How Formal Does Your Accounting Process Need to Be?
If you want someone to give you a long list of technical rules to follow, your accountant is probably a pretty good source. But do all of those accounting rules actually help you, and do you even need to follow them?
Why Accountants Have So Many Rules
The main goal of accounting is consistency and comparability. If you take two income statements from two different companies, you should easily be able to compare them side by side. The same goes if you’re comparing different years’ financial statements prepared for the same company by different accountants.
If every accountant did whatever felt right to them, every set of financial statements might be different. It might or might not include certain items, or there could be discrepancies about which year or quarter items should be reported in.
By creating a detailed set of rules, accountants can make sure they’re handling similar transactions the same way.
What is GAAP and Why Is It Important?
GAAP stands for Generally Accepted Accounting Principles. It’s the primary set of rules used by accountants. Some principles are very broad, while others include a technical step-by-step on very specific types of transactions.
What is SOX and Why Is It Important?
SOX or SARBOX is shorthand for the Sarbanes Oxley Act. SOX provides additional accounting rules and oversight for public companies. Because Congress put it in place to protect investors, violations carry potential civil or even criminal penalties.
Do You Have to Follow GAAP and SOX?
The first question to consider is whether breaking accounting rules will break the law or just make your accountant mad. Generally, only public companies have a legal obligation to follow GAAP and SOX. Public company means a company that sells stock and falls under the jurisdiction of the SEC.
Non-profits may also have special accounting requirements under state law. For the most part, other for-profit companies have no legal obligation to follow GAAP.
What’s the Difference Between Tax Accounting and Financial Accounting?
When used in different contexts, financial accounting usually means preparing financial statements under GAAP while tax accounting means preparing financial statements under the Internal Revenue Code and IRS regulations. The rules are sometimes different between tax and financial reporting because the IRS is mainly focused on collecting taxes, while the SEC and accountants, in general, are mainly focused on making information useful to owners and investors.
All companies have to use tax accounting to file their tax returns. If you have no other obligation to use GAAP, you might consider doing all of your accounting on a tax basis to avoid having to keep two sets of books.
When Else Do You Need to Follow GAAP?
Following GAAP is also useful when you’re trying to raise capital by bringing in a partner or seeking a loan. If someone who’s reviewing your financial statements knows that you used GAAP, they know exactly how you prepared them.
Virtually all lenders will deny your application if they can’t understand your financial statements or track your cash flows. Others may insist that you use GAAP so that they don’t have to do the work of converting your financial statements before they analyze them.