Accounting: What is GAAP and Why Use It?

What is GAAP?

Generally Accepted Accounting Principles, or GAAP for short, is the set of practices and principles used to recognize, measure, and report the financial activity of a company.

GAAP is put together by the American Institute of Certified Public Accountants and is documented in a set of published standards.  When GAAP is applied consistently by all companies in preparing financial reports, it allows stakeholders & potential investors to make valid comparisons between similar companies.

The best form of communicating the financial position and risk profile of a company is through financial reporting, including the preparation and presentation of financial statements.  The financial statements include: Balance sheet, Income statement, Cash flow statement, and notes to financial statements. GAAP standardizes the content and format of these reports to provide clarity and transparency to the reader.

The information provided in the financial statements is key in the financial decision-making process used by outside parties such as banks, investors, and creditors.  For this reason they must be assured that the information complies with GAAP standards in order to interpret the results correctly.  Internal management must also understand the financial health of the company in these same terms.

Why use GAAP?

GAAP dictates the use of Accrual-Based accounting.  The Accrual Basis is the method of accounting for revenue and expenses when they are earned or incurred, regardless of when cash actually is deposited in the company’s account (see prior published solution for more information on accrual basis).   If your company is looking for investment, loans, line of credit, or opening accounts with vendors, you may need a GAAP compliant version of your financial reports.

One of the benefits of using the accrual method is that a company has a better idea of what it costs to run the business each month and sees more clearly how much money it makes. By recording revenues and costs as they happen, there is an automatic alignment of Income to its related Expense, to show how much remains as profit.

Cash planning is also enhanced with Accrual-Based accounting as the timing of cash deposits and disbursements can be predicted based on the financial statements.

Cash basis accounting is not acceptable under GAAP for external reporting, but is often used for tax preparation. Cash basis accounting records transactions when cash comes in or leaves the company’s account. With this method, there is typically less revenue on the income tax filing and therefore a smaller tax burden.  Companies with over $5.0M in annual revenue or who carry inventory, however, are not eligible to use Cash-Based accounting for taxes.

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