it easy for investors to compare companies, view data trends over time, and ultimately make informed investment decisions.
What’s more, all public companies in the United States must follow the rules of the U.S. Securities and Exchange Commission (SEC), which includes—you guessed it—regular submissions of GAAP-compliant financial statements. Audits are conducted by certified public accounting firms to ensure GAAP compliance. Many non-publicly traded U.S. companies follow GAAP, too, as it’s favored by investors, creditors, and lenders.
When to Use GAAP Accounting
Once a business owner knows about GAAP, the follow-up question is usually, “When do I need it?” To answer this question, we first need to look at the three stages of accounting. Each stage ranges from basic to more complex. As a business grows, it will likely move from one to the next or even fall somewhere in between each stage.
- Cash Accounting
- Accrual Accounting
- GAAP Accounting
Cash accounting is simple: you put cash in, you take cash out. This method is ideal for new businesses as it’s straightforward—you know exactly where your money is.
You spend cash, you get cash, you record a transaction. Although cash accounting is the furthest thing from GAAP, we’re building a continuum up to GAAP accounting. It all starts here.
With accrual accounting, things start to get more complex. Accrual records money when it is earned, and when it is incurred—this can give small businesses a better idea of their success. For example, if a client will pay 30 days from now, you don’t have to wait to receive that cash payment to see your profit.
As soon as you leave cash accounting, you step in some form of accrual accounting, which eventually culminates in GAAP accounting. Things start to get more complex because we’re putting non-cash transactions on our balance sheet. We want to know how much people owe us and how much we owe them, so we’ll put in accounts receivable and accounts payable. Those accruals are not like a cash transaction, and so we see these complexities in our accounting records start to incur slowly over time.
Finally, GAAP accounting tops the complexity chart and encompasses everything in accrual accounting, plus very specific rules around equity accounting, deferred revenue, stock-based compensation, amortization, depreciation, and every other complex accounting buzzword you can think of.
We’re on this journey to understanding our business and making our financials make sense, and GAAP accounting is ultimately meant to be a level playing field for public companies.
Why You Need GAAP Compliance
You know what it is, you know when to use it, now here’s why GAAP compliance is so important for businesses in the growth stage. GAAP accounting is required for audits, acquisitions, raising capital, and going public, but it’s also important for creditors and lenders, too.
If your company goes public, the SEC requires that you follow GAAP. Another time you’ll need GAAP accounting is if you’re looking to get acquired by a larger company. When that happens, they’ll look at your financial statements; they’ll ask if you have GAAP books. It’s also a requirement to get audited after any significant venture capital deal.
The first time we usually see people make the switch to full GAAP accounting is when they get that investment of $3 million or more, or when they have an external stakeholder that’s no longer active and involved with the business that owns a big portion of the company. So say, like, if I’m an owner, manager of my business, and I retire, but I still own a business, I might require GAAP accounting.
Accounting Software & GAAP: What You Should Know
We often get questions about whether or not software like QuickBooks and Xero are “GAAP compliant.” While the software functions independently of these principles, the important thing to note here is that these accounting tools can help you produce GAAP-compliant financial statements.
The problems arise not with the software, but when unnecessary processes start getting added on.
Accounting can start to get expensive for people as they move towards GAAP accounting because they often add all these other processes and items that have nothing to do with cash. All of these things just add complexity and require a more sophisticated accounting team in your back office.
That’s where Acuity comes in. Our services were designed to grow with you as your business grows, from cash through GAAP. You can start with bookkeeping, then as you grow in complexity, you can add services from our controller team. And, when you’re ready, our CFO team can really take it all to the next level.