GAAP vs. tax-basis: Which is right for your business?

Young woman comparing two things.

Most businesses report financial performance using U.S. Generally Accepted Accounting Principles (GAAP). But the income-tax-basis format can save time and money for some private companies. Here’s information to help you choose the financial reporting framework that will work for your situation.

The basics

GAAP is the most common financial reporting standard in the United States. The Securities and Exchange Commission (SEC) requires public companies to follow it — they don’t have a choice. Many lenders expect large private borrowers to follow suit, because GAAP is familiar and consistent.

However, compliance with GAAP can be time-consuming and costly, depending on the level of assurance provided in the financial statements. So, some private companies opt to report financial statements using an “other comprehensive basis of accounting” (OCBOA) method. The most common OCBOA method is the tax-basis format.

Key differences

Departing from GAAP can result in significant differences in financial results. Why? GAAP is based on the principle of conservatism, which prevents companies from overstating profits and asset values. This runs contrary to what the IRS expects from for-profit businesses. Tax laws generally tend to favor accelerated gross income recognition and won’t allow taxpayers to deduct expenses until the amounts are known and other deductibility requirements have been met. So, reported profits tend to be higher under tax-basis methods than under GAAP.

There are also differences in terminology. Under GAAP, companies report revenues, expenses and net income. Conversely, tax-basis entities report gross income, deductions and taxable income. Their nontaxable items typically appear as separate line items or are disclosed in a footnote.

Capitalization and depreciation of fixed assets is another noteworthy difference. Under GAAP, the cost of a fixed asset (less its salvage value) is capitalized and systematically depreciated over its useful life. For tax purposes, fixed assets are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which generally results in shorter lives than under GAAP. Salvage value isn’t subtracted for tax purposes, but Section 179 and bonus depreciation are subtracted before computing MACRS deductions.

Other reporting differences exist for inventory, pensions, leases, start-up costs and accounting for changes and errors. In addition, companies record allowances for bad debts, sales returns, inventory obsolescence and asset impairment under GAAP. But these allowances generally aren’t permitted under tax law.

Departing from GAAP

GAAP has become increasingly complex in recent years. So some companies would prefer tax-basis reporting, if it’s appropriate for financial statement users.

For example, tax-basis financials might work for a business that’s owned, operated and financed by individuals closely involved in day-to-day operations who understand its financial position. But GAAP statements typically work better if the company has unsecured debt or numerous shareholders who own minority interests. Likewise, prospective buyers may prefer to perform due diligence on GAAP financial statements — or they may be public companies that are required to follow GAAP.

Contact us

Tax-basis reporting makes sense for certain types of businesses. But for other businesses, tax-basis financial statements may result in missing or even misleading information. We can help you evaluate the pros and cons and choose the appropriate reporting framework for your situation.

© 2019

Valuing Profits Interests in LLCs

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The use of so-called “profits interest” awards as a tool to attract and retain skilled workers has increased, as more companies are being structured as limited liability companies (LLCs), rather than as corporations. But accounting complexity has caused some private companies to shy away from these arrangements. Fortunately, relief from the Financial Accounting Standards Board (FASB) may be coming soon.

New twist on equity compensation

Corporations tend to award traditional stock options. But profits interests are used exclusively by LLCs. As the name suggests, these arrangements provide recipients with a share of the company’s future profits. Under existing U.S. Generally Accepted Accounting Principles (GAAP), these transactions may be classified as:

  • Share-based payments,
  • Profit-sharing,
  • Bonus arrangements, or
  • Deferred compensation.

The classification is determined by the specific terms and features of the profits interest. In most cases, the fair value of the award must be recorded as an income statement expense. Profits interest can also result in the recognition of a liability on the balance sheet and require footnote disclosures.

Need for simplification

Profits interest arrangements can accomplish a variety of business objectives. Though they’re most often awarded to employees, profits interests can also be given to investors, third-party service providers and other individuals.

These awards are usually issued in exchange for future services, without direct payment or financial investment. Various terms and features can be incorporated into a profits interest. For example, these awards often have contingency features, such as vesting requirements, participation thresholds, the occurrence of certain events, limited time periods, expiration dates and forfeiture provisions. In turn, this variability can cause additional complexity compared to other forms of equity compensation and require special valuation techniques.

“Profits interest continues to come up as an area private companies are struggling with,” said Candace Wright, Chair of the Private Company Council (PCC) during a meeting with the FASB earlier this year. Private companies have been clamoring for practical expedients and additional guidance from the FASB on such issues as acceptable valuation methods, audit techniques and disclosure requirements.

