When running your business, you need to maintain an effective system of accounting. This is required not only as a financial record of your business but to also obtain important business and financial insights essential for strategic decisions. Major business transactions and partnerships rely upon a common understanding of the business status and performance and GAAP compliance can be critical in that regard.
What is GAAP?
Generally Accepted Accounting Principles (GAAP) are basic accounting guidelines that companies can use to prepare their financial statements, maintain accounts and accounting standards. These guidelines were set by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA) and are required in multiple scenarios. For example, all public companies must follow GAAP financial standards as per the United States Securities and Exchange Commission (SEC). Many private investors require their portfolio companies follow GAAP standards as well.
GAAP helps provide a framework that helps businesses create comprehensive accounting standards and practices to obtain financial statements and accounting disclosures. Compliance with GAAP ensures that financial reporting processes are transparent, consistent, easily comparable, and helps business owners and investors alike make evidence-based decisions.
GAAP also helps minimize variance in interpretation by standardizing definitions and methods using the agreed-upon principles. This helps to ensure that accountants and startups don’t paint a misleading picture of their venture’s financial health.
What are GAAP’s basic principles?
The GAAP framework comes with a basic set of accounting principles that companies must fulfill to disclose their overall financial conditions.
The four basic principles for adherence to GAAP concern costs, revenues, matching, and disclosure.
- The cost principle dictates that all costs are actual, accurate costs and do not record the market value or inflated cost of the items.
- The revenue principle sstates that all revenue is reported when it is recognized and earned rather than when actual payment is received. This principle is also called the accrual principle since it serves as the basis of accrual accounting.
- The matching GAAP principle matches an expense to the revenue to which it is related. This means a similar approach to assessing when revenue is actually earned is applied to assessing when expenses are actually incurred, irrespective of when payment is made to a vendor.
- The disclosure principle states that all the information pertinent to the company’s financial position will be legibly included in the company’s financial reports.
Is it important for early-stage startups to comply with the GAAP?
While you are not required to follow GAAP principles as a startup, adhering to its processes and guidelines from an early stage of your venture can add great value. Note though that many of your stakeholders may require you to follow GAAP.
Tracking financial health accurately with accrual accounting
GAAP recommends using the accrual accounting method. This approach gives a far more precise view of your startup’s financial health, enabling you to make better data-driven decisions. Using the accrual-based accounting method the revenue is recognized on a Profit & Loss statement when it is realized and not necessarily when any related payment is received. This approach is valuable to a startup as it paints a more realistic picture of your startup’s revenue and growth over a period.
The IRS also requires businesses earning over $5 million annually in revenue to use the accrual accounting method. Companies can choose to switch from cash to accrual when the timing is right.
Preparing to raise capital
Investors and auditors depend upon companies adhering to the GAAP principles and guidelines to evaluate and compare a startup’s finances and benchmark it against other ventures. Following the GAAP standards right from the start for the fundraising and/or due diligence process will mean you don’t have to redo your financials. Moreover, even after you’ve received funding, the investor will expect to receive all financial statements as per the GAAP standards.
Adhering to GAAP standards offers significant benefits to your business over long-term growth. However, for most founders, embracing the GAAP framework is not an exercise for the uninitiated or those lacking expert skills. Our accounting team at Rooled is fully equipped with skills and knowledge on the application of GAAP principles and the latest accounting regulations.
If you need to adopt GAAP reporting or want to talk more about how to manage your accounting and financials effectively, send us an email at [email protected].