Understanding GAAP and Fundamental Accounting Principles

When it comes to accounting standards, there’s one thing that investors, governments, and lenders universally accept: The Generally Accepted Accounting Principles (GAAP).

And when it comes to the lives of a CFO and their finance team, certain compliance-related functions are a non-negotiable part of the job, such as:

• Closing the books on time
• Getting meaningful reports out to management
• Making sure you’re in good shape to pass any audit
• And combining all of the above to comply with GAAP

When accounting fundamentals are operating well, everyone takes them for granted, but they’re a constant pain point if they are operating poorly. GAAP is at the heart of accounting fundamentals.

If you're beginning to focus on GAAP in your finance team or want a refresher on the principles, read on. We’ll cover:

What is GAAP in accounting?

The GAAP provides financial standards for companies and organizations in the US and worldwide. The principles are a playbook that companies, governments, nonprofits, and employee benefit plans must follow when preparing and presenting their financial statements.

GAAP is constantly evolving as the business environment changes. GAAP changes are typically issued by the Financial Accounting Standards Board (FASB). Some of the most recent changes to GAAP include new revenue recognition and lease accounting rules.

GAAP includes principles for revenue recognition, expense recognition, asset valuation, and more. While there are some variations from country to country, the core principles of GAAP in the US are the same. This makes it easier for investors and other stakeholders to compare financial statements from different organizations.

Who needs GAAP?

Accountants and bookkeepers use GAAP to prepare financial statements and tax returns. Investors, market analysts, and state and federal regulators look for GAAP compliance to understand a company’s financial rigor.

Internally, GAAP makes it easy for finance teams to compare performance across time frames. The GAAP makes businesses more accountable for their financial performance, which can drive better management decisions, more profitable businesses, and healthier economies.

“To attract financing to hire workers, build plants, and invest in research and development, companies and organizations must report financial information that investors, lenders, and donors find credible and useful.” —The Financial Accounting Foundation

While FASB develops accounting standards, the Securities and Exchange Commission (SEC) regulates financial reporting and disclosures by public companies in the United States.

What does GAAP cover?

Ten individual principles make up the GAAP (more on them soon), which cover areas such as:

• How assets, liabilities, revenues, and expenses should be recognized in financial statements
• Which line items, subtotals and totals should be displayed or aggregated in financial statements
• What specific supporting information is most important to investors, market analysts, and state and federal regulators who will review financial statements.

When do businesses need to follow GAAP?

Public companies are required to use GAAP and private companies can also use GAAP for transparency, said Armine Alajian, CPA and founder of the Alajian Group. “Usually, growing companies, startups, and companies that want to be acquired would benefit from using GAAP, especially if they track their KPIs, and have budgets and projections,” she said.

The 10 accounting principles of GAAP

“Following the principle of consistency ensures that the same [GAAP accounting] standards are applied throughout the entire reporting process across all periods and that any changes to those standards are noted when necessary, making this one of the most important principles to follow,” said Alajian.

GAAP in practice: what it means for your books

GAAP is based on accrual basis accounting, where corporations recognize revenues and expenses during a transaction. This differs from the cash basis technique—more common among small businesses and solopreneurs—where sales are realized when payment is received.

• Accrual accounting represents the present worth of sales income, giving businesses a better picture of their financial situation
• Accrual accounting involves double-entry accounting, meaning every financial transaction has equal and opposite effects in at least two different accounts
• You enter a matched transaction in a different account when you enter an accrued transaction

Assume you sell $10,000 of raw materials in November, and your buyer agrees to pay $2,500 monthly for four months. If you used the cash basis approach, your accounting team would have to make a journal entry every month you got paid, which means your financial reporting will span two accounting periods.

Under the accrual method, you'd record the $10,000 in your receivables account and debit your inventories.

7 GAAP concepts for founders and startups

As seasoned CFOs and accountants know, GAAP is far more complicated than the 10 principles above, or the example we have just provided.

In fact, if you research GAAP, you’ll soon discover a bewildering array of information covering public and private companies, along with GAAP guidance for other entities, such as governmental bodies and not-for-profits.

That won't be all that helpful for you if you’re a startup founder, first-time CFO, or early-stage finance team member.

These additional GAAP concepts may be more useful to you, at this early stage of business.

1. Business entity concept

This one is important for founders. It means transactions made by the business should be reported separately from transactions of the owners of the business or any other affiliated business entity.

2. Historical cost concept

All business transactions must initially be recorded at historical cost. If an asset’s value on your balance sheet increases over time, you still register that asset ‘at cost’ on the balance sheet.

3. Revenue recognition concept

This determines when revenue is recorded. This is particularly important because the timing of revenue recognition directly impacts a company's bottom line.

4. Matching concept

The matching principle is an effort to ensure that expenses are recognized at the same pace as the revenue that those expenses help generate.

5. Objectivity concept

Your accounting records should be free of bias. Your financial information should not be misleading but objective and verifiable.

6. Currency concept

The monetary unit concept states that all transactions must be expressed as a currency, such as the US dollar, Euro, British Pound Sterling, or Yen.

7. Time frame concept

This means transactions should be recorded in the same period in which they occurred.

5 tips for ensuring GAAP compliance

Much of GAAP compliance comes down to good people and processes. Experienced CFOs and accountants will know GAAP well, and they will keep up-to-speed with any changes to the standard. That said, there are some things every finance team, and more junior finance professionals can do to stay GAAP compliant.

1. Hire experienced accountants

Employing accountants who have received the necessary training in the procedures and standards dictated by GAAP and setting up the right conditions for their success is the first step in achieving GAAP compliance, according to Levon Galstyan (CPA) of Oak View Law Group.

2. Continuously train your team

“As the business grows, consider providing ongoing education and training for all employees involved in GAAP initiatives. Procedures should be in place to keep accountants and others informed of the most recent developments because accounting standards and principles are frequently changing,” said Galstyan.

“To avoid falling behind and risking non-compliance by implementing new procedures too late in the process, finance teams should also ensure that incorporating the most recent changes in GAAP is a part of their everyday operations,” he said.

3. Create internal controls

Startups and SMBs should have internal controls that state their financial practices and policies, and stick to them every month. “For example, in accounts payable, a policy should state who processed it, who approves it, when it’s paid, and who will record it,” said Alajian. “This segregation of duties that states all steps and is followed every month is a strong policy requirement.”

4. Reduce accounting errors

Consistency and regularity are two of the key principles of GAAP, so it’s important to keep accounting errors to a minimum.

• The right small business accounting software, enterprise resource planning platforms, and other financial management SaaS can all support these efforts.
• Finance teams can now harness automation for significant aspects of accounts receivable, accounts payable, and employee expense reimbursement.
• Automation can make activities like revenue recognition and expense matching much easier to complete and cross-check.

5. Carry out regular audits

An audit is another way to stay GAAP compliant.

“Beyond GAAP concerns, internal auditors examine a variety of business operations, including market share, productivity, quality, and customer satisfaction,” said Galstyan. “Internal auditors help ensure compliance procedures are in place about GAAP so that all workers working on transactions and financial reports adhere to the correct standards.”

• You can engage a CPA to pore over balance sheets, P&L statements, and cash flow statements, and let you know if your books have any issues
• Potential investors, lenders, and market regulators all demand GAAP compliance from private companies.

By carrying out regular audits, you can ensure you face no surprises when first dealing with these important stakeholders. Galstyan suggests establishing an audit committee to manage your accounting division and ensure there are enough personnel and resources to handle GAAP compliance.

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