EBITDA and Other Scary Words: Scary Word No. 1 – GAAP
"This article originally appeared on Financial Poise and is reprinted here with permission."
In the beginning… the financial world was in disarray. Numbers and financial information were floating all over the place in no particular order. Assets, liabilities, debits, credits, dollars and cents… all in random order with different meanings to everyone. And then it happened: the Stock Market Crash of 1929, sending our country into one of its darkest times — The Great Depression. The questions everyone must have asked were endless. How could this happen? What can we do? How can we prevent this from happening again? It was time to bring order to the chaos. Ergo, the origins of GAAP.
Ok, so what is GAAP? GAAP, short for “Generally Accepted Accounting Principles,” is the accountants’ equivalent to the bro code. A set of rules and guidelines all accountants must follow, which defines how those assets and liabilities, credits and debits and dollars and cents are presented. And this is what dominates your financial information, what your business presents, and what the numbers mean to you and anyone else who is on the outside looking in. It also means full disclosure: nothing hiding behind the scenes. It’s all out in the open for everyone to see.
But what exactly does this mean to your business? I mean, who really, really understands GAAP? In a 2008 deposition, Steve Jobs was asked if he “had a general understanding as to what Generally Accepted Accounting Principles are” and his response was “not really.” Hmmm….
As if the world of finance was not confusing enough, now throw into the mix these “generally accepted accounting principles.” As we said before, we act like they are generally understood to everyone. But by whom are these principles generally accepted? They are accepted by the United States of America. Meanwhile half of the world uses something called “International Financial Reporting Standards” or IFRS. Let’s not even open that can of worms.
So what are these principles and guidelines? Well, 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 (7,692 pages and counting, which by the way, are always being updated). In an effort to calm your fears, here is the 10,000 foot view:
GAAP is made up of three basic concepts: Assumptions, Principles and Constraints. So what are these concepts? In the Assumptions’ corner, (and notice they all have the word “assumes”) the business entity concept assumes that the business is a single entity separate from its owners and other business, and it should all be kept that way. In other words, every bird in its own nest. The going concern concept assumes that the entity will continue its normal operations in the future, or at least for another year. (Yes, this is an example of a recent “update.”) The monetary unit concept assumes the entity is using a stable unit of currency to record its transactions (Monopoly money not allowed). The time period concept assumes that the activities of the entity can be divided into specific periods of time for reporting purposes, so information can be reported daily, weekly, quarterly, etc.
In the Principles’ corner, the historical cost principle tells us that the initial recording of financial transactions are done at their original cost. So it’s not how much you think it should cost, it’s what it actually costs. And yes, there are some exceptions, of course, in those thousands of pronouncements that are continually being updated. The revenue recognition principle suggests that revenue be recorded by the entity when it is earned. (Key word here being “earned;” again, not taking into account various exceptions and yes, we will discuss this topic in future installments.) Next we have the matching principle, which suggests that expenses must be matched with the revenues that helped generate them and therefore are recorded in the same period the revenue was earned. Finally, the full disclosure principle is exactly what it says. Everything is out in the open; nothing is hiding behind the curtain; past, present and future material information is available for all to see.
And in the last corner: Constraints, to help keep everything in check. The first one being objectivity; in other words, make sure you have evidence to back up the information (and yes, it must be verifiable evidence). Second is materiality, which asks the question: How significant is the information? If it will affect the decision of the reader of your financial information then it matters and therefore it is material. Next is consistency, which means do it the same way always (let’s not make it more complicated by doing it differently just this once). And finally, conservatism, simply put, when in doubt, always and we mean always, choose the less favorable outcome.
So there you have it GAAP in a nutshell. Confusing, yes; scary, not so much!