As a small business owner, you wear the “accountant” hat from time to time. But while you may not need a degree in accounting to run your business, or even just to get a basic handle on your company’s books, it’s a great idea to familiarize yourself with some of the principles and guidelines that operate at the foundation of accounting. This will give you a better understanding of your company’s financial statements which, in turn, makes you better placed to make smart financial decisions and allow your business grow and flourish. In the U.S., these are known as the Generally Accepted Accounting Principles. What are the Generally Accepted Accounting Principles, you ask? Read on and find out...
What Are the Generally Accepted Accounting Principles (GAAP) and Why Should You Follow Them?
First of all, you may be wondering what exactly the GAAP are, and why you should concern yourself with them as a small business
owner in the U.S. Simply put, the Generally Accepted Accounting Principles, or GAAP, are a set of principles and guidelines that U.S. companies of all sizes, across all industries adhere to. (Note: in a forthcoming post, we'll talk about the Canadian equivalent, the Accounting Standards for Private Enterprises, or ASPE.) Whether we’re talking about a sole proprietorship, a limited liability company, or even in a huge multi-million dollar corporation, the GAAP will be operating at the root of all of the company’s accounting transactions. Thanks to the GAAP, a company’s financial statements can be compared to others in the same industry because the same accounting methods and principles are being used.
One reason companies pay attention to the GAAP when preparing and analyzing their financial statements is because this allows them to put into practice a clearly-defined set of rules, methods, and procedures. This ensures that the information contained in these financial statements is consistent and accurate. It also allows the people who look at your company’s financial statements (i.e., stakeholders, investors, and creditors, and auditors) to make an accurate assessment of your company’s financial health and make informed decisions about whether they want to do business with you. (Picture a bank deciding whether or not they will extend credit to your business or a potential investor deciding whether it’s worth it to put their money into your company). Not only that, but following the GAAP in your company’s accounting can help you to avoid possible accounting errors, fraud, and tax-related headaches!
GAAP and Your Financial Statements
Let’s take a closer look at how the GAAP help shape the information found on your company’s financial statements. First of all, what are your financial statements? Those would be your company’s balance sheet and income statement, both of which are crucial documents for charting and analyzing your business’ financial health. (Learn more about important financial documents like the balance sheet.)
One of the most important accounting principles that you should be following while preparing your balance sheet is the matching principle. This means that you’ll be recording your company’s revenues and expenses during the time period in which they actually take place, and not when the related payment is made or received. (The revenues and expenses will “match” the actual period of time in which they happened.) For example, if you make a sale in January but don’t collect payment from your client until February, you would still record the revenue/income from the sale on January’s financial statement. This is also known as the accrual method of accounting as opposed to the cash-based method. (Learn more about cash and accrual accounting methods.)
Another important part of the GAAP is the cost principle. Following this principle means that the original cost of an item is recorded on the financial statement, regardless of changes to the cost over time (due to factors like inflation). Even if the market value of an asset, like a piece of real estate, has gone up over time, the original cost of the asset (which can be objectively verified, unlike the current market value, which is a bit more difficult to pin down) is still recorded on the books.
Over on your income statement, the revenue recognition principle will have an effect on when your company’s revenue/income is recorded. According to this principle, revenues should only be recorded on the income statement once they’ve actually been earned. Maybe you’ve already signed a big contract or are anticipating a huge sale in the near future, but that doesn’t mean you can go against this accounting convention and put that income on the books just yet!
Keeping it Reliable, Verifiable and Consistent
Making sure your business is in tune with the GAAP is not only a great way to keep clear records so that you can gauge what’s going on within your own company from a financial standpoint; but it also lets outside parties know that you’re conducting your business in a way that’s consistent with industry standards. Even if you’re starting your business with just you, you and a partner, or a small team, make sure you and your company’s accountant are well-informed about the accounting principles that make well-organized accounting possible in the first place.