Closing the Gap: Why You Should Use GAAP Financial Statements
GAAP financial statements. You’ve heard the term. Maybe it’s because you keep being asked whether your startup financials conform to GAAP standards. But what the heck are GAAP financial statements? And why are they important?
What is GAAP?
GAAP, or Generally Accepted Accounting Principles, is a set of rules-based financial standards and practices developed in the aftermath of the 1929 stock market crash and the Great Depression that followed it. GAAP is governed by the U.S. Securities and Exchange Commission (SEC) and administered by an independent organization, the Financial Accounting Standards, Board (FASB).
GAAP’s underlying principles include: regularity, financial reports that meet GAAP conventions; consistency, using the same standards; good faith, financials that are presented honestly; and continuity, meaning the firm is a going concern. The principles and GAAP as a whole are intended to enable investors, creditors, and other financial statement users to access relevant, clear, and reliable information about a company’s financial position that is comparable across companies.
What is a GAAP financial statement?
Now that you have a feel for what GAAP is, what are GAAP financial statements? To put it simply, they are financial reports that are prepared in accordance with GAAP principles and practices. The three key financial statements that get the most attention are the balance sheet, income statement, and cash flow statement. Below is a little bit about each.
- Balance sheets provide a point in time picture of a company’s assets (cash, physical property, and intangibles like trademarks and patents), liabilities (think debt and other obligations like lease payments and taxes). They also include shareholders’ equity, or the difference between assets and liabilities. This is where you’ll see dividends and investor capital reflected.
- Income statements show a company’s revenues, expenses, and earnings over a set timeframe.
- Cash flow statements report a company’s cash activity (cash inflows and outflows) over a defined time period, broken down by category, for instance, regular operating expenses like payroll, or cash that came in from the sale of an asset, or that you spent to purchase one.
According to the SEC, GAAP financial statements should provide “comparability, full disclosure, and transparency.” And it isn’t enough just to provide a data dump of your numbers: your raw number should be supplemented by footnotes that provide more detail on what’s happening with the business. On top of that, GAAP financial statements must be prepared using accrual accounting. That means you recognize and record revenues and expenses as you earn/incur them, not when the cash actually changes hands.
For example, let’s say you’re running a company with a SaaS business model, with an annual subscription charge. Under accrual accounting, you recognize the revenues from those subscriptions in increments over the subscription period instead of all at once, when you receive the annual payment.
What’s so special about GAAP financial statements?
That’s all good, but at the end of the day, what’s the big deal about them? And why are they important for founders to have? Well for starters, GAAP financial statements are required:
- By the SEC if your company is publicly traded;
- By banks as a condition of providing loans;
- By the IRS once your business reaches a certain size.
Since GAAP was adopted to make sure investors, lenders, and others have the benefit of transparency into a company’s financials and its overall health, even if you aren’t required (yet) to prepare financial statements that conform to GAAP, for instance, you’ve only really started up, there could be compelling reasons for you to consider doing so. And as you begin to scale, you’re going to want to move to GAAP. Here’s why.
One, using GAAP places you on an equal footing with other companies potential investors may be considering. That’s because they enable investors and potential acquirers to more easily, and with greater confidence, compare and evaluate your company’s results, now and over time, to others in your industry.
Two, it gives you credibility. GAAP-based financial reports are using the accrual method of accounting. By avoiding the timing mismatches that exist with cash accounting (which can mean large swings in from one time period to the next), you are more accurately conveying your business’ financial situation and prospects, showing your business is professional and that you’re planning for the future.
There’s one more super important benefit. Because it improves your visibility into your results, GAAP’s transparency helps you better manage your business, forecast, and plan for the future.
GAAP and taxes: why timing is everything
The IRS allows several different accounting methods for tax filings as long as you’re consistent and don’t flip flop between methods. But…of course there’s a catch. If you’re bringing in more than $25 million in annual sales, or meet other criteria, you have to use GAAP for tax filings. You also need to get IRS approval to change from one accounting method to another. By using GAAP sooner rather than later, you’ll also avoid the hassle and stress of getting IRS approval to change methods.
The ways GAAP accounting could affect your taxes mainly come down to timing. Since one of GAAP’s cornerstones is matching income with expenses, you could end up paying more or less in taxes during any one tax year under GAAP accounting versus cash accounting. That’s because while GAAP is concerned with matching, the IRS is concerned with taxing you based on cash that changed hands during the tax year.
It’s common when you launch your business to use cash basis accounting — which by definition isn’t GAAP — rather than take on the time and expense of producing GAAP financials. But know that there are tradeoffs, and that in the long-term GAAP is the way to go. While it can all seem daunting, working with a trusted accountant and/or tax professional will help you navigate any rough spots.
Do you have more questions about GAAP financial statements? Contact Early Growth with your questions.