Understanding the Importance of GAAP
February 27, 2018
Business Owners & Executives Alike Should Understand the Importance of Generally Accepted Accounting Principles aka GAAP
Business executives, particularly business owners, should understand the importance of generally accepted accounting principles (GAAP). While you don’t need to be an accounting expert, it is important to be able to determine whether GAAP is being applied properly and appreciate the role it may play in certain contract provisions.
What Are Generally Accepted Accounting Principles?
In basic terms, GAAP is a collection of widely-followed accounting principles, rules and standards for financial reporting. It is intended to ensure consistency in financial reporting, which makes it easier for investors to analyze the information presented and compare it between companies.
GAAP reflects established concepts, objectives, standards and conventions that have evolved over time to guide how financial statements are prepared and presented. GAAP addresses the following aspects of financial reporting, among others:
- Recognition: What items should be recognized in the financial statements, such as assets, liabilities, revenues, and expenses
- Measurement: What amounts should be reported for each element of the financial statements
- Presentation: What line items, subtotals and totals should be displayed in the financial statements, as well the manner in which items are aggregated within the financial statements
- Disclosure: What specific information is most important to the users of the financial statements. Disclosures serve to supplement and explain amounts in the statements.
The Financial Accounting Standards Board (FASB) sets GAAP for public and private companies and not-for-profit organizations. It is recognized by the Securities and Exchange Commission (SEC) as the designated accounting standard setter for public companies.
Similarly, Governmental Accounting Standards Board (GASB) establishes GAAP for state and local government. The international version of GAAP is the International Financial Reporting Standards (IFRS), which is set by the International Accounting Standards Board (IASB).
Last year, GAAP underwent its largest overhaul in several years. The FASB initiated the Accounting Standards Codification (ASC), which supersedes all prior standards. Prior to ASC, GAAP guidance was comprised of thousands of individual pronouncements. While there is now only one authoritative source, it is still a complex system of codification.
Should Your Company Use GAAP-Based Financial Statements?
If your business plans to seek outside credit or investment and/or your ultimate goal is to become a public company, GAAP-based financial statements will ultimately become a necessity. Because it can be expensive and cumbersome to switch accounting systems once a company has been operational for some time, it is wise to adopt a GAAP-based system from the outset.
Most creditors and investors require financial statements to be GAAP-compliant because it allows them to quickly and reliability assess the viability of your company. Internally, GAAP financials also you to readily compare your company’s financial performance with competitors and other similar companies. It also ensures that financials can be consistently compared year after year.
Because the SEC requires public companies to file GAAP-compliant financial disclosures, businesses considering an initial public offering or other means of going public must also move to GAAP-based statements. The switch can be burdensome because GAAP must not only be applied going forward, but its impact on past financials must also be analyzed.
For investors, the lack of GAAP-compliant financial statements should raise concerns. While some companies use both GAAP and non-GAAP compliant measures when reporting financial results, non-GAAP measures should be clearly identified in financial statements and other public disclosures.
Do you have any questions? Would you like to discuss the decisions further? If so, please contact me, Fred Zemel, at 201-806-3364.