I have written about this in the past, yet it is an ongoing subject that we deal with business owners day after day… A client recently asked me why we (The Strategic CFO) were insisting on generating the clients financial statements on an accrual basis and per GAAP.
He insisted that cash basis was fine and that we were just creating a lot of busy work.
He also stated that he did not care or need the balance sheet, just the income statement.
Today, we’re talking about the importance of using GAAP financial statements.
GAAP Financial Statements
Our firm did not invent GAAP financial statements.
GAAP means Generally Accepted Accounting Principles.
These principles have evolved over time as we get smarter and more advanced.
The main principle behind GAAP financials is to generate a set of financial statements that represent the most accurate picture about your company. They should be comparable, not misleading and clear so a third party can understand.
So the uniform application of GAAP to business transactions would most clearly represent a true picture of your business.
The Importance of Using GAAP Financial Statements
There are several reasons companies should be using GAAP financial statements.
First, public companies and certain loan documents require GAAP financial statements. We recommend that all private businesses also use GAAP financials as a best practice so you can have the best information to run your business.
Second, by not having your financial statements per GAAP (which uses accrual based accounting), you are basically 60-90 days behind your business.
Running Behind Your Business without GAAP
Let’s look at an example of a manufacturing facility.
Someone in the manufacturing facility orders $50,000 worth of raw material, but you have not yet received an invoice from the vendor.
The vendor takes 30 days to generate an invoice because they have an inefficient accounting department.
The invoice gets mailed, taking 1 week to get to you.
Your staff person got the mail and did not enter the invoice in the system for a week.
Then because you did not review your aged payables until the end of the month, you are likely to be 60 days behind your business. You will not have the liability section reflecting the payable for this example until much later.
That means your balance sheet is not accurate.
Plus, you may not have that payable in your cash forecast for payment.
This example is one transaction, but it adds up when you consider all the transactions in your business.
You will be 60 to 90 days behind your business by not keeping your books on accrual basis.
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Accurate Reports on Your Business
As a business leader, you want the most accurate reports on your business on a timely basis so you can make business decisions.
Your income statement, balance sheet, and statement of cash flow paints the picture of the recent historical performance of your business.
You need to monitor the trends so that you can make business decisions timely.
Critical for Growth
We see it over and over again… A good business is mismanaged because the CEO or entrepreneur does not want to spend the money or take the time to understand his financials or keep them per GAAP. Eventually, they are upside down on working capital and run out of cash. This is especially true in a high growth environment.
Reasons for Using GAAP Financial Statements
If you have a small business of 3 employees with one legal entity and have sales of $800,000 per year with no plans for growth, no debt, no outside investors, then you can certainly keep your books on cash basis and ignore GAAP.
But if you grew beyond that and have a substantial business that you want to grow, or you have debt, our outside investors, then you seriously need to consider keeping your books and records on an accrual basis and per GAAP.
In short, why should you keep your books and records on an accrual basis and per GAAP?
- Working Capital – Not having them per GAAP can lead to operational disaster
- Outside Investors and Lenders will require them
- Growth – If you are beyond a mom and pop shop, then these financials will be your key tool for growth
- Value – From a valuation standpoint, GAAP financials add value
Why Use GAAP Financials
So to answer the question we started this blog with why use GAAP financials?
First, using these principles allow your business to be presented correctly to third parties.
Then, you need accrual based financials to properly run your business. Otherwise, you are 60-90 days behind running your business. It may be required by your lender.
Having your books kept per GAAP actually adds value to your business from a valuation perspective. While you are working on adding value, make sure there aren’t “destroyers” taking value from you. Download our Top 10 Destroyers of Value whitepaper and protect your company’s value.
