In the United States, the most common accounting framework for the preparation of financial statements is Generally Accepted Accounting Principles (GAAP). This framework provides a common set of rules in order for readers to properly understand and interpret financial results. GAAP is also the most common framework used when composing contract language for a merger or acquisition transaction.
Errors or omissions in applying GAAP can be costly in a business transaction; impacting credibility with lenders and leading to incorrect decisions. These violations can cause inaccurate reporting for internal and budgeting purposes, as well as a reduced reliance on prepared financial statements for 3rd party readers. Damaged credibility can furthermore cause a negative impact to the purchase price when going through a sale of the business.
As such, we have composed a list of the five most common GAAP violations routinely uncovered when we begin working with a new client.
1. Escalating Rent
As a financial incentive, lessors quite often offer incentives in order to solicit a lessee into entering a rental contract. Many times these incentives can include “free rent” at either the beginning or the end of the lease arrangement. GAAP accounting requires that operating lease expenses be recognized on a straight-line basis – requiring lessees to divide the total rent payments over the lease term by the number of months in the lease to calculate monthly rent expense – unless a more rational basis is found. Any difference between payments and expenses would be classified as either a current or non-current asset or liability on the balance sheet.
Over the past decade the tax code has allowed for accelerated depreciations methods, such as Section 179 expensing (up to $500,000 in certain years) and bonus depreciation. Before these accelerated methods were in place, it was common that fixed asset depreciation for book purposes would replicate that of the tax method. These accelerated tax methods of depreciation do not comply with GAAP reporting rules, as outlined in FASB ASC Topic 740.
In addition to accelerated depreciation, structural building improvements made to leased property would normally be depreciated over 39 years for tax purposes; however, GAAP stipulates that these improvements should be depreciated over the shorter of their useful life or the lease term, including renewable options that are expected to be exercised. It is common for businesses to incorrectly default to using the tax method of 39 years of depreciation for GAAP reporting for leasehold improvements.
3. Capitalization of Overhead Costs
A reporting requirement often overlooked is the capitalization of overhead. Many times only direct costs, such as labor and raw materials, are used to value the production of inventory. Overhead is typically either not associated or applied incorrectly to the basis of the value of inventory. The exclusion of overhead would be a departure from GAAP reporting.
Overhead is based on variable and fixed factors, both of which are founded on actual usage drivers and formulas constructed by capacity vs. production for cost allocation. By not applying overhead calculations, large inventory valuation errors can occur on the balance sheet, and related cost of goods sold on the income statement.
4. Accrued Vacation/PTO
A common benefit offered to employees is vacation time. The business, either through a formal written or informal (i.e. past practice, oral agreement) policy, sets forth the requirements for employee participation. It is common for companies to have a “use it or lose it” policy in regards to vacation time. This type of policy dictates that should an employee not use their allocated vacation time during the year, the unused portion would be lost. However, there are many companies that will pay cash for unused vacation time at a certain point (i.e. anniversary date, specific calendar date, or upon separation from the company). A written formal plan in a human resource handbook does not by itself dictate a potential employer liability. Rather, a verbal and accepted policy is enough to trigger an employee’s potential right to compensation which might need to be accrued.
Depending on the length of employee tenure and vacation time awarded, it is not uncommon that the liability associated with these policies can be significant. The impact is even more pronounced when a client is selling their business, and the buyer factors this liability into the required working capital target as well as the computing enterprise value, as a multiple of earnings.
5. Uncertain Tax Positions
FASB ASC Topic 740 established a threshold condition where a tax position taken in a previously filed tax return, or to be taken on future tax returns, be recognized currently in the financial statements. Uncertain tax positions must be recognized under a two-step process:
- A “more likely than not” (more than 50%) approach that a tax position will be sustained under an IRS audit
- The tax position is measured at the largest amount of tax benefit/expense that is greater than 50% likely
- The ability and ease to reach new markets outside of the businesses state of residence continues to propel businesses into new markets. Depending upon the nature and duration of the activity conducted outside of their home state, businesses could face an income tax liability in these states. If the company does not register to do business. and does not register to file tax returns in these states, they would not preclude the GAAP financial statements from accruing the tax liability and disclosing it on the financial statements.
Other Common tax uncertainties that need analysis include:
- Business expenses (i.e. meals and entertainment, unreasonable compensation)
- Valuation of deferred tax assets (i.e. net operating Losses)
- Transfer pricing between foreign related parties
- Built in gains tax (BIG) on conversion to an S-Corp
- Pending IRS examinations
Framework for Small and Medium-Sized Entities (FRF for SMEs)
The majority of our clients are entrepreneurs who have started their own business and watched it succeed and grow. For many of these clients, GAAP reporting can be cumbersome considering the complex guidance and potential limited resources. For this qualified group, FRF for SMEs is a potential non GAAP reporting option.
FRF for SMEs was released in June of 2013 by the American Institute of Certified Public Accountants (AICPA) as an Other Comprehensive Basis of Accounting (OCBOA).This accounting framework is much more focused on cash flows, and relieves eligible companies of the unnecessary accounting burdens required by Fortune 500 companies, and driving GAAP pronouncements. For example, uncertain tax positions, consolidation of certain Variable Interest Entities (VIEs), accounting for unrealized gains and losses in derivative contracts, and goodwill impairment testing would not be required under the FRF for SMEs framework. Changes to GAAP for recent FASB pronouncements, such as accounting for leases and revenue recognition, would also be not applicable under this accounting framework.