Financial statements are windows into the health of your business, and managing them can be a complex challenge.
From balance sheets to disclosures, accurately reporting on your financials requires a responsible approach.
In the world of business accounting, GAAP, or Generally Accepted Accounting Principles, has become the standard for completing financial statements.
But the complexity of these rules and procedures has urged some businesses (especially small and/or private ones) to question the need for following them.
If you’re wondering whether GAAP really matters in the preparation of your financial statements, read on for some eye-opening truths and expert insights.
Short Answer: Yes, you need to follow GAAP
In a nutshell, the answer is: Yes, GAAP does matter. And, ultimately, you do need to follow it.
It’s certainly true that private companies are not mandated to use GAAP, but doing so is the only way to verify compliance for financing.
Banks and investors are highly cautious of businesses that do not follow this accounting standard, and you could jeopardize investment opportunities by failing to follow GAAP in the preparation of your financial statements.
If you’re a company with publicly traded stock, you must base your distributed financial statements on GAAP, in addition to adhering to U.S. Securities and Exchange Commission (SEC) rules.
According to the Financial Accounting Foundation, “This requirement dates back to the creation of the SEC following the onset of the Great Depression, which highlighted the need for comprehensive accounting reform.
Many market participants felt that poor accounting and reporting procedures for publicly traded companies contributed to the stock market collapse of 1929 and the decade-long depression that followed.”
GAAP levels the playing field
Why is GAAP so important in the world of business finance? It enables investors and the public to compare companies based on a uniform set of terms and accounting measures.
It is a way to help ensure that the recipients of your financial statements (namely, investors) can rely on the figures presented (though they do not guarantee that a company's financial statements are free from errors or omissions).
Internally, you have the advantage of seeing how your business financials stack up against those of other companies. Accounting.com says
“GAAP compliance makes the financial reporting process transparent and standardizes assumptions, terminology, definitions, and methods. External parties can easily compare financial statements issued by GAAP-compliant entities and safely assume consistency, which allows for quick and accurate cross-company comparisons. Because GAAP standards deliver transparency and continuity, they enable investors and stakeholders to make sound, evidence-based decisions. The consistency of GAAP compliance also allows companies to more easily evaluate strategic business options.”
These principles have been developed and revised over the years to establish regularity, consistency, sincerity, the permanence of methods, non-compensation, prudence, continuity, periodicity, materiality, and utmost good faith in disclosing business financials.
GAAP has become highly complicated
Many business owners have complained about GAAP being so complicated that it’s difficult to understand the financials.
Private and/or small companies often find it particularly challenging to comply with all of the rules and procedures, mainly due to the fact that these reporting standards were basically designed for large corporations.
Because of the burden that GAAP places on smaller businesses to comply, some in the profession would like to see a “Baby GAAP” version.
A lighter, less complex set of accounting principles could help solve this issue, though no such version has been officially established.
GAAP does have its problems
As a professional in the business financial industry for more than 30 years, I have also questioned the rules and value of GAAP. In a number of cases, the standard has proven to be illogical or confusing. Here are a few examples:
- Accounting for setup and implementation fees: Let’s say, for instance, that you sell and license software. You charge an implementation fee. That fee should be recognized over the expected life of your customer, not just when you implement it. But because you may not be able to determine your customer lifetime, you end up recognizing it over the life of the customer contract.
- Stock options: A private company will issue stock options that may not have value until the company goes public or is acquired. And even if you are fortunate enough to have one of these events occur, there is still a possibility that the options are underwater. The options are valued and put on the books with a recorded estimated expense, but that stock may never hold a value if the company never goes public.
- Beneficial conversion feature: A convertible note (a note that comes with a discount toward the next round of fundraising) is issued, and the discounted amount becomes an expense that runs through the P&L. It is considered non-cash, and most people don’t understand it.
These are just some of the reasons why businesses have a hard time getting in line with GAAP.
But, as previously mentioned, it is still important to follow the U.S. standard.
To wade through any difficulty you may be facing, consider working with an experienced financial consultant who understands the specifics of GAAP and can lend assistance in managing your business financials.