Mind the GAAP!

If you’ve ever taken a train in the London Underground, or the “Tube” as the locals call it, chances are you’ve seen the ubiquitous “Mind the Gap” sign. The sign is designed to remind people to be careful as the Tube can be a pretty dangerous place. Trains travel at up to 60mph and there’s a big drop-off with electric rails that carry hundreds of volts – potentially lethal to anyone unfortunate enough to come in contact with them.

Likewise in today’s modern-day corporations, whether a small LLC startup or a multi-billion-dollar global enterprise, people – especially finance and accounting, employees – must mind a GAAP, or “generally accepted accounting principles,” in their day-to-day work.

And while the danger doesn’t include hundred-volt penalties for not adhering to the admonishing signs, there can be serious penalties for non-compliance. ?And that can include fines, and even jail. Yikes.

But there’s more reason to comply with GAAP than just to avoid penalties. It’s just plain good business to have your books in order. Especially if you’re a startup (my specialty), but even if you’re a mature business, it just makes sense.

“To attract financing to hire workers, build plants, and invest in research and development, companies and organizations must report financial information that investors, lenders, and donors find credible and useful.”?—The Financial Accounting Foundation

What is GAAP?

GAAP is a set of rules that guide business and corporate accounting. The Financial Accounting Standards Board (FASB) created and uses GAAP as the basis for its approved accounting practices. Moreover, U.S. law requires businesses that release financial statements to the public and companies that are publicly traded on stock exchanges and indices to follow GAAP guidelines.

Fundamentally, GAAP provides a consistent approach to a wide range of financial accounting issues. These include, for example:

-?????????Revenue recognition

-?????????Expense recognition

-?????????Financial and non-financial assets

-?????????Taxes and other liabilities

-?????????Leases

-?????????Accounting for mergers and acquisitions

While GAAP rules leave some room for interpretation, it does provide a common financial accounting framework that helps companies, investors, and other stakeholders reliably understand a business’s economic condition and see how it compares with other businesses. Accounting software makes it easier for companies to incorporate this framework into their business and helps ensure compliance with GAAP and other accounting standards. By automating accounting processes, financial software also improves efficiency and helps companies produce timelier financial reports. More on that later.

Why is GAAP Needed?

GAAP is needed so that everyone plays by one set of rules, with the goal of discouraging people from gaming the system for a short-term advantage; one which ultimately hurts the company’s shareholders. We’ve all heard the horror stories of companies like Enron, Tyco, Bernie Madoff, and most recently, the FTX crypto exchange, as well as others who reported fake earnings or hid debt or inflate assets or did other nefarious things to make the company stock rise artificially, only to leave the shareholders with massive losses when these scams were eventually uncovered. Just for fun reading, I’ve included a link to the top ten worst financial scandals in the comments section below.

Personally, I remember hearing a story about a company whose CEO, on December 31st of a year sometime in the anything-goes ‘80s, had a semi-truck loaded with company products, then had it driven around the corner, just so that the company could claim to have “shipped” a bunch of product to make their revenues look good. Sadly, events like these were not uncommon back then. ?(For the record, of course I did not/would not work at that company.)

Standards like GAAP, Sarbanes Oxley (aka “SOX”), ASC 605/606, and others, etc., were put into place to prevent the above types of events from happening and to protect shareholders. How would you feel if you invested in a company based on very strong, but completely fabricated, sales revenues? ?

Seven GAAP concepts for founders and startups

To the uninitiated, GAAP might appear as a bewildering array of rules covering public and private companies.?But the principles can be boiled down to a few, which are especially relevant if you’re at an early stage of your business.?

