Yes, VCs and Angels do want to be assured that their financials are presented on an accrual basis in accordance with GAAP principles. The tricky thing is… very few early stage startups can actually afford to do this. What the heck do these financials, and GAAP, really mean?
Let me break it down.
What is GAAP?
GAAP stands for Generally Accepted Accounting Principles; it’s the accounting “playbook” in the US that ensures that we’re all applying the same thought process. GAAP is defined, in the US, by the Financial Accounting Standards Board (FASB, pronounced “fass-bee”). Public companies are required to follow GAAP, but private companies have a lot more leeway in how they present their financial statements. HOWEVER, if your startup is going to raise venture capital funding, the VCs expect you to present your financials more or less in accordance with GAAP - with the biggest sticking point being that the type of accounting method you should be doing accrual accounting, not cash based accounting (cash based accounting is what most of the “automated” bookkeeping firms do, even if they claim otherwise).
What is Accrual Accounting?
Accrual basis financials are when we accountants do financial acrobatics to match the revenue or expense to the period (day/week/month) in which the transaction was incurred. You recognize the revenue/expense in the period when the transaction occurred, rather than when payment is made.
Sound easy? It’s not. But it keep us accountants fully employed, LOL. Let me give you an example. Let’s say your health insurance is $50K per month, but you forgot to pay it for 3 months. Cash Basis financials will show a $150K expense in March, whereas accrual basis financials will show $50K in Jan, Feb, and March. Another example: You purchases a coffee today, Monday, but it doesn’t get reported on your CC statement until 2 days from now, Wednesday. Proper accrual basis financials should show the Coffee expense happening on Monday.
Are my Startup’s Financials on GAAP Basis?
If you’re Seed, Series A/B/C/D… then very likely NO. Rather, your financials are on a semi-GAAP basis.
<record scratch>
How can this be??? Isn’t the term “semi-GAAP” heresy to say amongst the accounting community? Why can’t you just make my financials fully GAAP compliant?
**_The reason why so many startups financials are not really, truly 100% GAAP compliant is because the cost greatly outweighs the benefit. The cost is so big in fact, that I wont name it here until I get to the end of this article so that you may allow me to build my case.
My advice is to use semi-GAAP for now which will allow you, the founder, to make intelligent business decisions using our Kruze semi-GAAP financials. Focus on your product, growth, and getting to a point where you will become a tasty acquisition target. When an acquirer or investor DEMANDS full GAAP financials, then the benefit will outweigh the cost. Otherwise you might be padding your accountant’s pocket. That said, I’m always happy to take your $$$ if you want full GAAP now :)_**
What does it take to get my financials on full GAAP basis?
Without diving into the numerous codifications that are specific to each industry, allow me to break down the peskiest categories:
Revenue: there’s almost always a delay between when a customer pays and when a company will receive the funds. Sometimes this delay is as short as a day, or as long as years. In monthly semi-GAAP accounting, we can get away with making one entry to book and entire month’s sales. Proper GAAP accounting will require you to mark that revenue on the day in which the customer received their good. For example, lets say you do all your sales through the Apple App store. In the month of June, you did $250K in sales, which Apple then paid to you on July 7th, a few days after month end.
Monthly SemiGAAP: One entry at month end to record all June Sales, move the $250K transaction out of July. GAAP: potentially hundreds if not thousands of transactions hiding behind that $250K, each needing to be individually marked against that daily June sale. Those “Accounts Receivable” for June marked as fully paid on July 7th. A huge difference in the volume of work for us accountants, yet not much variance when you look at the Month over Month financials.
Cost of Good Sold: think of COGS as the direct parts/labor that went into the thing that you sold (eg the bumper on the car you sell). Expenses are indirect inputs (eg Management salaries).
**Semi GAAP: **Maintaining Inventory, Works-in-Process, and Raw Materials accounts is incredibly costly and time consuming. Every invoice will have to be scrutinized from both your Project Managers and the Accountants. If you’re a pre-revenue startup, that’s not the best use of anyone’s time or money. You’ll also need to check these balances daily/weekly/monthly to double check book accuracy and look for spoilage/theft/obsolete, etc. Not to mention the software needed to manage it.
**GAAP: **You’ll need to allocate the direct costs, dead-on, piece by piece, for each item sold on each day. Payroll: most payroll cycles hit on the 15th and 30th, with a 5 day processing delay. ie the payroll that hits on the 15th is really for the 25th-10th days worked. That means that your payroll spans more than a month, and it should be accrued for. Lets say that every 15 days, your payroll is $500K:
Monthly SemiGAAP: book two payrolls for that month to show a $1M incurred expense GAAP: create Journal entries to Show that there was an Accrued Payroll Liability at the end of the previous month that was then reversed and paid out on the 15th. Given that each employees’ salary and the number of working days accrued in the previous month, this can be a very time consuming. The end result is that ~$1M in payroll shows up for the current month, with a little fancy footwork now appearing on the Balance Sheet as well.
Other Expenses: like Rent, Contractors, Professional Services, etc are relatively easy compared to Revenue, COGS, and Payroll. If you’re using Bill.com its even easier because we accountants can either sync or lookup what month expenses should’ve fallen into. If you’re not using Bill.com, the endeavor can be 3-10x more time consuming, especially if we need to call the vendor for historical statements if bills were not properly stored.
What about the Software? Can’t I just toggle between Cash and Accrual basis in QBO?
This will come as a shock, but QBO isn’t reporting True Accrual/GAAP basis financials, even when you toggle to Accrual basis. QBO will remove AP and AR when you switch from Accrual to Cash, but will leave behind Accrual Based Adjusting Journal Entries and accounts like Unearned Revenue and Prepaid Expenses. Therefore, what you’re looking at is semi-GAAP financials. If you want true Accrual/GAAP financials then you’ll need to step it up to Netsuite, which has a $50K+/year MSRP. Since Kruze is a Netsuite BPO partner, we can offer y’all the software $5K/year, but only as long as you’re a Kruze client. As soon as you leave, the price will go up to $50K+/year. That’s a huge commitment. And given that QBO is only ~$250/year, most can manage just fine with semi-GAAP financials.
**OK, I get it. True GAAP is expensive. But I’m going to sell my company and I’m pretty sure I need true GAAP financials. **Nope, you don’t. Just wait it out. Wait until the acquirer or investor demands it. I oversee ~3 acquisitions every quarter to big companies like Apple, Google, Facebook et al, where our work is scrutinized by Big 4 M&A teams, hot shot lawyers and i-bankers. In most cases the acquirer takes our Kruze prepared financials as-is because it offers a holistic, high level, and granular view of the company’s operations. If the acquirer wants to see the financials on a more granular GAAP basis, we can oblige and we can hustle. We’ve done it. But whatever we were charging you for semi-GAAP… for full GAAP you’ll need to double or triple that price and multiply it by the months needed.
And a note - if an “automated” bookkeeper claims to be GAAP compliant, ask them about ASC 718: Stock Based Compensation. Then call me and we’ll have a laugh.
