Our goal at Lending Valley is to provide all small business owners access to the best loans possible for their business. You can rest assured we will get you the best rates in the market!
The abbreviation GAAP stands for generally accepted accounting principles. From the name, you already know that this has to do with accounting, but that may already have you puzzled. After all, why would any business person need to understand accounting principles when they can just hire an accountant?
We previously discussed the importance of hiring an accountant and that still stands, but there is still nothing wrong with understanding what an accountant does. Besides, knowing what rules an accountant follows will help you understand their role and why they do what they do. Accountants may sometimes seem too preoccupied with rules, and knowing these rules should help you know why they do so.
You don’t need to understand the specifics either, just the basic knowledge should be enough for the business owner. Leave the details to the accountants themselves while being aware of their roles to protect yourself and your business. There isn’t much to learn here, as there are only 10 essential principles under GAAP to understand.
This is the first basic principle that simply states that the business should be kept completely separate from other businesses and the individual. You will probably notice how pedantic an accountant gets about keeping things separate, perhaps to the extent that you become frustrated. For example, they will insist that the company get a separate business bank account.
They do this because of this fundamental principle of accounting, which is sometimes also referred to as the separate entity assumption. Doing this will help make things easier down the road, especially come tax season. Keeping things separate ensures that business transactions are independent from personal ones and business taxes can be filed appropriately. The economic entity assumption applies even for a sole proprietorship because, legally, the company is a separate entity from you, the owner. When you do decide to incorporate the sole proprietorship into a partnership or LLC, adhering to this principle will make the entire process easier and straightforward.
All financial activities of the company need to be stated in the same currency, states this accounting principle. Can you imagine having financial records being stated in multiple currencies? It would be complete chaos for both you and the accountant. Simply trying to study the books for an understanding of the cash flow and profits or losses would take ages as you would have to keep converting currencies. Moreover, you would have to do so at the historical prices at the time of the transaction. The accountant too would face the same challenge when trying to get the books in order for tax season.
For these reasons, all transactions must be stated in a single, stable currency. The FASB recommends using the US dollar as the monetary unit of record. It should also not be adjusted for inflation regardless of how long the business has been in operation. That means taking more time to perform bookkeeping tasks for transactions made in other currencies.
Dates matter very much to accountants because it is the only way they and anyone else can draw meaningful conclusions from the data. You may already have noticed how companies report their financial statements, for example, profits for the first quarter of 2019, assets remaining as of December 2018, and so on. This demonstrates how crucial dates are, and all financial statements must be dated.
Balance sheets indicating liabilities, assets and capital are usually indicated with ‘as of’ or ‘at’ a particular date. Meanwhile, reports on the profits and losses will be indicated over a specific period of time such as Q1, Q2, etc.
It may seem cruel, but a business is always assumed to continue operations beyond your lifetime. Theoretically, a business should survive the owner(s) and continue operating in perpetuity. This assumption is also referred to as the non-death principle. It is by this GAAP principle that expenses are always deferred to the next accounting period indefinitely because of the assumption that the business will still be in operation. If the accountant is concerned that the business may liquidate or otherwise go out of existence, they will indicate this explicitly in the GAAP principles.
Say, a company acquired an asset at the beginning of the year and since then the asset has doubled in market value. The accountant will still report that asset’s value in the balance sheet at the price it was acquired and not at the fair market value. This is done to avoid bias in the financial reporting of the company. Had that been the case, the information would be subjective and thus not reliable.
The idea behind the initial cost principle is to separate cost and value. The value of assets may change over time but the cost will always be the same. To reflect value, the assets are either stated indicated in depreciation values or after their sale. When a company needs to understand the value of its assets at any time, an expert is brought in to assess the fair market value. Nevertheless, debts and securities are mostly reported according to market value.
A company is supposed to provide all the necessary information needed for those reading the financial statements to make informed decisions about the company in question. The information to be disclosed can either be relayed in accompanying notes, the main financial statements or as supplementary information.
Inasmuch as a company is required to disclose company information under this principle, the cost of the information must also be considered. More information disclosed takes more time to prepare and effort to prepare, therefore costs more. Therefore, the final information displayed must be informative while still being reasonable in cost.
This principle basically means that expenses must be matched with the revenues. For most small businesses that operate on a cash basis, revenue is reported only when cash is received. On the other hand, an expense is recorded only when money is spent either in cash or credit card. However, this is not how accountants generate their financial reports because they follow the matching principle. Accordingly, transactions are not recorded unless they actually contribute to the revenue within a particular period. This means expenses like overhead costs and wages are recorded within the same accounting period.
This form of accounting is referred to as an accrual system, and it is better at showing the performance of a business compared to a cash basis. The accrual system will, for example, show how much expenses were incurred to provide the revenue.
Through the accrual basis of accounting, cash flow is not directly connected with revenue. This means that revenue will recorded the moment it is earned even if the actual payment will be made at a later time. The revenue recognition principle is similar to the matching principle in that it reports income and revenue accurately more than a cash system. On the other hand, losses are reported as soon as they are possible, even if the loss hasn’t actually occurred. This falls under a separate principle that will be discussed later.
The basic tenet of the convention of conservatism is that the less favorable outcome is to be preferred when choosing between two solutions. This means that possible future losses must be anticipated but not the future profits even when both situations are equally likely. It helps a company to play safe by leaning toward understating rather than overstating a company’s income. in general, expected losses are actual losses but expected gains are not actual gains.
In applying this convention, an accountant gets to use their judgement to analyse a situation and determine when a probable loss should be reported. Make no mistake, though, that an accountant can simply disregard all other principles and exercise this principle. It is actually only when recording a transaction as a loss or gain will have the same outcome that the accountant can exercise this convention.
While preparing the financial statements for a company, often an error will be encountered by the accountant. In such a situation, an accountant must use their own best judgement to either ignore the error or rectify it. If the error in accounting is small considering the size of the business, the accountant can deem this error immaterial and ignore it. On the other hand, a significant error that is material to the company must be addressed.
The decision to either ignore or address an error will depend on the size of the company. An error may be small enough to ignore for one company but not for another. A guiding principle when interpreting materiality is to consider the users of the information. If ignoring an error may negatively influence the decision of investors and shareholders, then it cannot be ignored, and vice versa. The general rule is that a 5% error in total assets and above is not immaterial.
It is not only the accountants that use the materiality principle. Auditors do too when they want to assess the authenticity of financial statements.
