What is GAAP? Keeping in Line With Proper Accounting Rules

Everywhere you go in life, you’ll have rules to follow. 

Standards of driving that mandate using turn signals — let’s pretend people don’t ignore this one.  

Rules of how your favorite sports are played — updated penalty standards that give your team an extra chance at scoring. 

Even unspoken rules of travel that establish that everyone keeps their shoes on once the plane takes off — we can debate this one forever.

So it makes sense that there would be rules for how you create and manage your financial statements. In the accounting world, those are called GAAP. 

But what is GAAP, and why does it matter for your small business? We’re so glad you asked.

What is GAAP? 

Another acronym to add to your mental catalog, GAAP stands for “generally accepted accounting principles.” 

These principles are meant to establish standards for preparing, presenting, and reporting financial statements in the U.S. and ensure transparency, consistency, and accounting accuracy of your financial activities.

Technically, only publicly traded companies are legally required to follow GAAP, but we highly recommend that you follow these from the moment you establish your business. 

Following these accounting standards as a private company:

• Establishes credibility for your financial statements
• Builds appeal with investors
• Allows for easy analysis by lenders
• Improves internal visibility and control of your finances
• Sets you up for a stronger IPO

That’s because GAAP uses certain principles to guide its framework and prevent any questionable financial reporting or bookkeeping.

The 10 principles of GAAP

In order to keep financial records clean and clear, GAAP relies on ten core tenets.

1. Principle of Regularity — Accounts must keep to a set of established guidelines.
2. Principle of Consistency — Accounting standards remain the same throughout the reporting processes.
3. Principle of Sincerity — Accounts must be impartial and objective in their reporting. 
4. Principle of Permanence of Methods — The same methods must be used across all financial report preparations.
5. Principle of Non-Compensation — All financial performance must be fully reported, regardless of positivity or negativity, with no anticipation of debt compensation.
6. Principle of Prudence —  No speculation can influence financial data reporting.
7. Principle of Continuity — It is assumed that the business will continue to operate.
8. Principle of Periodicity — Accountants must keep the reporting periods consistent and equally divided by fiscal quarters or years.
9. Principle of Materiality — The data used in financial reporting must be based on the company’s full monetary position. 
10. Principle of Utmost Good Faith — Accountants and all other parties must maintain honesty in financial reporting.

Since GAAP only applies to U.S.-based businesses, it’s important to understand the differences between American and international accounting standards. Let’s look at those in the following section. 

GAAP versus IFRS

Accounting standards break down into two sets of rules: Generally Accepted Accounting Principles and International Financial Reporting Standards (IFRS). 

Each shares some similarities in how you approach accounting processes, but it’s where the two differ that you need to be aware of.

• Geography — GAAP was developed by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) and is used for American businesses. IFRS was developed by the International Accounting Standards Board (IASB) and is used by businesses outside the United States.
• Methodology — GAAP is rule-based, holding stricter standards for accountants and businesses to follow. IFRS is principles-based, offering more flexibility in how accountants and businesses interpret and apply standards to financial transactions.
• Inventory — GAAP allows your business to value inventory using the Last In, First Out (LIFO) method. That is not allowed under IFRS.
• Research and Development — Under GAAP, you can report nearly all R&D costs as incurred expenses. IFRS requires you to report R&D as general expenses. If you can prove your business is commercially viable, then you can capitalize some of those expenses and write them off over time.
• Disclosures – GAAP requires businesses to make specific disclosures if they face potential liquidation. IFRS does not require those disclosures. 

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Sometimes, GAAP’s stricter standards can seem overwhelming as a small business owner. You might feel that you don’t have robust enough finances or accounting operations to warrant the efforts needed to align to GAAP.

We get it. But following GAAP from the start makes a big difference for your financial health long term.

Why your small business should follow GAAP

As a privately owned startup, you can decide how you want to manage your accounting processes. But what happens when someone else needs to examine your finances?

The reality is that following generally accepted accounting principles comes with benefits for both you and external bodies.

1. Sound financial tracking

GAAP uses accrual-based accounting to track your finances. That means you record transactions as you receive them, not as you pay them, so you’re tracking revenue and expenses in the same period. 

By doing so, you can have a more accurate, real-time view of your margins and improve cash management. 

You can also better track financial analyses since you won’t have to account for delays in your cash receipts or payments, making for a sounder big picture of your finances that you can use to plan for the future.

2. Accurate P&L reporting

GAAP’s accrual accounting methodology also improves your ability to keep accurate P&L statements. Since you’d account for payments as you receive them, you can record revenue as it comes, making for more accurate (and potentially impressive) numbers.

For example, if you invoice a new client during the last week of your quarter, but the payment isn’t due until the following week, you can record that sales revenue for the current reporting period, boosting that quarter’s sales numbers.

3. Dependable forecasting

With the more accurate accounting that GAAP allows, you can build more reliable financial forecasts over time. Under these accounting principles, you’ll report your financial activity the same way every time using the same data.

This consistency and accuracy allow you to have a more holistic view of your finances, build out dependable forecasts, and have confidence in your money as you look to the future.

4. Accessible audit and funding data

While financial reports that align with GAAP may be a nice-to-have for you, they’re a must-have for domestic financial institutions, lenders, investors, and auditors.

Having GAAP-compliant records ensures your financial statements are readily available and up to the standard that those groups are expecting to see. If you don’t stick to GAAP rules, you can expect to spend a lot more time, effort, and money reworking your data into a compliant format,

So, what now? Are you expected to learn all of GAAP yourself so you can reap the benefits? No. That’s where we come in.

We know GAAP, so you don’t have to

Yes, there are many rules to follow to properly prepare, present, and report your financial statements. No, you don’t have to start cramming like it’s the night before your college final to learn every accounting principle possible. You just need the right accounting team on your side.

At Hiline, we combine human expertise and tailored technology solutions to ensure all your financial statements are prepared accurately, on time, and, yes, in line with GAAP. Let us worry about your financial ecosystem so you can stick to running your business.

Reach out to see how you can use our outsourced accounting services to meet regulatory standards and maintain strong financial health.