1. Business entity concept - This one is important for founders. It means transactions made by the business should be reported separately from transactions of the owners of the business or any other affiliated business entity.
2. Historical cost concept - All business transactions must initially be recorded at their historical cost. This means if an asset’s value on your balance sheet increases over time, you still record that asset ‘at cost’ on the balance sheet.
3. Revenue recognition concept- This determines when revenue is recorded. This is particularly important because the timing of revenue recognition has a direct impact on a company's bottom line.
4. Matching concept - The matching principle is an effort to ensure that expenses are recognized at the same pace as the revenue that those expenses help generate.
5. Objectivity concept - Your accounting records should be free of bias. Your financial information should not be misleading, but objective and verifiable.
6. Currency concept - The monetary unit concept states that all transactions must be expressed as a currency, such as the US dollar, Euro, British Pound Sterling, or Yen.
7. Time frame concept - This means transactions should be recorded in the same period in which they occurred.

How do I ensure GAAP compliance?

Simple. Follow the rules. As discussed, GAAP is built atop a set of core financial accounting principles and assumptions. To ensure compliance, your company needs to set up and then follow the rules. Here are ten basic rules of Generally Accepted Accounting Principles:

1. Regularity:?Accountants should follow GAAP rules.
2. Consistency:?Accountants should apply the same rules consistently throughout all financial reporting and across all time periods. If they do make changes to reporting methods, these should be fully disclosed and explained.
3. Sincerity:?Accountants should be accurate and impartial.
4. Permanence of methods:?Consistent procedures should be used for all financial reports so observers can make comparisons more easily.
5. Non-compensation:?Accountants should be transparent about the existence of debts or costs and not hide them within assets or revenue.
6. Prudence:?Accountants should report only facts; no speculative assumptions.
7. Continuity:?Asset valuations are based on the assumption that the company’s operations are expected to continue.
8. Periodicity:?The company provides financial reports on a regular basis, such as quarterly.
9. Materiality:?All financial information that would be significant to an investor should be disclosed.

10.??Utmost good faith:?The honesty of all parties is assumed and expected.

While nothing is 100% perfect, you can take substantial measures to ensure that you are as compliant as possible. There are two fundamental steps in this effort: Set up proper processes, and then systematize them.

Setting up processes correctly results in “goodness in/goodness out” (a paraphrased opposite of the old IT adage of “garbage in/garbage out.”) This means that if the accounting processes are set up properly and those processes are properly implemented in the company’s systems, e.g., back-office accounting systems like QuickBooks, NetSuite, etc., then your company will be compliant. It’s quite simple. And you will sleep better at night as a result.

Set up your processes. (And do it right the first time.)

GAAP has a number of required processes, and for brevity’s sake we won’t get into them here; there are plenty of lists available at places like FASB.org, FAF GAAP, and others, (see the comments section below for links). But some of the more relevant/important ones should be prioritized. These include managing rev rec properly and placing accruals within the proper period, two big areas that often result in non-compliance.

Specific to roles of a?CFO?and their finance team, there are certain compliance-related processes that are a non-negotiable part of the job, such as:

-?????????Closing the books on time

-?????????Getting meaningful reports out to management

-?????????Making sure you’re set up to pass any audit

-?????????Combining all of the above to comply with GAAP

Five key process tips for ensuring GAAP compliance

Much of GAAP compliance comes down to good people and processes. Experienced CFOs and accountants will know GAAP well, and they will keep up-to-speed with any changes to the standard. That said, there are some things every finance team, and especially more junior finance professionals, can do to stay GAAP compliant.?

