Why Startups Must Comply With GAAP
While private companies are free to manage their own books however they wish (as long as they pay their taxes correctly), high-growth startups eventually need to organize their books according to standards known as GAAP: Generally Accepted Accounting Principles. GAAP was created and is maintained by the Financial Accounting Standards Board (FASB) for the purpose of standardizing financial reporting. While failing to use GAAP won’t actually get you into any legal trouble until you’re running a publicly-traded company, your company will need to follow these standards if you plan on working with investors, banks, or pretty much any financial entity. GAAP is quite technical and complex, and the only real way to ensure that your startup is GAAP compliant is to hire an accountant to handle your finances from day one.
Why GAAP matters to stakeholders
GAAP is the most commonly-used accounting standard in the United States. GAAP standardizes financial reporting and makes it easy for stakeholders to evaluate companies. GAAP is not a law, but it is a rigorous set of rules that you will have to follow if you want to fundraise or obtain a loan for your startup. The Securities and Exchange Commission (SEC) requires publicly-traded companies to comply with GAAP, and as a result, nearly all parties who either produce or consume financial information about any companies in the United States generally expect to use it too. More specifically, banks and investors require that startups use GAAP for two reasons: one is that they need to be able to compare companies to each other at the financial level. Two, the reason investors and banks work with startups is because they expect these startups to become the kind of companies that may eventually trade publicly. Therefore, startups need to comply with SEC standards.
Who does GAAP accounting?
Simply put, the only people who do GAAP accounting are accountants. Accountants are fully-versed in all the rules and regulations of GAAP because it’s their job. GAAP accounting is very complex and if you are not accountant you will get it wrong. Avoiding accounting altogether because it’s complicated and feels like a hassle is a very bad idea, as is trying to save money by not hiring a professional. You need GAAP because everyone you work with financially will expect you to follow it, and you need an accountant to make your financials GAAP-compliant, so hiring someone is really a non-negotiable investment.
Come tax time, your main concern is that you are providing complete and accurate records to the government from day one of your startup. Using GAAP could make it easier for your tax filer to do their job, but you’ll ultimately need a tax accountant with the right kind of expertise to report everything properly. Having an accountant manage your books is helpful but not sufficient for tax preparation—you can’t use accrual-basis accounting to do your taxes because they’re not the same thing. A corporate tax prep professional will ensure that your company’s reporting fully complies with IRS rules.
GAAP compliance: investments and loans
Investors will expect your startup to be GAAP compliant and will be cautious to invest in those startups that aren’t. GAAP makes it easier for investors to understand your business’s financial health and the potential impact they could expect their investment to have on your company’s success. Additionally, investors see GAAP compliant startups as more reliable because their reports are fully transparent.
You could still potentially fundraise without hiring an accountant, but consider this: you will need to hire an accountant if an investor comes on board anyway, and the money you need to pay that individual to fix your startup’s backlog of financial information could end up taking a sizeable chunk out of the money you’re raising. If you’re getting an investment of $150,000 and you need to pay an accountant $20,000 (yes, it could be that much), you’ll be losing a large portion of your capital right off the top of the investment—and having to use a significant portion of your investment to fix your finances after the fact doesn’t look particularly good to investors.
Your startup will face similar challenges trying to obtain a loan or a line of credit from the bank. Banks will require that your startup uses GAAP-based reporting. This is because banks need to be able to assess specific aspects of your startup’s finances in order to determine whether your startup qualifies for a loan, like its liquid assets (referred to as liquidity), cash flow, and its ability to meet financial obligations in the future (referred to as solvency). GAAP-based reporting ensures that these aspects are thoroughly reported.
If your startup doesn’t use GAAP-based reporting, and you try to secure a loan, the bank will see this as a red flag and you won’t be able to get one. Banks want to know what your startup is really worth on a comprehensive level (not just have much cash you have); they will only consider authorizing a loan for your startup if you have accurate financial records because it is less of a potential risk for them.
If your startup doesn’t follow GAAP, you won’t be breaking the law, but you’ll almost certainly have to pay otherwise avoidable accounting fees and you’ll have difficulty fundraising from professional sources. Ultimately, if you want to give your startup any chance of success, you should treat GAAP as a “must” rather than a “nice-to-have.” This means handling your finances the right way from the start by hiring an accountant who can guarantee that your company properly complies with GAAP.
Keep your books clean and GAAP-compliant for less.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.