Work in progress

Simplification of the financial reporting guidance would be welcome news for employers, employees and other stakeholders. Contact us for help reporting these transactions under existing U.S. GAAP or for an update on the latest developments from the FASB.

© 2019

Reasons Why Cash is King

Dollar Pipeline – lots of 20 Dollar Bills building a tube.

In financial reporting, investors and business owners tend to focus on four key metrics: 1) revenue, 2) net income, 3) total assets and 4) net worth. But, when it comes to gauging short-term financial performance and creditworthiness, the trump card is cash flow.

If a business doesn’t have enough cash on hand to pay payroll, rent and other bills, it can spell disaster — no matter how profitable the company is or how fast it’s growing. That’s why you can’t afford to cast aside the statement of cash flows and the important insight it can provide.

Monitoring cash

The statement of cash flows reveals clues about a company’s ability to manage cash. It shows changes in balance sheet items from one accounting period to the next. Special attention should be given to significant balance changes.

For example, if accounts receivable were $1 million in 2018 and $2 million in 2019, the change would be reported as a cash outflow of $1 million. That’s because more money was tied up in receivables in 2019 than in 2018. An increase in receivables is common for growing businesses, because receivables generally grow in proportion to revenue. But a mounting receivables balance also might signal cash management inefficiencies. Additional financial information — such as an aging schedule — might reveal significant write-offs.

Continually reporting negative cash flows from operations can also signal danger. There’s a limit to how much money a company can get from selling off its assets, issuing new stock or taking on more debt. A red flag should go up when operating cash outflows consistently outpace operating inflows. It can signal weaknesses, such as out-of-control growth, poor inventory management, mounting costs and weak customer demand.

Categorizing cash flows

The statement of cash flows typically consists of three sections:

1. Cash flows from operations. This section converts accrual net income to cash provided or used by operations. All income-related items flow through this part of the cash flow statement, such as net income; gains (or losses) on asset sales; depreciation and amortization; and net changes in accounts receivable, inventory, prepaid assets, accrued expenses and payables.

2. Cash flows from investing activities. If a company buys or sells property, equipment or marketable securities, the transaction shows up here. This section could reveal whether a company is divesting assets for emergency funds or whether it’s reinvesting in future operations.

3. Cash flows from financing activities. This shows transactions with investors and lenders. Examples include Treasury stock purchases, additional capital contributions, debt issuances and payoffs, and dividend payments.

Below these three categories is the schedule of noncash investing and financing transactions. This portion of the cash flow statement summarizes significant transactions in which cash did not directly change hands: for example, like-kind exchanges or assets purchased directly with loan proceeds.

Keep a watchful eye

Effective cash management can be the difference between staying afloat and filing for bankruptcy — especially in an unpredictable economy. Contact us to help identify potential problems and find solutions to shore up inefficiencies and shortfalls.

© 2019

Nonprofits: New Alternatives for Reporting Goodwill and Other Intangibles

nonprofit banner – word abstract in vintage letterpress printing blocks stained by color inks

Did you know that the Financial Accounting Standards Board (FASB) recently extended the simplified private-company accounting alternatives to not-for-profit organizations? Many merging nonprofits, including educational institutions and hospitals, welcome these practical expedients. Here are the details.

Alternative for goodwill

The first alternative accounting method allows for the amortization of goodwill on a straight-line basis over 10 years (or less if a shorter useful life is more appropriate). It applies only to:

  • Goodwill recognized in a business combination after initial recognition and measurement,
  • Amounts recognized as goodwill in applying the equity method of accounting, and
  • The excess reorganization value recognized by entities that adopt fresh-start reporting under U.S. Generally Accepted Accounting Principles (GAAP) for reorganizations.

Once an alternative has been elected, the organization must apply all the alternative’s subsequent measurement, derecognition, presentation and disclosure requirements to existing goodwill and all future additions to goodwill that fall within the scope of the accounting alternative.

Upon adoption of the accounting alternative, the organization must decide whether to test goodwill at either the entity level or the reporting unit level. However, annual impairment testing isn’t required under the alternative. Rather, testing for impairment is required only if a triggering event occurs that indicates that the fair value of the nonprofit entity (or the reporting unit) may be below its carrying amount.

Alternative for identifiable intangible assets

The second accounting alternative allows a nonprofit organization to bypass the separate recognition of noncompete agreements and customer-related intangible assets unless they can be sold or licensed independently from other assets of a business. In other words, such items would be considered part of goodwill. Nonprofits that elect this alternative would recognize fewer intangible assets in a business combination.

