Using standard accounting methods benefits any small business. For those looking to level up their financial reporting, adopting generally accepted accounting principles (GAAP) can unlock new opportunities but also involve challenges.
This guide defines GAAP, who uses them, and how regulation works. Explore GAAP accounting principles to understand the key concepts.
What is GAAP?
GAAP stands for generally accepted accounting principles. It's a comprehensive framework of guidelines, principles, and standards governing how publicly traded companies prepare and present financial information. Nonprofits and private businesses use GAAP accounting to standardize bookkeeping practices or meet stringent reporting requirements.
GAAP's purpose is to provide investors, regulators, and creditors with financial statements that are comparable and understandable. However, it also offers financial accounting, inventory management, and bookkeeping guidelines.
Since GAAP is mainly used in the United States, it's called the U.S. GAAP. The global equivalent is the international financial reporting standards (IFRS).
Who uses GAAP?
Publicly traded companies are required to comply with GAAP, which is enforced by the U.S. Securities and Exchange Commission (SEC). However, many other businesses and nonprofits follow GAAP to demonstrate transparency and consistency in financial reporting.
Examples of companies that might use GAAP in accounting include:
- Startups and small businesses seeking funding, potential buyers, or partners can use GAAP to satisfy reporting and accounting requirements.
- Regional banks and private insurance firms must adhere to strict regulatory requirements that usually align with GAAP, even though they aren’t public companies.
- Healthcare providers, energy firms, and government contractors might need to produce GAAP-compliant financial reports.
- Fast-food, retail, and fitness franchisors may mandate GAAP standards across locations to standardize reporting.
- Nonprofits may need to prepare GAAP-compliant financial statements to meet grant requirements or donor standards or maintain their 501(c)(3) tax-exempt status.
GAAP's purpose is to provide investors, regulators, and creditors with financial statements that are comparable and understandable.
Principles of GAAP
GAAP accounting principles are key concepts you can use to understand broader topics. Many accounting textbooks, courses, and educators cite 10 to 12 foundational ideas.
The core principles include:
- Accrual principle: Record revenue and expense transactions when they occur, not when money is exchanged. GAAP requires the accrual basis method of accounting. Let’s say a cleaning company receives a utility bill in January but pays it in February. Since they used the electricity in January, it’s recorded in January.
- Monetary unit principle: Log transactions in the same currency without adjusting for inflation. If a company bought shelving units for $2,000 five years ago, the amount remains the same in the accounting records; it is not changed each year for inflation.
- Economic entity principle: Separate financial activities and records are maintained for each owner, business entity, or subsidiary. A food truck business should pay for ingredients from a business bank account, even if the owner is buying personal groceries at the same time.
- Periodicity principle: Establish specific accounting periods for financial reporting, such as months, quarters, or years. Small businesses may review revenue and expenses monthly, then prepare quarterly reports for tax planning and annual financial statements for lenders.
- Cost principle: Record assets at their original purchase price, not the market or inflation-adjusted value. If a restaurant buys a delivery vehicle for $28,000, it records that price, even if similar vans later sell for a higher price.
- Revenue recognition principle: Acknowledge revenue when it's earned, not when cash is received. Consider a business that completes a project in March but doesn't receive payment until April. Under the revenue recognition principle, the company records this revenue in March because that’s when the work was completed.
- Matching principle: Record expenses in the same period as the revenues they help generate. For example, a retail shop may buy inventory in October for the holiday season and sell it in December. The cost of goods should match with the December sales revenue.
- Full disclosure principle: Provide all information needed to ensure clarity and transparency in financial statements using footnotes when necessary. If a small business is involved in a lawsuit, it may not show up clearly on statements. The owner must disclose this risk so lenders or investors understand the potential impact.
- Going concern principle: Assume the business will remain open unless you have evidence to the contrary. Let’s say a coffee shop buys a new espresso machine. It is treated as equipment that will be used for years, not something that must be sold right away.
