It is critical for business owners to understand basic accounting principles so they can make important decisions based on current financial data. Without it, you'll probably have a hard time answering the following questions:
- Is your company's revenue growing or shrinking?
- Which products are the most profitable?
- How much overhead expense does it take to run your business every month?
- Will you be able to pay your bills this month?
Generally Accepted Accounting Principles (GAAP) is the set of accounting principles and procedures issued by the Financial Accounting Standards Board (FASB). Public companies in the United States must follow GAAP when they report their financial results. The goal of GAAP accounting is to improve the clarity of reporting and the ability to compare results between different companies over a period of time.
Adhering to GAAP principles of financial accounting principles can help prevent companies from inaccurately reporting their financial results.
In contrast, cash basis accounting is where you recognize revenues when you receive payment for sales and record expenses when you actually pay them. There is another method called pro forma accounting that ignores the effects of one-time or unusual items. While both of these can be useful for business owners under certain circumstances, neither of these methods are in compliance with GAAP accounting.
1. Consistency and Disclosure
These accounting principles include displaying consistency and disclosure. (That is, how assets, liabilities, revenues, and expenses are recorded on financial statements.)
The number of accounting periods need to also be consistent from year to year including the year-end date. GAAP accounting includes how it is presented where the assets on one side of the balance sheet must equal liabilities and equity in the other side. Any extraordinary information not recorded in the financial statements should also be revealed like one-time gains or losses, non-monetary notes or industry specific accounting practices.
One of the core GAAP tenets is the matching principle (or sometimes called accrual accounting) which states that expenses are to be recognized in the same accounting period as related revenues. Within these reports, all items need to be recorded on an accrual basis.
This matching practice creates consistency in the financial statement; without that consistency, statements can be manipulated if expenses and therefore profits or losses are recognized either in earlier or later months. It correctly ties the revenue and expense recognition principles together. GAAP accounting also requires costs or expenses to be measured based on when they were made and not adjusted based on inflation levels or any other factor.
For private companies, GAAP accounting principles are not required by law, and accounting practices can vary by industry. However most companies follow these principles of financial accounting since accountants are trained in this methodology and it helps business owners gain insights into their companies.
GAAP Compliance for Small Businesses
Adhering to GAAP principles of financial accounting principles can help prevent companies from inaccurately reporting their financial results. It allows shareholders and creditors to correctly analyze what profits and cash flow are being generated by the business. As a result, they may be more likely to invest in your company or give it credit or a loan. This would not be possible if companies could pick and choose what they were to report. GAAP accounting minimizes the risk of erroneous financial reports by having these safeguards.
Most importantly, GAAP accounting allows the business owner to consistently measure their results from month to month and year to year. If you only use cash accounting, the business owner will not have the information to match revenue and expenses and have accurate financial statements to make critical decisions.
Remember, cash accounting can still be used to measure the increase or decrease in cash flow for your company. This will enable you to identify if you have enough cash and working capital to run your business. It is critical for every business owner to understand which basic accounting principles they are using to run their company and the insights that method can provide.
GAAP vs. IFRS
While GAAP was developed by FASB for United States based companies, IFRS is a set of accounting standards developed by an independent international organization called the International Accounting Standards Board (IASB).The goal of IFRS is to provide a general international framework for how public companies prepare and disclose their financial statements. This standard is critical for larger companies that have subsidiaries in different countries so they can use one reporting language to get a cohesive set of financial statements.
Read more articles on accounting.
Photo: Getty Images