Clayton & McKervey shareholder explains the 5 most common mistakes small to mid-sized business make with GAAP
Kevin Johns, a shareholder in the Small and Mid-sized Entities practice at Clayton & McKervey, an international certified public accounting and business advisory firm located in metro Detroit, says his work with new small to mid-sized businesses have a common theme when it comes to Generally Accepted Accounting Principles (GAAP) mistakes. GAAP, the most common accounting framework for the preparation of financial statements in the U.S., provides a standard set of rules in order for readers to properly understand and interpret financial results, and serves other purposes as well.
“GAAP is also the most common framework used when composing contract language for mergers and acquisitions; errors and omissions in applying GAAP can be costly in such business transactions,” Johns said. “They can impact credibility with lenders and lead to incorrect decision-making.”
GAAP violations can also cause inaccurate reporting for internal and budgeting purposes, as well as a reduced reliance on prepared financial statements for third party readers.
“The ripple effect of damaged credibility due to GAAP errors can have an additional negative impact on the purchase price when a business is put up for sale,” Johns said.
Johns offered a list of the five most common GAAP violations that he and his Clayton McKervey colleagues routinely uncover when working with a new client.
1. Escalating Rent
Lessors often offer financial incentives to solicit a lessee into entering a rental contract, such as “free rent” at either the beginning or end of the lease arrangement. GAAP accounting requires that lessees 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 is 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 depreciation methods and bonus depreciation. 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
Many times only direct costs, such as labor and raw materials, are used to value the production of inventory, and overhead is typically either not associated or applied incorrectly to the basis of the value of inventory. By not applying overhead calculations, large inventory valuation errors can occur on the balance sheet, and with related cost of goods sold on the income statement.
4. Accrued Vacation/PTO
Vacation or Paid-Time-Off (PTO) policies often incorporate a “use it or lose it” rule whereby employees lose the unused portion of their vacation. However, there are many companies that will pay cash for unused vacation time. A formal plan in a human resource handbook does not by itself dictate a potential employer liability. Instead, a verbal and accepted policy is enough to trigger an employee’s potential right to compensation of vacation or PTO that has not yet been accrued.
Depending on the length of employee tenure and vacation/PTO time awarded, the liability associated with these policies can be significant. The impact is even more pronounced when a business is for sale 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.