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Bill Burnham has an excellent rant up on GAAP accounting titled Is It Just Me or is GAAP Completely Broken? In case you don’t know, GAAP stands for “Generally Accepted Accounting Principles” and is a term regularly thrown around when staring at an income statement, balance sheet, statement of cash flows, or any other “supplemental information.”
I’m not a public market investor so I don’t have the twisted experience that anyone that deals with a public company has with GAAP since I don’t really care about understanding the financial statements of public companies (in any great depth.) Bill is – and he does a nice job of covering why GAAP has become such a mess in the public arena.
GAAP is also a mess in the private company arena. I get monthly financial statements for all the companies I’m on the board of (and quarterly for all the companies I’m an investor in.) The presentation varies, but it always includes a balance sheet, income statement, and statement of cash flows. I learned the value of understanding the financial statements early in my life – we were obsessed with them in Feld Technologies (my first company) and I was particularly fascinated with them when I started seeing them from other companies. Numbers stick in my brain and I can do straightforward math on the fly, so it’s easy for me to look at a set of financial statements and figure out what is going on pretty quickly.
Except for when the accountants get in the way. SaaS business models, revenue recognition, FAS xyz rules, tax vs. book, and option value / accounting creates a mess in private companies. All of a sudden I’m starting with the cash flow statement and working backward to actually understand what is really going on.
The irony of all of this is that most young private companies struggle to conform to GAAP, yet present their financials in a way that is clear and helpful – until they start trying to conform to GAAP. Of course, we have the accountants do an audit each year, at which point they ultimately restate things (sometimes minor, sometimes major) – almost always impacting the balance sheet and income statement, but rarely impacting the cash flow statement.
The arcania involved has radically increased in the past few years. I’m finding auditors reversing themselves within one year cycles – at one point they say “do things this way” and then nine months later they say “do things a different way.” It’s especially entertaining when you remind them of their previous approach, they say “we never said that”, and then you present them with the email they originally sent. Any accountant worth his paycheck knows how to say “yes, but it’s different now.”
It’s remarkable what a total waste of time and energy this is, especially when you get into the second order effect of actually trying to figure out what is really going on.
My advice to all entrepreneurs (and investors) is make sure you can read a statement of cash flows. Start there – not with the income statement. Once you understand the actual cash flows for a period, the chances of you catching the GAAP nuances of the income statement and balance sheet are much greater.