5 common GAAP violations
In the United States, generally accepted accounting principles (GAAP) is the most common accounting framework for the preparation of financial statements. GAAP provides a common set of rules to help readers understand and interpret financial results. It’s also the most common framework for composing contract language during mergers and acquisitions.
GAAP is shaped and enforced by two organizations: the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). Regulated and publicly held companies must adhere to GAAP. Additionally, about a third of private companies choose to comply with GAAP to offer transparency.
What are GAAP violations?
Errors or omissions in applying GAAP are considered violations — and they can be costly. In a business transaction, GAAP violations can damage credibility with lenders and lead to poor decisions. Violations can cause inaccurate reporting for internal and budgeting purposes, as well as a reduced reliance on prepared financial statements for third-party readers. A ding to your credibility could also negatively impact the value or purchase price of your business.
5 examples of GAAP violations
To avoid costly fines and other ill effects, steer clear of the most common GAAP violations:
1. Escalating rent
Lessors often offer incentives to entice a lessee into entering a rental contract. Many times, these incentives 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 noncurrent asset or liability on the balance sheet.
2. Depreciation
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. However, 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 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. Many businesses incorrectly default to the tax method of 39 years of depreciation for GAAP reporting for leasehold improvements.
3. Capitalization of overhead costs
Capitalization of overhead is a reporting requirement that’s often overlooked. Many times, only direct costs, such as labor and raw materials, are used to value the production of inventory. Overhead is either not associated with or applied incorrectly to the basis of the value of inventory. The exclusion of overhead is 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 versus 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
Paid vacation time is a common benefit offered to employees. It is also common for companies to have a “use it or lose it” policy regarding vacation time. This type of policy dictates that any unused portion of vacation time would be lost. However, some companies pay cash for unused vacation time at a certain point (i.e., an anniversary date, a specific calendar date or upon separation from the company).
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, 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 Accounting Standards Codification (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, can 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 business’s state of residence continues to propel businesses into new markets. Depending upon the nature and duration of the activity conducted outside the 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 on conversion to an S-corp
- Pending IRS examinations
A non-GAAP option for small- and medium-sized businesses
For entrepreneurs who are starting and growing their businesses, GAAP reporting can be cumbersome. For this qualified group, there is a potential non-GAAP reporting option called the Financial Reporting Framework for Small- and Medium-Sized Entities (FRM for SMEs).
FRF for SMEs was released in June 2013 by the American Institute of Certified Public Accountants as an Other Comprehensive Basis of Accounting (OCBOA). This accounting framework is more focused on cash flows, and it relieves eligible companies of the unnecessary accounting burdens required by Fortune 500 companies (including GAAP pronouncements).
For example, uncertain tax positions, consolidation of certain variable interest entities, accounting for unrealized gains and losses in derivative contracts and goodwill impairment testing would not be required under the FRF for SMEs. And changes to GAAP for recent FASB pronouncements, such as accounting for leases and revenue recognition, would not apply under this accounting framework.
How Wipfli can help
Which accounting standard is best for your business? Are you at risk of making a common mistake? Our accounting specialists are ready to answer your toughest tax questions and walk you through reporting frameworks. Together, we’ll find and apply the standards that bring you the biggest advantage. To get started, contact us today or learn more about our accounting services.
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