GAAP accounting rules: Understanding the 10 principles

A recent study of 500 startup founders reveals that the top two reasons for startup failure in 2022 were the lack of financing or investors followed by running out of cash. Whether you're a SaaS startup founder or lead a product-based venture, you must clearly understand your company's finances to steer the business in the right direction and avoid these pitfalls.

Reliable financial statements empower you to make strategic decisions that help increase revenue and profitability. This is where GAAP accounting comes into the picture. 

Though not mandatory, adhering to the Generally Accepted Accounting Principles (GAAP) helps standardize your financial statements and make them 100% accurate and reliable. This is a huge benefit when seeking to raise capital or preparing to go public with an IPO.

Think of GAAP as the beacon that helps you smoothly navigate the choppy waters of startup accounting and reporting.

What is GAAP?

The Generally Applied Accounting Principles (GAAP) are a set of standardized accounting practices and procedures that all publicly traded companies in the US must use to prepare their financial statements. GAAP principles cover various financial topics such as assets, liabilities, revenues, expenses, equities, forex, hedging, derivatives, and non-monetary transactions.

While the U.S. federal government requires all publicly traded companies to adhere to GAAP, they don't maintain it. Instead, several reputed boards and organizations are responsible for developing, distributing, and updating the GAAP principles. The Financial Accounting Standards Board (FASB) is a private and non-governmental board that regularly publishes helpful resources for businesses looking to adopt GAAP.

Adhering to these standard accounting procedures improves financial information's consistency, clarity, and comparability across organizations. The primary purpose of these principles is to provide an accurate and transparent view of a company's financial health to internal and external stakeholders. Standardizing financial reports across industries makes it easier for investors, lenders, and other stakeholders to assess the health of a company reliably.

GAAP’s relevance to startups

The Securities and Exchange Commission requires all public companies in the U.S. to comply with GAAP financial reporting process. However, private companies like startups can manage their books using any accounting principle if they pay taxes on time. That said, there are several benefits high-growth startups gain by following GAAP accounting practices:

Improve Credibility And Transparency

Startups in the early-growth stages often find it challenging to gain the trust of potential investors, lenders, and partners. By adhering to GAAP's basic accounting principles, you can demonstrate that your financial statements are prepared according to universally accepted standards. This improves transparency and credibility and earns the trust of stakeholders.

Compare With Industry Benchmarks

As a fast-growing startup, you might want to compare your performance with competitors and established players in your industry. Following GAAP accounting principles helps to build standardized financial statements that you can compare with industry benchmarks. This makes it easier to analyze and compare your business's strengths and weaknesses to peers.

Raise Capital

GAAP accounting compliance is a game-changer when you seek funding from VCs, banks, or individual investors. Investors often request financial statements prepared following GAAP, which provides an accurate picture of your startup's financial health. GAAP compliance increases your chances of securing capital and taking your business to the next level.

Comply With Legal And Regulatory Requirements

While startups are not required to comply with GAAP, adhering to these principles can help you protect your business from legal troubles and potential penalties. It demonstrates your commitment to ethical business practices and improves your business reputation.

Make Better Decisions

GAAP isn't just about standardizing your accounting books. It helps you make sound internal decisions. By adhering to GAAP principles, you better understand your startup's financial position, cash flows, income statement, performance, and potential revenue. This information is crucial for budgeting, resource allocation, and strategic planning, helping you steer the business toward growth and profitability.

The 10 GAAP principles

The ten basic principles of GAAP accounting include the following:

1. The principle of regularity

The principle of regularity dictates that your business must use standard, prevalent accounting practices. When adhering to the GAAP principles, you cannot choose alternative accounting methods to create and maintain your financial statements.

2. The principle of consistency

This principle indicates the importance of using consistent procedures. Your accounting team must commit to using the same standard practices for all reporting. Maintaining consistency helps to prevent errors and build a standardized accounting procedure. If your accounting team decides to switch to another reporting process, you must fully disclose the reasons for the change.

3. The principle of sincerity

This emphasizes your commitment to doing a sincere, objective accounting practice. The accounting team strives to accurately and transparently depict your company's financial position without hiding any details.

4. The principle of permanence of methods

This principle is related to the principle of consistency. It requires that the procedures you use in financial reporting are consistent and provide a coherent picture of the business. This consistent and standardized reporting allows for comparing your business to others in your industry.

5. The principle of non-compensation

The accountant promises to disclose complete and actual accounting details, including the positives and negatives. The accounting team remains objective without trying to compensate for the negatives. Debts are maintained separately from assets, and expenses are kept separate from revenues.

6. The principle of prudence

"Prudence" means good judgment, wisdom, and common sense. In GAAP, the principle of prudence demonstrates fact-based financial data representation. Your reports should be grounded and cautious without being speculative. You must avoid embellishing them to make them look impressive and let the numbers talk.

7. The principle of continuity

When creating financial reports, you should work with the assumption that the business will continue to operate in the long run. Asset valuations should always be determined by historical prices rather than disposable value.

8. The principle of periodicity

According to this principle, each financial entry should denote only one period. If the entry is for several accounting periods, like an annual subscription payment, the revenue should be split and recorded accordingly. This practice of splitting revenues across different periods is known as revenue recognition.

9. The principle of materiality and good faith

Also known as the principle of full disclosure requirements, this principle states that all significant information that influences financial decisions must be disclosed. This principle ensures that investors, C-suite executives, and other stakeholders can access accurate financial information about the company.

10. The principle of utmost good faith

All parties involved in preparing and presenting financial statements should act with integrity and honesty. They should not knowingly mislead investors and other users of the prepared financial reports.

The importance of GAAP accounting rules for startups

Following GAAP accounting standards can be challenging, especially if you're a startup with limited accounting resources. However, the benefits of complying with GAAP outweigh the challenges of adopting it. Here are a few reasons why your startup needs to comply with GAAP accounting rules:

• Increased financial transparency
• Reliable and accurate financial statements
• Reduced risk of fraud
• Improved compliance with regulatory requirements
• Informed decision making

Complying with GAAP ensures that your startup's financial statements are reliable, transparent, and accurate. This makes it easier to attract investment capital and make better financial decisions.

Impress your investors with GAAP framework

Investors are often wary of startups that aren't GAAP compliant. Adhering to GAAP increases your business's credibility and reputation and makes it easier for potential investors to understand your company's financial position. So, to raise capital and impress investors, you must treat GAAP as a "must-have" rather than a "nice-to-have" feature.

Whether you're in the early stages of growing your startup, or preparing for the next round of funding, investing in a GAAP-compliant accounting system or hiring a fractional CFO experienced in GAAP can help you comply with these standardized accounting rules and scale your startup by winning investor confidence and trust.

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