It applies to nonprofit organizations that are required to recognize or consider fair value of intangible assets when:

  • Applying the acquisition method for a business combination,
  • Evaluating the nature of a difference between an investment’s carrying amount and the underlying equity in the net asset of an investee when applying the equity method of accounting, or
  • Adopting fresh start accounting for reorganizations.

If an organization decides to elect the accounting alternative for accounting for identifiable intangible assets, it also must adopt the accounting alternative for goodwill. However, a nonprofit that elects to adopt the accounting alternative for goodwill isn’t required to adopt the accounting alternative for accounting for identifiable intangible assets.

Effective date and transition

Nonprofits can immediately elect to use these alternative reporting methods. If elected, the goodwill accounting alternative should be applied prospectively to all existing goodwill and for all new goodwill generated in acquisitions. And the alternative for accounting for identifiable intangible assets should be applied prospectively upon the occurrence of the first transaction within the scope of the alternative. Contact us for more information. Our accounting professionals can help determine if these alternatives are right for your organization.

© 2019

Internal Audit 2.0: Paperless and continuous Auditing Trends

Technology is altering the traditional approach to internal audits. Instead of reviewing reams of paperwork, today’s auditor is learning to use electronic records. In turn, going paperless facilitates a concept known as “continuous auditing,” where internal auditors continually gather data to support their procedures. Here’s how your business can modernize this process.

Targeting specific areas

Not every functional area of your company lends itself to paperless and continuous auditing. To determine whether sufficient, timely and accurate electronic data exists, you’ll need to review the systems that store and generate your company’s data.

For example, if a portion of your inventory accounting processes still relies on paper, it may not present an ideal candidate for paperless and continuous auditing. Alternatively, if your accounts payable (AP) process functions entirely on electronic records, it’s logical to include AP in the continuous audit program.

Planning the program

Before you can adopt a continuous audit program, you must determine:

  • Your primary and secondary business goals, and
  • The key risks you hope to mitigate.

Then you can design your program accordingly. For example, if you plan to continuously audit the AP process and you’re concerned about occupational fraud, you may decide to put a rule in place that looks for the creation of vendors whose address matches that of an employee.

From a practical perspective, it’s important to document how often you plan to sample the data that the continuous audit program makes available. Keep in mind that a daily review of the output often generates the greatest benefit.

Ensuring accountability

To help ensure accountability, a process must exist to review and evaluate the audit output. For example, if the review of employee payroll data uncovers unusual payroll disbursements, a process must exist to investigate those discrepancies.

The individual who should be responsible for reviewing the data will depend on the size and structure of your company. It could fall to the internal audit department, someone within the fraud team or a department manager.

Time for change?

Robust internal audits help management correct operational issues quickly, which prevents money from being wasted and risks from spiraling out of control. If implemented correctly, paperless and continuous auditing can improve your company’s internal audit and oversight abilities while also reducing its costs. Contact us for help converting paper records to an electronic format, as well as planning and implementing a continuous internal audit program that targets the optimal areas of your business operations.

© 2019

The Chances of an IRS Audit are Low, but Business Owners Should Be Prepared

Many business owners ask: How can I avoid an IRS audit? The good news is that the odds against being audited are in your favor. In fiscal year 2018, the IRS audited approximately 0.6% of individuals. Businesses, large corporations and high-income individuals are more likely to be audited but, overall, audit rates are historically low.

There’s no 100% guarantee that you won’t be picked for an audit, because some tax returns are chosen randomly. However, completing your returns in a timely and accurate fashion with our firm certainly works in your favor. And it helps to know what might catch the attention of the IRS.

Audit red flags

A variety of tax-return entries may raise red flags with the IRS and may lead to an audit. Here are a few examples:

  • Significant inconsistencies between previous years’ filings and your most current filing,
  • Gross profit margin or expenses markedly different from those of other businesses in your industry, and
  • Miscalculated or unusually high deductions.

Certain types of deductions may be questioned by the IRS because there are strict recordkeeping requirements for them ― for example, auto and travel expense deductions. In addition, an owner-employee salary that’s inordinately higher or lower than those in similar companies in his or her location can catch the IRS’s eye, especially if the business is structured as a corporation.

How to respond

If you’re selected for an audit, you’ll be notified by letter. Generally, the IRS won’t make initial contact by phone. But if there’s no response to the letter, the agency may follow up with a call.

Many audits simply request that you mail in documentation to support certain deductions you’ve taken. Others may ask you to take receipts and other documents to a local IRS office. Only the harshest version, the field audit, requires meeting with one or more IRS auditors. (Note: Ignore unsolicited email messages about an audit. The IRS doesn’t contact people in this manner. These are scams.)

