GAAP Accrual Accounting

by Adarsh Raj Bhatt in
black and white Texas Instruments calculator

Image credit: Unsplash

Key Takeaways

  • Startups must provide financial statements that comply with generally accepted accounting principles (GAAP). The income statement, the balance sheet, and the cash flow statement are the 3 primary financial records mandated by GAAP.
  • GAAP requires startups to produce financial records using the accrual accounting method. This way, costs are recorded in the timeframe in which they are generated, regardless of when they are paid, because the goal is to guarantee that expenditures equal income.
  • Employee pay, for instance, is recorded as a wage expenditure for the week the employee works, even though the employee will not get paid until later in the month. Similarly, revenue is acknowledged and recorded in accounting records at the moment of sale, even though the startup might get paid at a later date.
  • The accrual approach to accounting is based on the principle of recognizing revenues and costs when they are generated. Using this method has an impact on the balance sheet, since receivables and payables may be reported even if there is no accompanying cash invoice or transaction.
  • Both generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) support the accrual method of accounting.
  • GAAP-compliant financial statements have several benefits. They help to create uniformity in reporting, are accepted by all financial institutions, provide fact-based data reporting, and help to build a compelling business ethic.

Preparing Financial Statements in Accordance with GAAP

External audits look at whether a startup's financial statements comply with GAAP and how effectively they do so. The goal of GAAP is to provide universal continuity in accounting processes. GAAP-compliant financial reports, such as the income statement, balance sheet, and cash flow statement, are legally required, or your startup may risk facing serious repercussions.

GAAP requires startups to generate accounting records using the accrual accounting method and the matching principle. This way, costs are recorded in the timeframe when they are generated, regardless of when they are paid, because the goal is to guarantee that expenditures equal income. Employee pay, for instance, is recorded as a wage expenditure for the week when the employee works, even though the employee will not get paid until later in the month. Similarly, regardless of when the startup collects payment, revenue is acknowledged and recorded in accounting records at the moment of sale

Here is a GAAP financial statements template your startup can use. 

What is Accrual Accounting?

The accrual approach to accounting is based on the principle of recognizing costs and revenue when they are generated and collected. Using this accounting method has an impact on the balance sheet, since receivables and payables may be reported even if there is no accompanying cash invoice or transaction.

Both GAAP and IFRS support the accrual method of accounting. Each set of guidelines offers guidance on how to record expenditures and revenue when there are no cash invoices or payouts to record under the cash method of accounting.

GAAP-compliant Financial Statements

Startups must provide reports in accordance with GAAP. The following are the financial statements required by GAAP: 

  • The income statement 
  • The balance sheets
  • The cash flow statement

The Income Statement

The income statement, also known as profit and loss (P&L), outlines a startup's revenue as well as any costs incurred during the accounting period. This covers income from both operational and non-operational activities, enabling auditors, industry analysts, investors, creditors, authorities, and other stakeholders to assess the startup's financial status.

The Balance Sheet

A startup's balance sheet outlines assets and compares them to debt and shareholders’ equity. These three areas convey a startup's assets and how it funds its activities. The balance sheet is a transparent representation of a startup's assets and liabilities at a specific moment in time.

The Cash Flow Statement

A cash flow statement, which functions as the documentation of cash as it enters and exits the startup, is also required by GAAP. This is because the income statement and balance sheet are prepared using the accrual method of accounting, which generally overlooks actual cash flow.

Benefits of GAAP-compliant Financial Statements

Creates Uniformity

Because all financial accounts follow a similar set of rules, GAAP helps to create uniformity among them. Startups that adhere to GAAP and manage their financial records accordingly have an advantage since their records provide the most accurate information.

Accepted by all Financial Institutions

Because GAAP principles are accepted by financial institutions, banks, and government agencies, it is simpler for startups to qualify for loans and other financial assistance. Startups that prepare their financial statements in accordance with GAAP are generally trusted by banks and other financial institutions.

Fact-based Data Reporting

GAAP-compliant accounting statements are based on facts, not estimates, and all stakeholders are aware of this. Whether it's a lender, an investor, marketer, or someone else, people trust GAAP-compliant financial records and are willing to make important decisions based on them.

Helps Build a Business Ethic

It is essential for startups to have standards of conduct and to adhere to them. GAAP financial statements are designed to assist startups in adhering to ethical principles, which builds confidence with stakeholders.

