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What is GAAP accounting and why is it important?

Starting and managing your own business is an exciting prospect.  You probably ventured out on your own because you have a sp...

Starting and managing your own business is an exciting prospect. You probably ventured out on your own because you have a specialty, passion, or specific product idea. One thing that may not have crossed your mind? The accounting side of your business.

As with anything in life these days, there are a number of choices. Should you choose cash or accrual accounting? And what is this GAAP accounting you keep hearing about - is it a necessity or just a nice-to-have? These are important decisions, as they can affect your business’s ability to grow in the short- and long-term.

Cash accounting dictates that you record payments when they are received and expenses when they are paid. Accrual accounting requires that you record payments and expenses when they are incurred, rather than when they are paid.GAAP is an acronym for generally accepted accounting principles. It’s a set of accounting rules and standards that allow for uniform preparing of financial reporting - required by law for publicly traded companies.

So what does any of this mean for your business? Let’s take a brief look at the history of accounting to give a little more context.

Accounting practices for businesses date back hundreds of years, with the first recording of double-entry bookkeeping in the 13th century by a Florentine merchant named Amatino Manucci. These practices have evolved with the increasing complexity of businesses in a global market, but they lacked any uniform standard until the early 20th century.

Without any universal standards for financial reporting, companies were free to manipulate their metrics any way they could to show their themselves in financially positive way. This practice made it very difficult to compare the financial reports of two given companies. Ultimately they had very detrimental effects on the economy, as the Great Depression is widely attributed to misleading business reporting.

As a result of the massive economic upheaval of the Great Depression, Congress enacted legislation like the Securities Act of 1933 and the Securities Exchange Act of 1934. These acts are both targeted at regulating the activities of public companies. In 1973, the Federal Accounting Standards Board (FASB) was created as an independent organization to create and continually update the set of accounting standards known as GAAP. In the last 40 years, FASB has expanded it’s reach to create and manage GAAP standards for private companies and non-profits, in addition to public companies.

GAAP was established so anyone evaluating financial reports for public companies to could feel confident in making a side-by-side comparison. It is so effective that another organization was later formed to provide the same oversight for state and local governments - the Government Accounting Standards Board, or GASB. All 50 state governments in the U.S. adhere to GAAP accounting.

So what exactly is GAAP accounting? There are 10 tenets of GAAP accounting that you can find here. Here are some specific examples of those principles in action.

GAAP assumes three basic inputs for any financial reporting. These inputs include:

  • the monetary unit used
  • the time period for the report
  • the “going concern” assumption.

US dollars must be used in all GAAP reporting. Any transactions that cannot be represented in US dollars must be excluded. The time period can vary from several months to a year, but the main concern is the time period is represented accurately on the report (i.e., this report is from October 1-December 31, 2016). The “going concern” assumes that the business is not in the process of liquidating assets, and thus permits prepaid expenses to extend to future accounting cycles.

GAAP also requires businesses to use the accrual method of accounting, where payments and expenses are recorded when they are incurred, rather than when they are paid. Purchases made by a business are recorded on a GAAP statement including only the cost of the item - no inflation or appreciation is allowed.

It requires full disclosure of any information needed to judge the financial situation of the company, and allows businesses to absorb the cost of an item all at once, rather than spreading out the cost over the item’s lifetime. And when there are two appropriate ways to report an item, GAAP dictates that the accountant must choose the reporting format that shows a lower net income or smaller asset valuation.

GAAP accounting might seem awfully complex at the outset, especially if you’re just starting your business. However, it may be beneficial to implement GAAP accounting in the near term - especially if you plan to grow quickly or seek out investors. In part 2 of this series, we’ll discuss reasons why you should consider switching to use GAAP accounting.

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