Keep in mind that the tax agency won’t demand an immediate response to a mailed notice. You’ll be informed of the discrepancies in question and given time to prepare. You’ll need to collect and organize all relevant income and expense records. If any records are missing, you’ll have to reconstruct the information as accurately as possible based on other documentation.

If the IRS chooses you for an audit, our firm can help you:

  • Understand what the IRS is disputing (it’s not always crystal clear),
  • Gather the specific documents and information needed, and
  • •Respond to the auditor’s inquiries in the most expedient and effective manner.

Don’t panic if you’re contacted by the IRS. Many audits are routine. By taking a meticulous, proactive approach to how you track, document and file your company’s tax-related information, you’ll make an audit much less painful and even decrease the chances that one will happen in the first place.

© 2019

Measuring Fair Value for Financial Reporting

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Business assets are generally reported at the lower of cost or market value. Under this accounting principle, certain assets are reported at fair value, such as asset retirement obligations and derivatives.

Fair value also comes into play in M&A transactions. That is, if one company acquires another, the buyer must allocate the purchase price of the target company to its assets and liabilities. This allocation requires the valuation of identifiable intangible assets that weren’t on the target company’s balance sheet, such as brands, patents, customer lists and goodwill.

What is fair value?

Under U.S. Generally Accepted Accounting Principles (GAAP), fair value is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Though this term is similar to “fair market value,” which is defined in IRS Revenue Ruling 59-60, the terms aren’t synonymous.

The FASB chose the term “fair value” to prevent companies from applying IRS regulations or guidance and U.S. Tax Court precedent when valuing assets and liabilities for financial reporting purposes.

The FASB’s use of the term “market participants” refers to buyers and sellers in the item’s principal market. This market is entity specific and may vary among companies.

What goes into a fair value estimate?

When valuing an asset, there are three general valuation approaches: cost, income and market. For financial reporting purposes, fair value should first be based on quoted prices in active markets for identical assets and liabilities. When that information isn’t available, fair value should be based on observable market data, such as quoted prices for similar items in active markets.

In the absence of observable market data, fair value should be based on unobservable inputs. Examples include cash-flow projections prepared by management or other internal financial data.

While a CFO or controller can enlist the help of outside valuation specialists to estimate fair value, a company’s management is ultimately responsible for fair value estimates. So, it’s important to understand the assumptions, methods and models underlying a fair value estimate. Management also must implement adequate internal controls over fair value measurements, impairment charges and disclosures.

Valuation pros needed

Asset valuations are typically outside the comfort zone of in-house accounting personnel, so it pays to hire an outside specialist who will get it right. We can help you evaluate subjective inputs and methods, as well as recommend additional controls over the process to ensure that you’re meeting your financial reporting responsibilities.

© 2019

Management Letters: Have You Implemented Any Changes?

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Audited financial statements come with a special bonus: a “management letter” that recommends ways to improve your business. That’s free advice from financial pros who’ve seen hundreds of businesses at their best (and worst) and who know which strategies work (and which don’t). If you haven’t already implemented changes based on last year’s management letter, there’s no time like the present to improve your business operations.

Reporting deficiencies

Auditing standards require auditors to communicate in writing about “material weaknesses or significant deficiencies” that are discovered during audit fieldwork.

The AICPA defines material weakness as “a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected on a timely basis.” Likewise, a significant deficiency is defined as “a deficiency, or a combination of deficiencies, in internal control that is … important enough to merit attention by those charged with governance.”

Auditors may unearth less-severe weaknesses and operating inefficiencies during the course of an audit. Reporting these items is optional, but they’re often included in the management letter.

Looking beyond internal controls

Auditors may observe a wide range of issues during audit fieldwork. An obvious example is internal control shortfalls. But other issues covered in a management letter may relate to:

  • Cash management,
  • Operating workflow,
  • Control of production schedules,
  • Capacity,
  • Defects and waste,
  • Employee benefits,
  • Safety,
  • Website management,
  • Technology improvements, and
  • Energy consumption.

Management letters are usually organized by functional area: production, warehouse, sales and marketing, accounting, human resources, shipping/receiving and so forth. The write-up for each deficiency includes an observation (including a cause, if observed), financial and qualitative impacts, and a recommended course of action.

Striving for continuous improvement

Too often, management letters are filed away with the financial statements — and the same issues are reported in the management letter year after year. But proactive business owners and management recognize the valuable insight contained in these letters and take corrective action soon after they’re received. Contact us to help get the ball rolling before the start of next year’s audit.

© 2019

Budgeting is Key to a Successful Start-Up

More than half of recent college graduates plan to start a business someday, according to the results of a survey published in August by the American Institute of Certified Public Accountants (AICPA). Unfortunately, the AICPA estimates that only half of new businesses survive the five-year mark, and only about one in three reach the 10-year mark.