- Consistency principle: Apply accounting methods consistently. If you make changes, disclose and explain them. For example, if you switch inventory methods, then you should explain the change in statements so people can compare financial results accurately.
- Materiality principle: Focus on decision-making details and ignore insignificant information that doesn’t improve or affect the overall understanding. A small business may immediately expense an entire pack of pens worth $12 instead of tracking it long-term because it’s too small to affect the lender’s or owner’s view of the business finances.
- Conservatism principle: If uncertainty exists, choose the less optimistic solution that results in lower profits or asset valuations to avoid overestimating the organization’s financial health. For example, if a business believes a customer may not pay an invoice, it should not treat the full amount as guaranteed income. Instead, the owner may record a bad debt expense to ensure profits are not overstated.
How GAAP is regulated nationwide
The Financial Accounting Foundation, an independent, private-sector, not-for-profit organization, oversees the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB).
Both boards are responsible for maintaining accounting and reporting standards. The GASB guides state and local governments, whereas FASB maintains GAAP for public and private companies and not-for-profit organizations. FASB publishes the Accounting Standards Codification, a digital, frequently updated resource. Auditors, businesses, and other stakeholders offer public input to proposed changes.
The SEC enforces GAAP compliance for publicly traded companies by requiring accurate statements and forms. It can take legal action or impose fines for noncompliance. The American Institute of Certified Public Accountants provides additional guidance for private companies and accountants.
At the state level, boards of accountancy require that certified public accountants understand GAAP for licensing exams, continuing education, and professional practice. Third-party auditors may also review financial statements for public or private companies to confirm GAAP compliance and report discrepancies.
GAAP vs. cash-basis accounting: What the difference means for your small business
Cash-basis accounting tells you what’s in the bank. GAAP-based accrual accounting provides a more complete picture of what your business earned, owes, and owns.
Very small businesses may use cash basis because it’s simpler. You record income in your accounting software when money comes in and expenses when it goes out. But GAAP generally requires accrual accounting, which documents revenue when it’s earned and expenses when they’re incurred.
According to IRS Publication 538, Accounting Periods and Methods, businesses should use a method consistently, and some companies, such as those with inventory, must use accrual basis accounting. Since the timing of income and expense entries differs between methods, your taxes may be affected if you switch. The IRS may require businesses to submit Form 3115 before changing an accounting process.
When does your business actually need to follow GAAP?
You may not need GAAP for everyday bookkeeping, but situations may occur that require it. Although tools like QuickBooks Online let you switch between methods, you may need to adjust some entries to avoid double-counting revenue or expenses. Waiting until you apply for an expansion loan or sell your business can cause problems because buyers or lenders may request GAAP-compliant financial statements.
Other reasons you may need to follow GAAP include:
- Seeking investors: Third parties typically want standardized statements so they can assess risk and compare performance.
- Working with government contracts or grants: Some types of government work or funding require the business to follow more formal reporting standards.
- Preparing for a merger or acquisition: Interested parties use GAAP-based financials to confirm revenue, expenses, assets, liabilities, and margins.
Common GAAP missteps small business owners make, and how to avoid them
GAAP principles can be confusing for beginners. Many accounting mistakes come from misunderstanding how to record expenses or properly document changes on financial statements. An accountant can audit your account to catch errors before they affect your taxes or financial reports.
Here are a few mistakes that you can avoid:
- Not recording unpaid bills or outstanding invoices: Waiting until cash enters or leaves your account can skew financial reports, nor does it follow accrual-based GAAP. Establish a regular cadence or use automated accounting tools to ensure timely accounting entries.
- Paying personal bills from business accounts: Solo business owners may mix professional and personal transactions. This violates GAAP’s economic entity principle and can make it harder to understand business performance. Keep accounts separate to avoid inconsistencies.
- Not disclosing context or changes on financial reports: Failing to mention that you switched inventory accounting methods or have tax or legal issues can mislead lenders or investors. Consider hiring an accountant who can prepare disclosures to ensure third parties have important details.
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