US GAAP Fundamentals

US Generally Accepted Accounting Principles (GAAP) are the accounting standards required for US public companies and often expected by lenders, investors, and acquirers. GAAP is rules-based—specific, detailed guidance for most situations. The Financial Accounting Standards Board (FASB) sets these standards through Accounting Standards Codifications (ASC).

Core GAAP Principles

Revenue recognition principle: Recognize revenue when earned and realizable, not when cash is received. Under current standards (ASC 606), this means when performance obligations are satisfied.

Matching principle: Recognize expenses in the same period as the revenues they helped generate. If you sell a product in December, recognize the cost of goods sold in December—even if you paid for that inventory months earlier.

Historical cost principle: Record assets at their original purchase price, not current market value. A building bought for $500,000 stays on the books at $500,000 (minus depreciation), even if it's now worth $2 million.

Full disclosure principle: Financial statements must include all information that could affect a user's decision. Material facts go in the statements or accompanying notes.

Conservatism principle: When in doubt, choose the method less likely to overstate assets or income. Recognize losses when probable; recognize gains only when realized.

Consistency principle: Use the same accounting methods period to period. If you change methods, disclose the change and its impact.

Materiality: Focus on items significant enough to influence decisions. Immaterial items can be simplified or aggregated.

Revenue Recognition (ASC 606)

ASC 606 is the current standard for revenue recognition, effective since 2018. It replaced industry-specific guidance with a single five-step model:

Step 1: Identify the contract with a customer. A contract exists when parties have enforceable rights and obligations, payment terms are identifiable, and collection is probable.

Step 2: Identify performance obligations—distinct promises to transfer goods or services. A bundle of products might be one or multiple performance obligations depending on whether each is distinct.

Step 3: Determine the transaction price—what you expect to receive, including variable consideration (discounts, rebates, refunds). Estimate variable amounts using either the expected value or most likely amount method.

Step 4: Allocate the transaction price to each performance obligation based on standalone selling prices. If you sell a $1,000 bundle containing a $700 product and $300 service, allocate accordingly.

Step 5: Recognize revenue when (or as) you satisfy each performance obligation. Point-in-time for most goods; over time for many services if the customer receives benefit as you perform.

Common pitfalls: Recognizing revenue at contract signing instead of delivery. Ignoring variable consideration. Treating bundled products as single obligations when they should be separate.

Key Standards Business Owners Encounter

ASC 842 (Leases): Most leases must be recorded on the balance sheet as a right-of-use asset and lease liability. This affects ratios and debt covenants. Operating leases still exist for income statement purposes, but the balance sheet impact is new since 2019.

ASC 326 (Credit Losses): Expected credit losses on receivables must be estimated and recognized upfront—the Current Expected Credit Loss (CECL) model. You can't wait until a customer actually defaults; estimate losses when you originate the receivable.

ASC 350 (Goodwill): Goodwill from acquisitions is no longer amortized but must be tested annually for impairment. If the fair value of a reporting unit drops below its carrying value, write down goodwill.

ASC 718 (Stock Compensation): Stock options and equity awards must be expensed at fair value. This significantly affects companies with equity compensation programs.

Financial Statement Presentation

Balance sheet order: Assets listed from most to least liquid (cash first, then receivables, inventory, prepaid, fixed assets, intangibles). Liabilities from shortest to longest term (payables, accrued expenses, current debt, long-term debt).

Income statement formats: Single-step (all revenues, then all expenses) or multi-step (gross profit, operating income, then other items). Multi-step is more informative and more common.

Required disclosures: Significant accounting policies, related party transactions, commitments and contingencies, subsequent events. These notes can be longer than the statements themselves.

GAAP vs Tax Accounting

GAAP and tax accounting often differ. Common differences:

Depreciation: GAAP uses estimated useful life and methods matching asset consumption. Tax uses IRS schedules (MACRS) which often accelerate depreciation for tax benefits.

Revenue timing: GAAP may recognize revenue before cash receipt. Tax (especially for small businesses on cash basis) may defer until payment.

Bad debt: GAAP requires estimating expected losses (ASC 326). Tax typically allows deduction only when debts become worthless.

Book-tax differences create deferred tax assets and liabilities on the balance sheet. Temporary differences reverse over time; permanent differences never reverse.

When GAAP Compliance Matters

Public companies: Required by SEC. Annual reports (10-K), quarterly reports (10-Q), and other filings must follow GAAP.

Bank loans: Covenants often require GAAP-compliant financials, sometimes audited. Violation can trigger default.

Investors: VCs and acquirers expect GAAP financials. Non-GAAP reporting raises credibility concerns.

Private companies: May use GAAP, but FASB offers some simplifications through the Private Company Council. Smaller operations may use tax-basis or modified cash-basis accounting internally.

Common Misconceptions

"We're too small for GAAP." Size doesn't determine requirements—your stakeholders do. A small company seeking a bank loan or outside investment likely needs GAAP-compliant financials.

"Our accountant handles this." Your accountant implements GAAP, but management is responsible for financial statements. Understanding the principles helps you make better decisions and catch errors.

"GAAP and IFRS are the same." They're similar but differ in important ways. Inventory methods, lease classification details, development costs, and impairment reversals all differ. Companies operating internationally must know which standard applies where.

"We can choose whatever method we want." GAAP specifies methods for most situations. Where choices exist (FIFO vs weighted average for inventory), you must apply consistently and disclose your policy.