Why Is GAAP Important to Financial Statements?

A great concept, an ideal location and top-notch marketing can all play a role in the success or failure of your business. Proper accounting is even more critical, though. Good accounting gives you an accurate picture of your business’s cash flow, allowing you to make informed decisions. Small businesses typically aren’t required to use generally accepted accounting principles, or GAAP. However, these principles establish how to create accurate financial statements that can be easily understood by investors and other stakeholders.

TL;DR (Too Long; Didn't Read)

Financial statements prepared under GAAP are created by the same rules and standards. This ensures consistency and means that statements can be easily understood by stakeholders.

The Importance of GAAP

GAAP refers to a set of accounting principles that is used for financial statements. The objectives of GAAP include:

  • Creating consistency so statements can be easily understood.

  • Establishing ethical standards so firms are less likely to put misleading information on financial statements.

  • Ensuring that financial statements are factual and not based on speculation.

  • Providing financial statements on an established schedule, such as quarterly or monthly. 

If a company or business distributes its financial statements outside the company, then it must use GAAP. If a company is publicly traded, it must also follow the rules established by the Securities and Exchange Commission.

Why Were Generally Accepted Accounting Principles Established?

The stock market crash of 1929 established the importance of accounting principles and concepts. The crash may have been caused by inaccurate and misleading financial reporting by companies that were publicly traded. In response, the federal government worked with accounting professionals to establish standards to help prevent inaccurate reporting.

Over the years since the stock market crash, a few different bodies have been in charge of developing the standards. Today, the Financial Accounting Standards Board issues financial accounting standards when an issue needs clarification.

GAAP is specific to the United States. Other countries typically use the International Financial Reporting Standards. They are similar enough to GAAP that foreign companies that are registered in the U.S. can submit financial statements using IFRS rather than GAAP.

Understanding GAAP Financial Statements

The balance sheet shows a company’s assets and liabilities. It gives a snapshot of how a company is reporting during the accounting period. The cash flow statement shows how cash has moved in and out of the company. Understanding actual cash flow is essential because the balance sheet and income statement are created using the accrual basis of accounting.

Accrual accounting matches income and expenses based on when the transactions occurred rather than when payment was received or made. For example, a company may sell a batch of widgets to a customer and then send the customer an invoice. The customer might pay the invoice the following month, but in accrual accounting, the transaction would be recorded when the widgets were sold, not when the payment was received.

The income statement shows what revenue was earned during the reporting period. It also lists expenses that occurred from earning that income. It is also known as a profit and loss statement.

Applying GAAP in Your Business

The overall principles can help you create financial statements that are easily understood by others. This is especially important if you are seeking new investors or if you’re hoping to sell your business. GAAP does require accrual accounting, which can be more complicated. Many small businesses use cash accounting, but as your business grows, you may want to change to accrual accounting for financial statements.

Both methods can help you understand the financial status of your business. An experienced certified accountant can help you create financial statements and apply GAAP principles to your business.

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About the Author

Melinda Hill Sineriz is a freelance writer with over a decade of experience. She specializes in business, personal finance, and career content. She has worked in sales and has managed her own business for more than a decade. She has also written content for businesses in various industries, including restaurants, law firms, dental offices, and e-commerce companies. Learn more about her and her work at thatmelinda.com.