As a 16-year-old who was old enough to drive and old enough to date, my parents instituted a curfew. I was to be back home before 11pm on Fridays and Saturdays.
The curfew was short lived, however, because after only two weekends of this new house rule, my parents realized they didn’t want to stay up that late to enforce it. It wasn’t that difficult of a decision for them to revoke the curfew, as they trusted who I was as a person to not get into trouble and knew that I would make responsible choices. And to be brutally honest, I wore braces, glasses and was a nerd – I wasn’t invited to the type of parties parents worry about anyway!
As a business owner, GAAP concepts – a comprehensive set of detailed rules on how to keep your accounting books – can feel a lot like a curfew for your business. For the most part, you follow the rules… you’re just hoping that you can negotiate an extra 15 minutes past curfew every once in a while.
Last month, we discussed GAAP “House Rules” – Tips For When and How To Follow. Just like oral hygiene and curfew rules vary from home to home (did you have a curfew?), GAAP concept implementation varies from business to business. Depending on your business situation, some rules are great to follow and others you can follow with your own spin on them (as long as you don’t have an audit or review). But how do you know you’re doing it right and when is it appropriate to ask for an extra 15 minutes to be tagged onto your curfew (Come on, MOM!)?
If you are trying to do things right and are doing the best you can, you probably aren’t going to go (too) wrong. But complicated accounting means you need an expert eye to help you know how to set your own ethically and financially responsible house rules. You can think of me as your curfew fairy godmother. I’ll let you know when you need to be home by the stroke of midnight and when you can stay out until two! Contact me today and let’s start the conversation about your GAAP house rules.
4 More GAAP Concepts for Small-Medium Businesses
It’s important for every business owner to have a solid understanding of GAAP concepts. That way, when it comes time to determine which are best for your business to follow, you are setting your business up for long term financial success.
Here is an overview of four more* GAAP concepts and how they might be applied to small- to medium-sized businesses:
*Looking for the first four GAAP concepts? You’ll find them here.
Cost. Everything has a cost, right? In this GAAP concept, the cost of items recorded is never adjusted up. That means, if you purchased real estate for your business, you record the amount paid as the cost, and never increase it, even if the fair market value of it has increased. With very few exceptions, the cost basis is never adjusted up or down.
In the case of a slumped real estate market where it has a significant loss in value, you would need to write it down to net realizable value. Any appreciation is ignored on the books until you sell. Simply put, the cost is the cost you incurred. It doesn’t matter what happens afterwards.
Materiality. The fancy accounting definition is this: when correcting errors or making decisions about a transaction, use professional judgment to determine whether it is big enough to change someone’s decision about the company. The bottom line question is: when does a transaction matter, or not, when things are a little off?
Let’s think back to our curfew. Some kids know that they need to play it safe and get home early because their parents are strict with their curfew. Other kids know they have some wiggle room with their curfew – if they are five minutes late, it’s no big deal. But does 10 minutes matter? Does 30 minutes cross the threshold into “I’m in big trouble”? The GAAP concept of materiality helps you determine where to draw the line.
Here’s a real world accounting example: Midnight Pumpkin, LLC’s financial account is off by 35 cents. There is an error somewhere, but is it worth paying a bookkeeper 3 hours (and thus $300) to fix the 35 cent error? The answer is usually no. Write the 35 cents off as a loss and be done with it. But what if the account is off by $5? $20? $500? Typically, $500 is a good threshold for most small businesses to hunt for the issue.
The bottom line is this: don’t spend time on the little tiny stuff, because it doesn’t matter at the end of the day… UNLESS it’s something that is regulated by the government (sales tax, payroll tax, retirement, etc.). They make their money on all those pennies, so they will make you pay the 35 cents!
It can sometimes be hard to know where to draw the immateriality line for your business. If you need help, I’m here to provide expert guidance that will set you up for success.
Conservatism. This one is a lesson in ego. Conservatism will always make your business look worse than it is, but trust me when I say that it will save you from potential financial issues! The conservatism concept says that when there are two options for recording a transaction, select the option which understates revenue/assets and overstates expenses/liabilities.
Let’s say that you know you will be receiving a legal invoice in the first quarter of the year, but you aren’t sure if it will be $1,000 or $5,000. You should estimate it at $5,000 because it’s the larger expense. Then, when the actual bill comes and it’s $3,000, you can adjust the amount (true it up). It’s like you gained $2,000 instead of losing $4,000 (if you recorded it as $1,000 and it ended up being $5,000).
I like to say that conservatism is planning for the “worse case scenario” and choosing to be a pessimist in your financial outlook. It’s easier to adjust your business decisions if you are going from worse to better than better to worse. Generally, conservatism comes into play in more complicated transactions, not in the day to day bookkeeping.
Consistency. Be consistent when recording transactions for each period. So once you choose an accounting method, stick with it. In my opinion, this concept should be coined as an Accounting proverb. It is that important!
In real life, this GAAP concept looks something like this: If you decide that your fixed asset capitalization threshold is $1,000, you have to leave it as $1,000 for many years, maybe for the lifetime of the business. You can’t say it is $1,000, then bump it down to $500 when you purchase a $900 asset you want to capitalize, then move it up to $2,000 when you don’t want to capitalize something. As a small business owner reaching for financial success, you must create a capitalization policy and then stick with it. If you do this, your books will be comparable from month-to-month and year-to-year, making it easier to compare for success and make important business decisions.
And a note for all of you Quickbooks users out there, it is not easy (nor smart) to switch between cash basis and accrual basis accounting, no matter how simple QuickBooks makes it look with their fancy toggle button!
A GAAP Concept Foundation + Expert Guidance
Last month, we covered revenue recognition (accrual basis), matching, and proper-cut off…plus brushing your teeth. This month, the addition of cost, materiality, conservatism, and consistency (and curfews!) has provided you with a good overview of accounting concepts that all small to medium businesses need to know.
If you still need help with how this all fits into your specific business situation, I’m here to help.
For the success and financial health of your business, it’s important to know the big picture, and I can help you apply these concepts in the reality of your business. Contact me today for an initial conversation about setting up your GAAP “House Rules.”