Sam Patel, Manager Director of Client Services at Graphite
The gold standard for accounting methods in the United States is GAAP (Generally Accepted Accounting Principles). GAAP is more than just a set of best practices, though.
These standards are set by the Financial Accounting Standards Board (FASB), and public companies are legally required to comply with them. And many VCs require their portfolio companies to adhere to GAAP as well.
Failure to comply with GAAP can lead to regulatory issues with the governing bodies in your industry. In addition to the more concrete consequences, it can also lead to long-term problems within your organization, including:
- Inaccurate financial reporting, which leads to poor decision-making later on.
- A loss of investor confidence and damage to your reputation.
- Difficulty obtaining financing in the future.
If your organization isn’t prioritizing GAAP compliance, now’s the time to do so.
To set you up for success, we’re demystifying GAAP accrual and cash accounting, covering the most important GAAP principle to follow, and showing you the most common GAAP violations to avoid.
What Is the Difference Between GAAP Accrual and Cash Accounting?
GAAP accrual accounting methods are often compared to cash accounting, which is another method that many small businesses use. The biggest difference between GAAP accrual accounting and cash accounting is timing.
Cash accounting recognizes revenue and expenses only when a payment has been made, meaning the cash has traded hands. Alternatively, GAAP accrual accounting recognizes revenue and expenses when they are incurred, regardless of when payments are made or when cash is received.
Cash accounting methods are more straightforward for beginners, which is why they’re often used by small businesses or even by individuals looking to organize their personal finances. However, this method of accounting is far less informative and forward-looking than GAAP accrual accounting, as it doesn’t account for payments that have yet to be processed.
Alternatively, GAAP accrual accounting provides a more comprehensive view of your organization’s financial position. This is because it reflects your future economic activity and obligations, providing a more accurate representation of profitability.
Although cash accounting may be acceptable for tax purposes, GAAP accrual accounting is a necessary part of financial reporting for most companies. Publicly-traded companies are legally required to use GAAP accrual accounting, and many private companies need to use this method as well for industry compliance.
Additionally, GAAP accrual accounting’s more comprehensive approach helps your team make more informed financial decisions.
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This Is the Most Important GAAP Principle to Follow
All GAAP principles are important for financial accuracy and should be followed as closely as possible. However, the Full Disclosure Principle is one of the fundamental pillars of GAAP.
The Full Disclosure Principle requires your organization’s financial statements to provide a true and fair view of your financial position, performance, and cash flows. By emphasizing the need for transparency and completeness in reporting, it ensures that anyone using your financial statements will have access to the relevant information they need to make informed decisions.
Under this principle, organizations need to disclose all material information that could affect the judgment and decision-making of anyone using these financials, such as investors, creditors, and regulators.
It’s best to err on the side of caution when it comes to disclosure to avoid potential GAAP compliance violations. This includes the disclosure of:
- Significant accounting policies
- Related party transactions
- Any other relevant information.
Adhering to the Full Disclosure Principle is key to maintaining the integrity of your financial reporting and promoting transparency, comparability, and trust. If you’re raising capital for your startup, adhering to this principle also provides investors with reliable information, which is used to evaluate your organization’s financial health and ultimately make investment decisions.
The 3 Most Common GAAP Violations
FASB periodically updates GAAP to reflect changes in the financial and accounting industries. To remain GAAP-compliant, your organization will need to stay updated on these principles and seek professional support as needed.
Working with an accounting firm like Graphite will help you maintain proper documentation, implement internal controls, and conduct audits to ensure that your accounting is up to standard. Unfortunately, many organizations violate GAAP principles in their accounting, failing to notice the problem until damage has been done.
Currently, these are the three most common GAAP violations. Here’s our best advice on how to avoid them:
Improper Revenue Recognition
Improper revenue recognition happens when revenue is recognized prematurely or inappropriately, deviating from GAAP guidelines.
This violation occurs when an accounting team recognizes revenue before it’s earned or meets the criteria for recognition. Recording revenue that does not meet GAAP criteria negatively affects your financial projections later on.
To avoid improper revenue recognition, organizations need to carefully follow the criteria in ASC 606 and other guidance provided by GAAP. These guidelines ensure that revenue is recognized when it is earned, performance obligations are satisfied, and collectibility is reasonably assured.
Implementing robust internal controls and providing extensive employee training helps your accounting team better understand these GAAP guidelines and prevent improper revenue recognition. Not only is this key for compliance, but it also contributes to accurate future cash flow forecasting.
Inadequate Expense Recognition
Inadequate expense recognition happens when expenses are not recorded or are misclassified. This leads to financial statements that don’t accurately reflect your organization’s operational costs, which is misleading for potential investors, lenders, and other stakeholders.
To avoid this violation, organizations need clear expense policies and procedures in place based on GAAP. Your team should perform regular reviews to make sure that expenses are properly categorized, supported by appropriate documentation, and recorded in the appropriate accounting period.
Inadequate disclosure is the failure to provide sufficient and relevant information in financial statements and related footnotes.
When this violation happens, anyone using or reviewing your organization’s financial statements will fail to develop a complete understanding of your position and performance.
Organizations should carefully review the disclosure requirements outlined in the GAAP standards, ensuring that their financial statements and footnotes provide comprehensive and transparent information.
To adhere to these requirements, you need to provide information about significant accounting policies, contingent liabilities, related party transactions, and other material information.
Remain GAAP-Compliant With Graphite
Understanding and complying with GAAP standards is often a major challenge for rapidly growing startups. Switching from cash accounting to GAAP-compliant accrual accounting can be particularly challenging.
However, GAAP compliance is a must for any organization looking to scale, find investors, and potentially go public in the future.
We’re here to guide you through the GAAP compliance process and develop accounting strategies that work for you. See how Graphite’s accounting services support your organization’s financial compliance initiatives.
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