Small businesses may not think a whole lot about accounting beyond good bookkeeping practices, but this actually becomes a big deal as your company grows. If your startup becomes really successful, you might want to go public, which means you'll be subject to government regulation and watched by the U.S. Security and Exchange Commission. That’s where GAAP comes in.
These generally accepted accounting principles are the law of the land when it comes to public companies and nonprofits, but your small business may still wish to use GAAP accounting for other reasons.
What Are GAAP Principles?
Generally accepted accounting principles are a set of accounting rules for how certain businesses must record and report financial information. They’re set by the Financial Accounting Standards Board and Governmental Accounting Standards Board and typically require accrual-based accounting. In other words, you must record the transactions as they happen within a time period, like a fiscal quarter, rather than when the money actually changes hands.
Who Uses GAAP?
Generally, companies that put out official financial statements are required to use GAAP. For example, public companies must use GAAP principles when they’re filing financial statements with the United States Securities and Exchange Commission. Companies that use GAAP accounting generally include:
- Publicly traded companies
- Private-sector companies hoping to launch an IPO
- Private companies with business loans
All 50 states follow GAAP within their state government. Though it’s not always mandated by state law, about 70% of local governments still follow U.S. GAAP rules anyway. GAAP may also be beneficial to some small businesses that have business loans because lenders and creditors often prefer GAAP-complaint documents. Some financial institutions like banks, mortgage companies and credit unions may require annual financial statements that follow these principles when they issue loans.
The Assumptions of GAAP Principles
The accounting concepts found within GAAP can be split into four different areas. This includes:
- Disclosure: This is the way financial information is reported on statements. Generally, GAAP standards support full disclosure and transparency on financial documents and do not support things like pro forma statements, which may create an incomplete or inaccurate financial picture.
- Recognition: How certain aspects of a business, like assets and expenses, are accounted for.
- Measurement: The way profits and losses are factored in and written down.
- Presentation: How you share your financial results with the public.
There are generally 13 different principles within GAAP rules. These are easily outlined and have to do with how companies shape financial documents like balance sheets and income statements to maintain true transparency. The assumptions and principles of GAAP are:
- Economic entity assumption
- Principle of regularity
- Principle of consistency
- Principle of sincerity
- Principle of permanence of methods
- Principle of noncompensation
- Principle of prudence (or the principle of conservatism)
- Principle of continuity
- Matching principle
- Revenue-recognition principle
- Principle of periodicity (the time-period assumption)
- Principle of materiality (or full-disclosure principle)
- Principle of utmost good faith
1. Economic Entity Assumption
This assumption states that economic entities have separate financial records. In other words, governments, U.S. companies, churches, school districts and nonprofits must keep their records separate. This may seem like a no-brainer, as it’s always a good idea to keep personal finances away from business records (which inherently makes sole proprietors non-GAAP entities). Unfortunately, this actually gets a little bit complicated if a company has subsidiaries or a charity.
For example, if a corporation has a number of subsidiaries, it may be enticed to lump them all into one financial profit-and-loss report, but that goes against GAAP’s set of rules. Each subsidiary must fill out its own financial records.
2. Principle of Regularity
All this means is that the accounting professional in charge of filing reports and creating documents vows to use GAAP standards, rules and regulations in the accounting practices.
3. Principle of Consistency
This principle requires that the accountant use the same standards throughout the entire reporting process. This helps prevent errors and discrepancies across the board, and any changes must be explained in footnotes.
4. Principle of Sincerity
A GAAP-compliant accountant, such as one from the American Institute of Certified Public Accountants, must be committed to accuracy and proceed without any biases. Basically, this rule states that the financial data reported will show the true financial status of a company, at least to the best of the accountant’s ability.
5. Principle of the Permanence of Methods
Like the principle of consistency, this one focuses on methods instead of standards. This states that all methods and procedures used while preparing the financial reports must remain consistent. It allows for the comparison of financial data once it’s published.
6. Principle of Noncompensation
This is where pro forma statements come in or actually come out because you can’t use them and still be GAAP compliant. The principle of noncompensation dictates that you must show the full details of the financial data from which you’re drawing and not expect any form of debt compensation for your accurate reporting. Basically, you can’t cancel out debt with an asset or strike off revenue with an expense even if they balance. You must detail it all.
7. Principle of Prudence
The principle of prudence is also sometimes called the principle of conservatism and ensures accuracy in the event of a guess. Anything can happen when you’re making predictions, and one outcome is usually more likely than another, but that’s not always the case.
This accounting rule states that CPAs and accounting professionals must always use their best judgement when recording estimated transactions. If there are two equally likely predictions — like a highly optimistic estimate or an estimate with much less growth — you’ll need to record both. This way, you won’t ever overestimate gains and underestimate losses.
8. Principle of Continuity
This assumption has to do with asset valuations. Basically, you need to make asset valuations with the assumption that the business will continue to operate as usual without any gaps or interruptions. Assets cannot be adjusted for inflation or reported at their disposable value. They must be reported at the cost for which the item was originally purchased, or their “historical value.” This builds on the principle of prudence and helps to understand the true financial picture of a company.
9. Matching Principle
Per the matching principle, expenses must be recorded along with the revenue it produces, which outlines a clear ROI. For example, commission is recorded when the sale is made, not when you actually pay it to an employee. Similarly, the wage of an employee is reported when the work is completed, not at the actual payday. This gets a little tricky with advertising since the ROI can’t be directly tied to revenue, so instead, you’ll need to report these costs in the financial time period in which the ad ran.
10. Revenue-Recognition Principle
Similarly to the matching principle, the revenue-recognition principle dictates that revenue must be reported when a product is delivered or a service is complete. For example, if you’re a retail company manufacturing custom t-shirts, you cannot record the revenue when a customer prepays a purchase order for a specific design. You can only record the revenue once the order is manufactured and sent to the customer.
11. Principle of Periodicity
This is also known as the time-period assumption. This basically states that you’ll list the period of time being reported in the heading of your financial statements.
12. Principle of Materiality
This helps streamline the accounting process for large companies making big bucks and helps ease the burden of following the GAAP principle. Basically, it states that you can ignore a principle if the amount is insignificant. This usually manifests in financial records being rounded up to the nearest dollar or thousandth. All other financial data and values must be disclosed in records with full transparency.
13. Principle of Utmost Good Faith
This is perhaps the most important GAAP principle. Basically, all parties involved in financial reporting vow to act honestly. Don’t fudge figures on purpose (and if you do, you’ll have major issues with the Securities and Exchange Commission).
GAAP accounting can be confusing, and you should most definitely hire an accountant to deal with this process. However, you may wish to read up on GAAP accounting yourself.
There are plenty of resources, but Thomas Reuters's PCC GAAP guidebook allows you to cross-reference topics with the Financial Accounting Standards Board Accounting Standards Codification, which rules all new standards (and yes, this stuff does change). You can also get an annual subscription to the Financial Accounting Standards Board for a little more than $1,000 a year.