Part of owning a business is accounting for income and expenses and there is more than one way to do this. For example, you can follow Generally Accepted Accounting Principles (GAAP) or choose a non-GAAP method such as cash basis accounting. The format you choose is going to affect the net income you report to the Internal Revenue Service (IRS) and the numbers you provide to current and potential investors.
It is important that you choose an accounting method that provides a reasonable level of transparency and reports your business activity in the most accurate way possible. In other words, choosing the wrong accounting method could be misleading. Here are a few things to know about GAAP versus non-GAAP reporting so that you can choose the accounting method that fits your business.
If you were an investor, would you be able to determine if a business was operating effectively and was profitable based on the financial statements if every company was using a different accounting method, perhaps one that they developed internally? Probably not. Without a set of uniform rules, it would be impossible to determine if the company is a good investment. This is where GAAP comes in. The Financial Accounting and Standards Board (FASB) was responsible for developing GAAP so that there is a standardized approach to accounting. GAAP provides guidelines for recognizing, disclosing and measuring transactions. Investors can easily compare companies that use GAAP to determine which may be a good investment.
Unfortunately, GAAP is not appropriate for every business’ financial reporting needs. In cases like this, businesses are able to choose an alternative method for accounting. However, these companies must disclose their accounting method as non-GAAP along with a report that reconciles the regular and adjusted results of using the chosen method. For example, in most non-GAAP reporting, the accountant will not include expenses that are noncash or transactions that are exceedingly out the ordinary. This method often gives a more accurate view of the ongoing business because it adjusts out the results of one-time or temporary conditions. The downside of non-GAAP reporting is that its use does not always align with both the needs of shareholders and corporate management.
If you are planning on forming a new business, keep in mind that the type of accounting method you choose matters, especially if you plan to eventually bring in more investors. Be sure to choose the method that most accurately presents your company’s operations.