March 27, 2018
If you’ve financed any aspect of your business operation and are required to provide a financial report to your creditors, you probably have a GAAP issue.
GAAP is an acronym used by financial experts. It stands for Generally Accepted Accounting Principles. It is a standard used by creditors, vendors and outside shareholders for determining whether or not your financial reports are comparable to those issued by others. Most of the readers of financial statements mentioned above want you to report your statements in conformity with Generally Accepted Accounting Principles. But do you really need to do it?
The use of GAAP basis accounting may be different than the basis of accounting you use for income tax purposes. Where GAAP comes into play for many smaller, non-publicly traded businesses is through their business loan agreement with their bank. If your business loan agreement requires you to deliver a financial statement to your bank, it likely says that the statements must be presented using Generally Accepted Accounting Principles.
Reporting on a GAAP basis will ensure that your financial statements are comparable to, and that they use many of the same standards, as those used by publicly-traded companies. However, if reporting on a GAAP basis produces different results than reporting on an income tax basis of accounting, then your cost of compliance with these different objectives can be a significant cost to you.
Many businesses don’t realize that their bank may be using a standard form for a business loan agreement. Furthermore, your bank may be willing to negotiate the terms of the business loan agreement. Why might this be true? It is possible that your bank is relying more on the value of the assets that provide collateral for the loan rather than relying on the results reported in a GAAP basis financial statement. From their perspective, they may be entirely happy with a financial statement reported on the income tax basis method of accounting.
If they will accept the income tax basis method of accounting, then your cost of preparing a financial report to submit to the bank just went down.
A few of the areas of accounting that can make a significant difference when reporting on a GAAP basis rather than an income tax basis may include:
- Depreciation expense – For income tax purposes, you generally want to write-off your capital expenditures as quickly as possible. For GAAP basis reporting, you generally must use the economic life of the asset for spreading the deduction. This may force you to maintain separate depreciation schedules for tax purposes from your financial reporting purposes.
- Inventory accounting – For income tax purposes, you may, or may not, be required to use the UNICAP method under Internal Revenue Code Section 263A, and you may, or may not, be required to capitalize a portion of your overhead costs to the cost of inventory. For GAAP purposes, your inventory capitalization methods may differ from all of the above, especially if your depreciation methods are different between income tax basis and GAAP basis. This may force you to maintain separate inventory records for income tax purposes from your inventory records for financial reporting purposes.
- Recognition of expenses for employee vacation pay and sick pay – For income tax purposes, you may accrue these liabilities, but may only be able to deduct them for the amount paid within 2 1⁄2 months from your fiscal year end. For GAAP purposes, you may need to accrue the full liability, regardless of when it is paid. This may force you to reconcile the differences between the two methods every year.
These are just a few of the many differences between GAAP basis methods of accounting and income tax basis methods of accounting. Each added complexity, adds to your cost of producing financial reports.
We believe it’s in your best interest to challenge reporting requirements that cost you money. We’ve found that many creditors are more than willing to accept reports based on the method of accounting that you already must use for income tax purposes.
It’s likely your bank already requires you to provide copies of income tax returns. If you can convince the bank to accept the income tax basis method of accounting, then is it a further stretch to ask them if they need a financial statement at all! The argument to present is that they are already receiving an income tax return that may contain the information they need?
If they need more details on specific assets or liabilities, then a special report on those items may be much less costly than maintaining records on both an income tax basis and a GAAP basis method of accounting.
At Kernutt Stokes, we try to challenge requirements that cost you money, especially if those requirements do not add to the value of your operation. If you’d like more information about either income tax basis methods of accounting or GAAP basis requirements, please contact us.