GAAP. It may seem like accounting jargon, but if your business is entering a Series A round and you’ve begun to have serious discussions with potential sources of capital, those four letters can be the difference between securing and losing out on funding. That’s because investors, banks, and other outside parties expect your business to comply with GAAP.
Let’s back up. What is GAAP accounting, and why is it important? What are the benefits of GAAP? When is GAAP necessary? Which businesses must use GAAP?
So many questions, so few clear answers out there for business owners who aren’t already CPAs. Here’s everything you need to know about GAAP—what it means, why it matters to your startup, its pros and cons, and when you should start thinking about making the switch to GAAP accounting.
What Is GAAP?
GAAP stands for Generally Accepted Accounting Principles. The purpose of GAAP is to standardize the recording and reporting of financial data. Think of it as the lingua franca—the common language—of bookkeeping and accounting.
GAAP has 10 underlying principles (more of a guidelines, really):
- Materiality: documents should disclose the organization’s complete financial reality.
- Sincerity: documents should disclose the full, objective truth.
- Consistency: every financial document should follow the same system and standards.
- Permanence of methods: all documents should be prepared the same way.
- Non-compensation: accountants should not expect additional compensation for doing their work.
- Prudence: accountants should not allow future potentialities to influence fact-based financial reporting.
- Continuity: any asset valuation should assume the organization will continue to be in business.
- Periodicity: reports should be created and divided over an appropriate time period—e.g. monthly, quarterly, or annually.
- Regularity: after implementing GAAP, an organization should not deviate from it.
- Utmost good faith: everyone should act honestly and fairly and assume everyone else is doing the same.
GAAP is not the same as accrual accounting, but accrual accounting is required for GAAP. In other words, you can’t simply record money as it goes in and goes out—i.e. cash accounting—if you want to be GAAP-compliant. (Learn more about the difference between cash and accrual accounting methods—and see which is right for your business—here.)
Why Does GAAP Matter?
GAAP establishes a shared set of values, goals, and expectations for everyone with interest in your organization. This reduces friction, uncertainty, and ambiguity for all parties.
GAAP has numerous benefits for stakeholders within and outside your startup. For example, when you use GAAP…
- an investor can rest assured your business will provide detailed financial records in a uniform format, every quarter
- investors can easily compare your financial records to those of another business
- accountants are able to provide guidance to you for how to interpret contracts and convert them into financial measures
Basically, GAAP makes it easier to explain what you’re doing—with accurate, consistent, easy-to-follow numbers.
What Kinds of Startups Need to Comply with GAAP?
Keep in mind that the principles above are general, overarching guidelines. Becoming “GAAP-compliant” requires a deep understanding of business contracts and management's intent, and may mean different things based on where an organization is located.
Not all organizations need to worry about GAAP. In fact, the only businesses that are legally required to comply with GAAP are publicly-traded companies.
Why Do Only Some Businesses Use GAAP?
Most businesses don’t start with GAAP accounting, and not just because they don’t need to.
GAAP is complicated—too complicated for most early-stage companies—and implementing it can be expensive and time consuming. When your company is pre-revenue, you haven’t gone to market, or the only money you’ve raised came from friends and family, angel investors, or crowdfunding, GAAP may not be worth the cost. At this stage, owners are better off focusing on immediate financial concerns such as taxes, burn rate, and overall business strategy.
That said, GAAP might be a good idea for your business regardless of whether you intend to go public any time soon. Doing so can help you not only establish trust with investors but improve the clarity of your leadership and decision-making. Moreover, if you tell someone you’re using GAAP and you’re not, you’re in for some major problems.
Signs It’s Time to Switch to GAAP
However, if a big investing round, product launch, long-term agreement, or other business milestone is around the corner, it may be time to consider switching to GAAP accounting methods. If you’re thinking about going public in the next 3-5 years, or ready to get real about your exit strategy, it’s definitely time to switch to GAAP.
Here are a few critical moments in your business lifecycle that necessitate GAAP:
1. You’re ready for later stage financing. As you transition from early, speculative investments (e.g. seed funds, your wealthy uncle, etc.) to sophisticated and institutional sources of capital, your accounting method needs to evolve as well. The more you raise other people’s money, the more important the transparency provided by GAAP becomes. GAAP also gives you the deep, objective visibility into your finances you need to speak intelligently about your business; it allows you to think like an investor.
2. You need to account for what will happen, not just what is happening. When you enter a long-term agreement that doesn’t involve a loan or equity—such as a contract with a vendor or a complex revenue-sharing arrangement—you’re adding another dimension to your books: time. You need to be diligent about how you record and spend your money now and over the duration of the agreement. Accrual-based accounting through GAAP allows you to recognize and track future revenue and expenses in the present, so you aren’t hamstrung waiting for the cash to hit your accounts.
3. Your business has grown significantly or is growing at a rate faster than you can keep up with. Cash-based accounting has its limits. It simply isn’t sufficient for organizations that have reached a certain size or are undergoing meteoric growth. Again, GAAP empowers you as a leader; without it, you’ll need to dig deep to justify your strategic decisions and forecasts. Additionally, if your business generates $5 million in annual gross sales or has inventory worth more than $1 million, the Internal Revenue Service requires you to use accrual accounting.
4. You’re considering an IPO. Don’t forget that all public companies must comply with GAAP. During the IPO process, auditors may want to look at financial reporting from as far as three years ago so a last minute GAAP transition will be really expensive and could potentially lose you investors. It’s certainly easier—and cheaper—to switch to GAAP in advance of going public rather than waiting until the last minute.
Thinking about making the switch? At inDinero, we can make transitioning to accrual-based, GAAP-ready accounting as quick, cost-effective, and painless as possible. Learn more in our free business owner’s guide to GAAP—and when you’re ready to speak with an accounting expert, schedule a call with us.