Accounting in startups is usually made up of a chaotic hodgepodge of cash-basis, GAAP-basis, and tax-basis. While your company might have stakeholders who don’t expect you to follow and report GAAP-based financials, adhering to GAAP guidelines from early on can bring great value in the long run. In fact, most startups start with cash basis reporting and implement GAAP basis reporting in parallel as the business matures and it becomes a clear requirement for external reporting purposes.
While different industries have their own specific GAAP standards, the below guide summarizes key accounting standards you should consider implementing now, irrespective of your industry.
1. ASC 606: revenue recognition
Like most startup finance leaders, you probably care most about top-line growth, or, to put it another way, how you recognize revenue and determine when you “make money”.
Under the cash-basis accounting rules, revenue is recognized the moment money changes hands. But, under the GAAP-basis accounting rules, revenue is recognized when a service is performed or a product is delivered—regardless of if cash has been transferred.
ASC 606 creates a framework within GAAP for recognizing revenue from customer contracts and transactions, which applies to all business entities that enter into agreements to provide goods or services to customers; including non-profit, private, and public companies.
2. ASC 705: cost of sales and services
If revenue represents the total sales of your company’s products and services, then the cost of sales and services is the accumulated expense of creating or acquiring those products and services.
Put simply, it’s a measure of the input necessary to generate the output required by customer demand. To be more specific, by the GAAP definition, COGS (COS in SaaS business) refers to direct costs required to produce the finished goods or services sold by a business or organization. It generally excludes indirect or overhead (SG&A) costs.
For instance, in a manufacturing business, the COGS can include costs from all aspects of a product’s creation and delivery, including materials, production, delivery, and labor costs. In a SaaS business, the COS may include the hosting server, infrastructure team, customer success team, and any other periphery software that is included in the delivered service. Understanding and managing the cost of revenue will help founders run their startups more efficiently and profitably.
Your ability to accurately capture the true incremental costs needed to drive revenue, and to subsequently manage those spend levels is vital to proving the financial viability and scalability of your business.
3. ASC 730: research and development
Companies are always researching innovative ways to improve their product lines so they can attract consumers and maintain market competitive advantages, and startups are no different.
Even though research and development are critical for a business’s long-term survival, most of the time it is very expensive, especially for early-stage startups. It’s also confusing where R&D fits into your accounting.
You might be wondering: Are R&D expenses a direct cost or an investment? How can you move towards profitability while incurring significant innovation expenditures?
Fortunately, GAAP sets out clear rules for this. ASC 730 outlines the different scenarios where R&D costs should be expensed immediately, and when certain R&D costs can be capitalized and amortized over time.
4. ASC 305: cash and cash equivalents
Everyone knows the saying “Cash is King!”, and for startups, this is true. Cash is the major lifeline for startups—it’s the first indicator that shareholders, investors, and creditors will review to assess your business’s financial health.
While many startups do not produce positive cash flow for a long time, it is vital to have a precise understanding of your liquidity position to know how much can be invested while allowing for an adequate liquidity buffer. ASC 305 not only illustrates the general concept of cash but also introduces examples of cash equivalents which could be potential financial vehicles for you to consider investing in to earn returns on excess cash.
5. ASC 718: stock-based compensation
Offering equity compensation to acquire top talent is a common practice in the startup world. The reasoning behind it is simple: early-stage companies are not cash-rich, and granting stock options or awards and providing partial company ownership to employees can enhance employee engagement at work without stretching the budget.
Even though stock-based compensation expense is a non-cash expense, ASC Topic 718 requires companies to recognize stock-based compensation at its fair market value over the vesting period on the income statement.
Although most startups don’t get audited until raising Series B or Series C funding and adopting a stock-based compensation method might seem like a futile exercise, being ASC 718-compliant at an early stage will streamline your due diligence and audit process and help your business grow to the next level.
6. ASC 205: financial statement presentation
Maintaining a proper set of financial statements that comply with accounting rules is essential for all businesses. Not only does it help you report your actual results easily and accurately, but it also serves as a decision-making tool that provides the foundation for the management team to analyze, evaluate, and plan your business growth.
Preparing financial statements in accordance with GAAP is especially important if you need more capital and are actively seeking funding rounds. It will help investors and creditors better understand your business and gauge their return on investment through the standardization of key financial metrics.
While every business is unique and there is no cookie-cutter solution to structuring financial reporting frameworks, ASC 205 provides very comprehensive general concepts of financial statement presentation and disclosure requirements. It also covers topics such as discontinued operations, going concern basis of accounting, and liquidation basis, which are often scrutinized during year-end audits.
Conclusion
Overall, being GAAP-compliant is an arduous journey for startups that may not immediately seem worth it. But, if you push through, it will allow you to detect and prevent accounting errors and improve your financial reporting quality.
Be patient and eventually you'll see the benefits: An accurate and consistent financial picture, lower risk of data misrepresentation, smoother future processes with auditors, and increased trust from investors!