What can you do to improve your start-up’s odds of success? Comprehensive, realistic budgets can help entrepreneurs navigate the challenges that lie ahead.

3 financial statements

Many businesses base their budgets on the prior year’s financial results. But start-ups lack historical financial statements, which can make budgeting difficult.

In your first year of operation, it’s helpful to create an annual budget that forecasts all three financial statements on a monthly basis:

1. The income statement. Start your annual budget by estimating how much you expect to sell each month. Then estimate direct costs (such as materials, labor, sales tax and shipping) based on that sales volume. Many operating costs, such as rent, salaries and insurance, will be fixed over the short run.

Once you spread overhead costs over your sales, it’s unlikely that you’ll report a net profit in your first year of operation. Profitability takes time and hard work! Once you turn a profit, however, remember to save room in your budget for income taxes.

2. The balance sheet. To start generating revenue, you’ll also need equipment and marketing materials (including a website). Other operating assets (like accounts receivable and inventory) typically move in tandem with revenue. How will you finance these assets? Entrepreneurs may invest personal funds, receive money from other investors or take out loans. These items fall under liabilities and equity on the balance sheet.

3. The statement of cash flows. This report tracks sources and uses of cash from operating, investing and financing activities. Essentially, it shows how your business will make ends meet each month. In addition to acquiring assets, start-ups need cash to cover fixed expenses each month.

By forecasting these statements on a monthly basis, you can identify when cash shortfalls, as well as seasonal peaks and troughs, are likely to occur.

Reality check

Budgeting isn’t a static process. Each month, entrepreneurs must compare actual results to the budget — and then adjust the budget based on what they’ve learned. For instance, you may have underbudgeted or overbudgeted on some items and, thus, spent more or less than you anticipated.

Some variances may be the result of macroeconomic forces. For example, increased government regulation, new competition or an economic downturn can adversely affect your budget. Although these items may be outside of an entrepreneur’s control, it’s important to identify them early and develop a contingency plan before variances spiral out of control.

Outside input

An accounting professional can help your start-up put together a realistic budget based on industry benchmarks and demand for your products and services in the marketplace. A CPA-prepared budget can serve as more than just a management tool — it also can be presented to lenders and investors who want to know more about your start-up’s operations.

Auditing Grant Compliance

A business situation.

Has your organization received any public or private grants to fund its growth? Grants sometimes require an independent audit by a qualified accounting firm. Here’s what grant recipients should know to help facilitate matters and ensure compliance at all levels.

Federal compliance

Federal awards require compliance with the Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards (also known as 2 CFR Part 200). This guidance requires any entity that expends $750,000 or more of federal assistance received for its operations to undergo a “single audit,” which is a rigorous, organizationwide examination.

To provide grant recipients with the latest guidance on compliance, the Office of Management and Budget (OMB) releases an annual compliance supplement. It covers compliance requirements for a dozen areas when performing a single audit:

  1. Activities allowed or unallowed,
  2. Allowable costs/cost principles,
  3. Cash management,
  4. Eligibility,
  5. Equipment and real property management,
  6. Matching, level of effort and earmarking,
  7. Period of performance,
  8. Procurement, suspension and debarment,
  9. Program income,
  10. Reporting,
  11. Subrecipient monitoring, and
  12. Special tests and provisions.

The supplement also includes sections dedicated to agency program requirements, including clusters of programs that share common compliance requirements.

Your auditor will assess whether your organization has sufficient internal controls in each of the 12 areas. To help ensure compliance, your organization should clearly document decisions and processes, as well as provide a clear audit trail of activity.

Other levels of compliance

The requirements for state, local and private sector grants vary significantly. But compliance generally hinges on the following, regardless of the source providing the funding:

  • A detailed understanding of the grant’s compliance and reporting requirements,
  • A mapping of requirements to individual controls and processes,
  • A documented set of grant management policies and procedures that your organization publicizes and follows,
  • A robust set of internal controls and mechanisms to prevent fraud, waste, and abuse,
  • Training programs designed to promote grant compliance,
  • Frequent risk assessments to map your organization’s policies and procedures against evolving requirements for each grant, and
  • Periodic auditing in compliance with relevant guidance and statutes.

In addition, your auditor will evaluate whether your organization is willing to adapt to regulatory changes. For example, has it adopted new grant controls to accommodate best practices or legislative changes?

We can help

If juggling multiple levels of grant compliance seems overwhelming, contact us to learn how to streamline your approach. We can help your organization improve its ability to satisfy grant requirements at multiple levels.

© 2019