Installment #3 describes financial statements in more depth. Before we get there, however, we want to make sure we are all on the same page with four basic terms and one key concept.
The concept is Generally Accepted Accounting Principles (GAAP). It sets the standard for how financial statements are (or should be) reported (at least for U.S. companies). It is a set of basic accounting principles and concepts that guide accountants in their everyday work.
The four basic terms are revenue, costs, assets, and liabilities. Please don’t skip ahead – this is the bedrock of everything else you will read in this series.
How much has your company made in sales? In other words, how much has your company received for its products or services?
This differs from income in that revenue doesn’t take any of your costs into account. Gross income is revenue minus the cost of goods sold. Net income is a further refinement, which also subtracts overhead expenses. In other words, net income (aka net profit) is the amount that remains after all expenses have been deducted from sales.
There are a few ways to look at costs, but we’ll stick to those that can be valued monetarily (and not, for example, the emotional cost of losing your hair to stress).
A cost can be expensed or it can be capitalized. The choice determines how the cost is treated on the company’s financial statements.
As long as you follow GAAP guidelines, you may determine for yourself whether to capitalize or expense. Most companies, however, follow a rule of thumb that any cost over a certain dollar amount will be treated as a capital expense, with all lesser costs being treated as an expense.
One last point: sometimes, expenses are referred to as operating expenses, and sometimes a cost that is capitalized is called a “capital expense.” On the one hand, it’s sort of annoying that there are multiple terms for the same thing; on the other hand, it’s convenient to have a term for costs that are capitalized, so much so that that the term “capital expense” is commonly shorthanded to CAPEX.
Assets are tangible and intangible “things” that your company owns that can be sold and converted to cash. This can be anything, and there are many different asset classes. Valuing assets correctly and transparently is a subject unto itself.
A liability is an amount owed to someone and includes any sort of borrowing (whenever you buy something on credit, for example, you are borrowing). Liabilities are commonly divided into current liabilities (those that have to be paid in less than a year) and long-term liabilities.
GAAP – again, an acronym for “Generally Accepted Accounting Principles” – is a commonly recognized set of rules, guidelines, and procedures that govern corporate accounting and financial reporting in the United States.
GAAP was developed jointly by the Financial Accounting Standards Board and the Governmental Accounting Standards Board. All companies that publicly release financial statements, nonprofits, and governmental entities must follow GAAP.
GAAP is (or should be) a cornerstone for how a privately owned company reviews and understands financial information. Even if you don’t want to follow GAAP you should understand that a lot of third parties may expect you to. These include potential lenders, investors, or buyers of your company.
What started with five broad principles recommended by an American Institute of Accountants’ special committee following the stock market crash of 1929 has evolved into thousands of GAAP pronouncements on accounting topics with an accumulated wisdom approaching 10,000 pages.
We’ll give you the 10,000-foot view.
GAAP is made up of three basic concepts: Assumptions, Principles, and Constraints all of which have four tenets:
So, there you have it: GAAP in a nutshell.
We discussed GAAP in this installment as a stop on our way to discussing financial statements since financial statements ought to be in compliance with GAAP. With an introduction to the importance of GAAP out of the way, in the next installment of this series, we’ll go through an overview of financial statements.
Browse all installments of Know Thy Numbers/Know Thy Business, starting at the beginning with ‘Know Thy Numbers’ Installment #1 – Welcome to the Jungle, an Introduction to the Series.
[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
This is an updated version of an article originally published on November 12, 2019.]
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Since graduating from the University of Michigan in film and screenwriting, Kristina Parren has worked as a copywriter and grant writer across multiple industries, including healthcare, finance, manufacturing, and travel. In addition to her work as an editor and copywriter, she is an avid wildlife conservation activist, involved in conservation and reintroduction projects throughout Africa.
Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer”, by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…
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