GAAP - What is it, really?

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Each week, ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories.

First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.

Many times we will interlace non-series articles with series articles in order to create a friendly and diverse mix of content. So this week we are taking a break from our Accounting 101 series, but we will be back to that series before you know it.

To many CPA's, today's article may seem 'basic', but to many of our readers, this article will provide a better understanding of a fundamental of accounting, "Generally Accepted Accounting Principles" (GAAP).

If you’ve ever been a part of a financed business transaction, you’ve undoubtedly seen the loan documents reference the requirement for GAAP-based financial statements. Or, you’re speaking to an attorney about a business transaction, and she says she needs GAAP financials. Been there? No offense to bankers or attorneys, but most of them don’t know what they are requesting in a GAAP-based financial, right?

Generally accepted accounting principles, or GAAP. Those of us practicing business disciplines, whether accounting, finance, or other derivations, deal with the fact that GAAP is a part of our life as it relates to financial statements. Now, I know, most of you preparing financials out there dispel the notion that they must be prepared under the strict guidelines of GAAP. I agree with you. If you are a small business owner or an accountant preparing financial statements for small businesses, you are most likely leaning toward cash- or tax-basis financial statements. GAAP-based financials are overkill and unnecessary. Right? Those shunning GAAP financial statements cite opposition that true GAAP financials are stringent, often onerous, and arguably less than useful to the small business. A quick look at a few selected characteristics of a GAAP financial statement makes it clear why it might be less than beneficial to the small business entity:

  • Accrual accounting – accounting purists believe the only basis of accounting is the accrual basis. Conversely, most owners of small businesses believe the most beneficial (and thus, best) basis of accounting is the cash (or income tax) basis. Why? Because the accrual method recognizes revenue before it is collected, and small business owners have no interest in paying the Taxman before the tax is legally due.
  • Statement of Cash Flows – yep, the dreaded cash flow statement. This statement, while important to accounting wonks and mandatory in a GAAP financial statement, makes most readers cringe and turn the page immediately. And, how about preparing this seemingly cryptic statement? Forget it. All the negative hype aside, if one spends the time necessary to understand the message this statement actually delivers, preparing and publishing this statement is not as difficult as first impressions might appear. That said, why does the owner of any small business need this statement? Except for specific reasons or situations, the small business owner will rarely need it, but more importantly, want to pay for its preparation.
  • Footnotes – if you have read a full GAAP financial statement or annual report of a publicly traded company, you’ve seen the footnotes accompanying the financials. Most of them are informative and provide insight that a read of the financials do not provide. Well, that’s what they’re supposed to do. However, for all the good the footnotes can do, the small business owner is less than interested in explaining anything more than the financial statements themselves reveal. Rather, he wants the numbers presented for the most reasonable cost possible; consequently, footnotes typically get nixed.

These are just a few of the primary arguments small businesses make against GAAP and the financial statement requirements under GAAP. But, that is not the focus of this article. The focus of this article is this: Do you know (or remember) the actual attributes of the “P” in GAAP? The Principles! Regardless the basis of accounting you use or the resulting financial statements you prepare, understanding the principles, or at least being aware of them, is paramount to getting it right.

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The Underlying Principles

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There are a great number of principles in accounting, but a core set provide the basic guidance necessary to identify, classify, and post transactions to the accounting records. The idea of these principles is to understand what guides the preparation and presentation of accurate financial statements. And, make no mistake; these principles cross over to other bases of accounting. Do not believe the principles under GAAP don’t apply if you prepare something other than a GAAP financial statement. Let’s take a quick look at the core principles.

Historical cost. Record transactions at cost. That is, when recording or booking a transaction, you should only book the amount paid or received. Forget what it might be worth. The cash (or equivalent) paid or received is what matters.

Full disclosure. This principle requires that the financial statement contain enough information or explanation so as not to be misleading.

Revenue recognition. Record and recognize revenue only at the point when all the activities associated with generating that revenue have been completed. [Note: These processes will be different depending on your chosen accounting method, cash or accrual.]

Matching. The expenses associated with a revenue-generating activity should be recorded in the same period in which revenue is recognized (i.e. match the costs to generate revenue with/when the actual revenue is generated).

Economic entity. This principle is based on the theory that the transactions of a business entity stand on their own, and should not be commingled with that of another entity regardless existing relationships.

Monetary unit. All transactions should be measured and recorded in financial terms or a currency.

Time period. Financial reporting should be expressed over standard periods of time, such as months, quarters, or years. Other periods are acceptable if standardized.

Going concern. This assumption is present in all viable businesses; that is, the business will continue operating for the foreseeable future.

Materiality. An item is considered material if its inclusion or omission would influence the reader of the financial statement.

Conservatism. The accounting treatment of any transaction should be considered from the perspective that it will not overstate assets and revenues or understate liabilities and expenses.

Cost-Benefit. The cost of providing financial information should not outweigh the benefit of such information.

Industry Practice. The financial statements and underlying transactions in certain industries (e.g. construction, oil & gas, etc.) do not necessarily follow strict accounting principles. The peculiarities of an industry should always be considered where deviations from GAAP are warranted.

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The Bottom Line

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While you may never prepare, or have the need to prepare, a GAAP-based financial statement, the principles driving GAAP should always be considered, and are, at some level, universal to recording all accounting transactions and preparing the underlying financial statements. Do yourself a favor…ensuring you have a good understanding of these principles and applying them properly will result in a better, more accurate financial statement.