Change is challenging, particularly as your business becomes more complex. However, the decision to produce financial statements that conform with GAAP accounting principles can help you make better financial decisions, and prepare your company for long-term success.
What is GAAP, and why is it used?
GAAP (Generally Accepted Accounting Principles) is an accounting framework people conform to so that companies can produce financial statements that are comparable to others.
The Financial Accounting Standards Board (FASB) establishes financial accounting and reporting standards for public and private companies that follow GAAP.
Firms that follow GAAP accounting must conform with a number of guidelines, which are based on principles. Here are three of the most important principles:
- Consistency: Standards must be applied at every step in the financial reporting process.
- Continuity: Accounting requires each business to place a value on company assets. Asset values assume that the company will continue to operate, and that the assets will be used to generate revenue.
- Periodicity: Revenue is reported based on standard accounting periods, such as a month, fiscal quarter, or fiscal year.
Keep in mind, however, that some accounting policies are unique to specific industries. Retailers must use GAAP standards to value inventory, while banks apply GAAP standards to account for possible losses on unpaid loans. Both types of entities can use GAAP, but the accounting issues between firms may be different.
Who is required to use GAAP?
Both public companies and private companies with annual gross receipts totaling more than $25 million are required to conform with GAAP. If you’re preparing for an IPO, or your company is growing rapidly, you may need to conform with GAAP standards. GAAP is maintained by the FASB, which in turn is adopted by the SEC as acceptable (although SEC guidelines deviate in certain respects).
All publicly-traded companies are required to conform with GAAP, so that investors receive full disclosure to make informed decisions. The Securities Act of 1933 and 1934 are designed to protect investors and improve disclosure. If you issue securities to investors, you must conform with GAAP.
Any privately held company with annual gross receipts totaling more than $25 million is legally required by the IRS to conform with GAAP for tax reporting purposes. Note that tax accounting shares similarities with GAAP but some areas are complete departures. For example, companies generally keep two sets of depreciation schedules for fixed assets, one for book accounting the other for tax accounting.
Why complex businesses should consider using GAAP
Because GAAP standards deliver transparency and continuity, they enable stakeholders to make informed decisions. Stakeholders can include customers who rely heavily on your business for supplies or services, governmental agencies that may award company contracts, and other parties that have an interest in doing business with you. Here are some other reasons to use GAAP.
The accrual basis, which is a requirement to conform to GAAP, uses the matching principle. Accrual accounting matches revenue with expenses, which reports a more accurate profit and loss total, regardless of cash transactions. The budgeting process is much easier when you use the accrual basis, because your plans aren’t distorted by the timing of cash inflows and outflows.
Consider a retailer who is calculating profit on product sales for the upcoming year. The retailer matches the cost of inventory with the sale price of each item. An item sold for $70 with an inventory cost of $40 generates a $30 profit, before considering other costs. Accrual accounting matches each sale with the cost of inventory, regardless of when the inventory item was purchased.
GAAP accounting rules give you a better understanding of how your spending decisions impact the bottom line. GAAP requires that assets must be recorded on the balance sheet at historical cost, or the cost paid for the asset. In most cases, fair market value is not used to value assets.
Assume that a restaurant purchases a commercial oven for $5,000. The asset is depreciated over 10 years at a rate of $500 per year. The owner can compare the annual cost of the oven ($500), with the revenue generated by using the oven. By using the historical cost method, and posting depreciation expenses using accrual accounting, the owner can determine if an asset purchase makes financial sense.
Better financial analysis
Conforming to GAAP makes it easier to compare your overall performance to competitors, and identify opportunities for improvement. Firms that conform with GAAP always include the revenue recognition policy as a footnote in their financial statements.
If you’re comparing your company’s performance with five other firms that conform with GAAP, you can confirm how they recognize revenue. Following GAAP allows your firm to accurately compare financial results with hundreds of other companies.
Meet the needs of stakeholders
Your firm’s stakeholders may expect you to generate GAAP-conforming financial statements. Investors, creditors, regulators, and vendors all rely on your financial statements. By conforming with GAAP, your stakeholders will have more confidence in the accuracy of your financial statements.
Prepare for a business sale
If you decide to sell your business, the process may require financial statements that conform with GAAP. A potential buyer in a private transaction will want financial statements that conform to GAAP in order to compare your results with industry benchmarks. The transition to GAAP accounting takes effort, and you need to think carefully before making the change.
The challenges of GAAP implementation
- Conforming to GAAP can be time-consuming and expensive. You’ll need an in-house accountant or CPA who understands GAAP accounting, and staff members who are involved in the accounting process will have to be trained.
- GAAP is not one size fits all, and each industry will have unique requirements. Here are some other challenges that businesses face:
- Complexity: GAAP standards may be too complex for the firm’s existing accounting staff, and hiring personnel to create GAAP-conforming reports can be expensive.
- Management reports: Management reporting may be very different from GAAP-conforming financial statements. Most companies generate management reports for internal use.
- Time required to set new standards: Implementing new accounting practices to conform to GAAP may require time to approve and perfect.
- If you aren’t required by stakeholders to produce GAAP conforming statements, and you don’t plan on selling your business in the next few years, you may think twice about implementing GAAP. However, firms that are considering a sale, obtaining financing, or registering securities for an IPO should consider GAAP accounting principles.
Audited financial statements
If you register securities with the SEC, you must provide company financial statements and other information each year. In many cases, you need to submit audited financial statements. An independent CPA firm performs the audit, and the financial statements are prepared by management.
The auditor provides a written audit opinion, which must state whether or not the financial statements were prepared in compliance with GAAP. The company’s annual report must include financial statements that have been audited.
Benefits of switching to accrual accounting
- A foundational GAAP principle is accrual basis accounting.
- With accrual accounting, you can analyze your financial status today, and project your financial result in the future. Accrual accounting makes it much easier to identify trends in your business, and to make changes that improve profitability.
The greatest benefit of accrual accounting is the ability to match revenue with expenses, regardless of the timing of cash inflows and outflows. Consider a manufacturer that buys raw materials in January, uses material to create a product in February, and sells the product in March.
Accrual accounting matches the revenue generated in March with the cost of raw materials purchased in January. If the firm pays labor costs to manufacture the product in February, the labor costs will also be included in the profit calculation.
Accrual accounting generates a clear, consistent set of accounting records that you can analyze and use, even as your operations become more complex.
How your business can start the process to comply with GAAP
To start the process of conforming with GAAP, have a conversation with a CPA. Provide several years of recent financial statements, and your chart of accounts. The chart of accounts lists all of your accounts, grouped by type. The CPA can review your accounts, and determine which accounts you need to add to conform with GAAP.
It’s likely that your business will have accounting needs that are unique to your industry. Find an accountant who has experience in your industry and experience in helping businesses transition to GAAP compliance.
Managing complex operations can be challenging, and the best way to address this challenge is to prepare in advance. GAAP-compliant financial statements are more useful for making business decisions, and the preferred method for your stakeholders. If you decide to transition to GAAP compliant accounting, you can ensure your company’s finances are prepared for your long-term needs.
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