What Are the Generally Accepted Accounting Principles?

Most small businesses only encounter Generally Accepted Accounting Principles (GAAP) requirements in articles or situations where they are caught off guard and should have already familiarized themselves with them. That's because GAAP requirements don't apply to small businesses, though they can often make small business accounting more valuable.

GAAP is an accounting standard allowing businesses to be directly compared to each other. Instead of wondering which system was used in one business and having to massage results to mirror those of another business, GAAP allows direct comparisons.

If you're interested in obtaining investors, selling your business, or opening your books to external parties for any other reason, having GAAP-compliant books—which you're already organizing in your accounting software, right?—can make all the difference. Even if these specific situations never arise, having a measuring stick that applies to both your business and others can be incredibly helpful.

All that aside, you won't get very far without a sufficient knowledge base. What exactly are GAAP, and how can they help your small business?

What are the Generally Accepted Accounting Principles?

Based on two securities acts passed in the 1930s, the SEC is in charge of "[prescribing] the methods to be followed in the preparation of accounts and the form and content of financial statements to be filed under the Acts."

Rather than being managed by the SEC, however, the GAAP are defined by the Financial Accounting Standards Board (FASB), a non-government entity the SEC has outsourced standardization to.

Iterations of the GAAP have existed in the U.S. since 1939, when Congress responded to the Great Depression by increasing oversight of private business. The system was most recently revamped in 2008 when the FASB reorganized the rules to make them easier to understand.

Despite this, the principles aren't easy to understand. I'm going to make this as clear as possible, but take a deep breath before we dive in. The best way to understand GAAP requirements is to look at the ten guiding principles of GAAP reporting.

GAAP fundamentals

These ten principles—which you can think of as the GAAP mission statement—are the backbone of GAAP.

1. Principle of Regularity – Mandates that accountants use a system for reporting and don't just make it up as they go along.

2. Principle of Consistency – Ensures that the system used is employed universally. If you're going to use U.S. GAAP for one aspect of your reporting, don't switch to International Financial Reporting Standards (IFRS) later on.

3. Principle of Sincerity – This means that the accountant preparing the report isn't trying to mislead anyone. All financial information and analysis is presented as fairly and accurately as possible.

4. Principle of Permanence of Methods – Like any other science, completed accounting should be replicable. Another accountant looking at the books should reach the same conclusions.

5. Principle of Non-Compensation – “Compensation" here refers to offsetting accounts. GAAP-compliant reporting shouldn't try to cover up any accounting facts by hiding debts behind assets or costs behind revenue.

6. Principle of Prudence – Accountants should only report facts. There's no room for speculation or prediction, especially as such activities can muddy the waters of fact-based reporting.

7. Principle of Continuity – When preparing reports, an accountant should assume that the company will continue to operate as it has. That means assumptions about the future should be in line with what's actually happened in the past.

8. Principle of Periodicity – This means that accountants should report financial data based on consistent and accepted time intervals. Don't compare this quarter to the final two weeks of last year, or make up a five-month period to report against. Keep it simple and standard. Months, quarters, years—all good options to work with.

9. Principle of Materiality – All financial data should be laid out in a GAAP-compliant report. This principle is supposed to ensure that your accountant doesn't skip accounts or debts, or mislead readers by omitting information.

10. Principle of Utmost Good Faith – Don't lie. Seriously.

Shortcomings of GAAP reporting

If you've ever read another company's SEC filings, you've encountered their GAAP adherence (or lack thereof). These principles are SEC-mandated financial reporting protocols, and the first guidelines businesses deviate from as soon as possible.

GAAP are a stringent set of rules that rarely capture the complexity of modern business. While the principles are great at leveling a playing field, they struggle to reflect the reality of a business' day-to-day operations.

Most small businesses skip GAAP reporting because they aren't super helpful in the internal decision-making process. The principles are meant to standardize an industry, not give micro-level insights into businesses.

Another common small business problem with GAAP arises due to the complexity and associated costs of maintaining the principles. It takes time, money, and specialized accounting knowledge to build GAAP-compliant reports. Many businesses—especially those with no plans to look externally for major investors—will never see the full benefits of GAAP reporting, making it hard to justify the cost as a preemptive strike.

Alternatives to GAAP

For businesses that don't have the time or energy to implement GAAP or for those outside the U.S., there are lots of GAAP alternatives. The most straightforward? The Whatever System You Use Now (WSYUN) standard, which runs on a single principle: if it ain't broke, don't fix it.

If you want something a bit more regimented, consider the International Financial Reporting Standards (IFRS) for SMEs.

In short, they're good for small businesses while functioning as an international standard. Having some sort of consistency across reports is valuable, as it can help you and your business understand your place in the market and gives others—banks, investors, potential buyers—a clear view of your success.

Selecting an accounting system for your business

While the system you end up with should be based on personal needs and resources, all systems are most effective with a strong accounting software package underpinning them. Consistency in your reporting is worthless if you lack accuracy in your reporting.

If you've used GAAP, IFRS for SMEs, or another standard, drop a line in the comments and let me know if you think it was worth it. I'd love to hear about your experience.