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Leaping the GAAP

Posted by Seth Elliott On September - 7 - 2010

One of my clients once said to me “When I first had to deal with accounting and financial statements, it made me want to cower in fear.” While that may not be the typical entrepreneur’s experience, it can sometimes feel like accounting processes were designed to be overly complicated and confusing. Today, we’ll examine GAAP standards, IFRS and the various categories of financial statements rendered by accountants. Understanding these will give you an advantage when evaluating your needs regarding financial statements and raising capital.

Mind the GAAP

GAAP stands for Generally Accepted Accounting Principals. GAAP standards are used within the United States (and in many global functions) when a Certified Public Accountant (CPA) performs and audit (see below). GAAP is also the de-facto standard within the United States for any financial statement preparation. When you read U.S. based financial statements, you can assume that they are GAAP-based, unless otherwise stated.

GAAP is primarily based on the standards and interpretations of the Financial Accounting Standards Board (FASB). FASB is the prime overseer, along with the Securities and Exchange Commission (SEC), of accounting and financial reporting rules and regulations. FASB is the top governing body that issues all standards and interpretations that form the basis of GAAP legislation. The SEC provides a complementary function, regulating the frequency and type of accounting required for companies that are publicly traded and identifying issues regarding standards and reporting that FASB should address.

What About IFRS?

IFRS refers to International Financial Reporting Standards. Previously referred to as IAS (International Accounting Standards), these are principles based accounting standards, interpretations and frameworks adopted by the International Accounting Standards Board (IASB). As the name suggests, these standards are used throughout the world, other than in the United States. Currently more than 110 countries have adopted IFRS. Although the SEC is examining the use of IFRS, the earliest possible transition date is 2015. Thus, if you are a U.S. based entrepreneur it is likely that GAAP will serve as the foundation of your financial statements for some time to come.

Types of Financial Statements

There are generally 3 types of financial statements produced by accountants: certified, compiled and reviewed. It’s worth the time to learn the difference in these categories and understand how they are viewed by investors and lenders.

Certified Statements

Certified financial statements are deemed the highest caliber of statements – the greatest level of assurance that the financials do not contain material misstatements. Certified statements are ones that an investor can trust to be most accurate. Often, these are simply referred to as audited statements. A CPA offers opinion on the quality and accuracy of the financial statements and performs a comprehensive audit and analysis of the company. In order to provide a certified statement, a CPA will verify and confirm financial and physical records, and analyze the accuracy of financial statements, all pursuant to GAAP. Investors and lenders can use the certified financial statements with confidence when evaluating a company. Certified financial statements are required annually for publicly traded companies. Additionally many institutional investors and lenders require Certified statements.

Reviewed Statements

Reviewed financial statements carry less weight than Certified statements – the level of assurance that material misstatements do not exist is not as strong. A CPA performs limited testing procedures regarding the accuracy of information provided for Reviewed financial statements. A CPA is required to make certain inquiries and corroborate particular information contained in a Reviewed financial statement with third parties. Additionally, a CPA providing Reviewed statements examines the notes to the financial statements for accuracy and compliance with GAAP. Note, however that no opinion is overtly offered by the CPA on the quality and accuracy of the financial data. Reviewed statements are less expensive to produce than Certified statements. Some investors and lenders will accept Reviewed statements from companies, particularly in the early stage of a company’s life.

Compiled Statements

Compiled financial statements provide the least assurance that there are no existing material misstatements. Compiled statements do not require any testing procedures or independent inquiries to third parties on the part of a CPA. The CPA also has no requirement to evaluate the accuracy and compliance of any notes accompanying the financial statements. A statement of Cash Flows is not required when delivering Compiled financial statements, so is likely to be absent. Although an investor or lender can receive some helpful information from a compiled financial statement, it usually does not provide the certainty needed when deciding to provide funds to a company.

As you can see, it is valuable to understand the “hows and whys” of financial statement production – particularly how they are evaluated by prospective lenders and investors. By arming yourself with this knowledge, you will be more effective when discussing various options with your accounting providers.

In the next post in this series, we will begin to examine the components of a financial statement – starting with the Income Statement.

You may want to review the other posts in this series:

Corporate Finance and the Entrepreneur

The Entrepreneur and the Income Statement

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About the Author

I have spent the last 15 years advising entrepreneurs on starting and growing their businesses, as well as assisting in financing those growth efforts. I have also been an entrepreneur on several occasions myself. By writing this blog, I hope to provide actionable advice on how to achieve your goals and become more successful.