1. Hire experienced accountants – Employing GAAP-trained (and ideally certified) accountants, as well as setting up the right conditions for their success, is a key first step in achieving GAAP compliance.
2. Continuously train your?team - As your business grows, consider providing ongoing education and training for all employees involved in GAAP-related activities. Procedures should be in place to keep accountants and others informed of the most recent developments, as accounting standards and principles are frequently changing. Implementing new procedures early in the process; finance teams should ensure that they’re incorporating the most recent changes in GAAP as a part of their everyday operations.?
3. Create internal controls?- Startups and SMBs should have internal controls that state their financial practices and policies, and stick to them on a monthly basis.?For example, in A/P, policy controls should state who processed it, who approves it, when it’s paid, and who will record it.
4. Reduce accounting errors - Consistency and regularity are two of the key principles of GAAP, which keeps accounting errors to a minimum. The right small business software (like QuickBooks), or enterprise resource planning (ERP) platforms (like NetSuite), and other financial management software (ideally cloud-based SaaS), can all support these efforts.?More and more finance teams are now harnessing the power of automation?for significant aspects of accounts receivable, accounts payable, and employee expense reimbursement.?The goal is to eliminate “swivel chair” copy-and-paste work, which is usually redundant, time-consuming, and error-prone. Automation can make activities like revenue recognition and expense matching much easier to complete and cross-check. And as a bonus, can minimize errors – as long as it’s done correctly the first time.
5. Carry out regular audits - Regular audits are another way to stay GAAP compliant.?I know, I know, “audit” can be a four-letter word to accountants, but, like a regular workout, it keeps your systems healthy and on-track. And, similar to how working out helps you in many different ways, internal audits examine a variety of business operations, including profitability, productivity, market share, customer satisfaction and other metrics. These audits help ensure that GAAP compliance procedures and that all workers working on financial transactions and reports adhere to the correct standards.

• Engage a CPA or auditing firm to review over balance sheets, P&L statements, and cash flow statements, to help identify any possible issues.
• Your company’s investors, lenders, and market regulators will all demand GAAP compliance, so it’s best to have principles and processes in place ahead of time. It’s good for your business.

By carrying out regular audits, you can ensure that you’ll face no surprises when first dealing with your most important stakeholders. You might even establish an audit committee to review your accounting processes and ensure there are enough personnel and resources to handle GAAP compliance.

Set up your systems.

Once you’ve properly set up your processes, those need to be carried over into your systems. ?This includes not only back-office systems like NetSuite, but also front-office systems such as a CRM like Salesforce. Systems like these are often inextricably tied together and setting up one correctly is just as important as setting up another.

An example of a properly set up system is implementing a revenue recognition module for managing revenue recognition properly across systems. This includes ensuring that the terms of the sales contract created in the CRM is carried out accurately, i.e., according to the contract terms, in the back-office system, such as NetSuite, for automated billing. This is an ASC 605/606 compliance mandate and must be strictly adhered to.

Automate inventory controls. Good inventory management is a vital aspect of GAAP compliance because it can help limit the overstating of profits and/or value associated with inventory, which is recorded as the lesser of cost or “market value.”

According to FASB,?market value is defined as the current replacement cost as limited by net realizable value. Put simply, it’s the amount of money that an item can be sold for at a given time in a given market. For example, GAAP states that all inventory must be valued and stated using either the cost or the market value method, whichever is lower. An inventory reserve is money that is taken out of earnings for the purpose of paying cash or non-cash anticipated as future costs associated with inventory.

Lock down Internal controls. Back-office systems such as NetSuite can lock down internal controls, such as segregation of duties (e.g., so you don’t have one person doing both A/P and A/R – a recipe for mistakes, or worst case, fraud); ?preventive controls such as controlled access; detective controls, to identify issues after they’ve occurred; and others. ?

Fine-tune authority matrices. Automate approval flows to create additional that internal control. These also can be minutely fine-tuned in NetSuite. (See link below for more detailed “how-to” info on this subject).

Conclusion

Mind the GAAP, indeed. Avoid potential third rail consequences. Encourage investment in the setting up, training, and communicating of GAAP principles into your organization. Set up your accounting processes in accordance with GAAP principles and then automate them with a back-office system like NetSuite to ensure that they are done properly every time.

If you’d like to learn more about how to set up your accounting processes and back-office systems, contact me over LinkedIn. I’m happy to give you a free 30-minute consultation to help you figure things out. ???All my best, Kim?