Understanding GAAP vs. IFRS

Financial reporting and accounting requirements differ from one country to the next. The Financial Accounting Standards Board (FASB) establishes standardized financial reporting methods in the United States, which are based on GAAP. GAAP refers to a collection of universally acknowledged accounting rules, regulations, and processes that startups and their accountants must adhere to while preparing financial reports.

The International Financial Reporting Standards (IFRS) are a collection of global accounting principles that specify how certain operations and other activities must be recorded in accounting records. The International Accounting Standards Board (IASB) issues IFRS, which regulates how auditors must record and present their accounts. IFRS was created to provide standard accounting language that would allow startups and accounting reports to be recognized globally. IFRS, which aspires to provide a single worldwide language for business accounting concerns, has been accepted by more than 144 nations throughout the world. While the Securities and Exchange Commission (SEC) has stated an interest in moving away from GAAP and towards IFRS, progress has been gradual on this front.

Generally Accepted Accounting Principles (GAAP)

GAAP should be implemented whenever a startup discloses its financial statements to outside parties. Accounting records must also follow the SEC's guidelines if the startup's stock is publicly listed.

Revenue, balance sheets, item categorization, and shareholder equity metrics are all covered by GAAP. Investors tread cautiously when a financial report is not prepared in accordance with GAAP. When declaring financial results, certain startups may utilize both GAAP and non-GAAP-compliant statistics. According to GAAP standard, non-GAAP metrics must be labeled in financial statements as well as other public releases, such as media articles,

International Financial Reporting Standards (IFRS)

The goal of IFRS is to provide financial sustainability and accountability. IFRS allows startups and private investors to understand exactly what has been going on with a startup, allowing them to make good investment decisions. IFRS is used in the European Union (EU) and many Asian and South American nations, although not in the United States. The SEC will not move to IFRS in the foreseeable future, but it will continue to consider a proposal that would allow IFRS data to augment financial reports in the U.S.

IFRS vs. GAAP Financial Statements

Constituent Factors

The main distinction between IFRS and GAAP is that GAAP is based on regulations, whereas IFRS is based on principles. This difference is reflected in the specific elements and perspectives of the two approaches. In general, IFRS guidelines contain far less overall depth than GAAP standards. As a result, the IFRS's theoretical foundation and principles provide more leeway for interpretation, which may require extensive accounting information disclosures. The logically coherent and transparent concepts of IFRS, however, are more uniform and intuitive, and may best reflect the realities of commercial transactions. 

Inventory Management

Inventory management is perhaps the most significant distinction between GAAP and IFRS. Last-in, first-out (LIFO) inventory accounting systems are prohibited under IFRS requirements. LIFO is, however, permitted under GAAP. The first-in, first-out (FIFO), and weighted average-cost methods are used in both. Inventory reversals are not permitted under GAAP; however, they are permitted under IFRS (under specific situations).

Intangible Asset Management

Intangible assets are also handled differently under IFRS and GAAP. Intangible assets are only recorded under IFRS if they pose a significant economic advantage to your startup. It is then feasible to assess the asset and assign a monetary value to the asset. However, intangible assets are valued at their present fair market value under GAAP, and no further factors are necessary.

IFRS vs. GAAP: Which is Better?

Ease of Use

In comparison to GAAP, which contains more than 25,000 pages of codes and regulations, IFRS has fewer than 3,000. For recognition of revenue, IFRS uses two primary concepts, whereas GAAP uses a step-by-step, and sometimes industry-specific, technique. Under GAAP, startups must incur research and development expenditures, but under IFRS, they can be capitalized in particular cases. The income statement and balance sheet benefit from cost capitalization. By allowing startups to declare the fair market value of assets less cumulative depreciation, IFRS allows them to present a better balance sheet. Only cost less accumulated depreciation is permitted under GAAP.

Global Benefits

Switching to IFRS for preparing financial statements allows U.S. startups to compare their financial records to those of their global peers who already employ the standard. The financial statements of overseas subsidiaries such as public corporations and global medium-sized companies are regularly prepared using IFRS. Following mergers and acquisitions, these businesses may apply IFRS across the board, avoiding or eliminating the need for redundant accounting activities.

Advantageous for Startups

While some of the benefits of IFRS over GAAP are limited to bigger or publicly traded businesses, IFRS could just as well benefit startups. Startups seeking overseas investments may be more likely to succeed if they present business and audit data in a format that international investors can comprehend. Startups with a foreign investor that uses IFRS, can deliver financial statements that eliminate the need for the investor to convert the report from GAAP to IFRS.

IFRS is easier to interpret when compared to GAAP since it is more principles-based.

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