What’s Wrong With My Financials?
If you recently started a company, and are in full bootstrap mode, you (or a beleaguered loved one or employee) are likely keeping the books. While this may be the right answer from a cash flow perspective, using someone who doesn’t have an accounting background often results in financial records that are not in audit shape. This conclusion is based on a fair amount of historical observation, and the reality that applying generally accepted accounting principles is sometimes like navigating in complicated downtown Boston. You know where you need to be, you just can’t quite get there. It’s hard to keep up with nuanced accounting rules, even if that is your day job. To put this historical experience to good use, and prepare you if an audit is in your near future, here are some items of which to be aware.
When you set up your books, you will need to determine which accounting basis to use. The basis is the fundamental framework that will guide the accounting policy choices you make. While there are a number of options out there, most companies elect to keep their books on either a cash basis or an accrual basis—accrual accounting is required under GAAP (Generally Accepted Accounting Principles). Privately held companies frequently choose cash as the basis for their accounting, as it simplifies daily operations by keeping the books of record consistent with most of the policies used when preparing the company’s tax return. For a small business, cash basis is a totally acceptable method but can create challenges when the company seeks outside funding. GAAP basis is the most accepted methodology for preparing financial statements for third party investors or lenders.
GAAP basis financial statements differ from cash basis financial statements in several ways. In the spirit of sharing, here are some typical areas that most non-accountants do not consider when “closing the books.” These are some of the most common areas where accounting differs most between GAAP and cash basis.
This is a fundamental difference between cash basis and GAAP basis accounting. When recording transactions on a cash basis, if you didn’t pay or receive it in cash the transaction (sale or expense) is not recorded in the books. Accrual accounting (a foundational GAAP concept) attempts to reflect the transaction in the period when the related transaction occurred, regardless of when cash changed hands. Even companies that apply accrual accounting frequently miss transactions that occur at or near a year-end.
- Revenue recognition
Revenues are immensely important to a potential investor. Revenue recognized on a cash basis can result in financial results that don’t make a lot of sense. If all of the cost of sales are recorded in Year 1, but the cash for the sale isn’t received until Year 2, Year 1 results look terrible (all cost, no revenue) and Year 2 results look spectacular (all revenue, no cost). For accrual-based companies, the rules can be difficult to follow. And the rules are about to change!* Determining how much revenue to recognize in a given period gets more complicated as the company’s product becomes more complex. For example, selling a football is pretty simple. Selling a ticket to a football game is only slightly more complex. Selling a season ticket, slightly more so. Selling a box, with naming rights and sponsorships, well, that takes some analysis.
- Stock options
If a company issues stock options, that company is usually at the point where GAAP-based accounting makes the most sense. The accounting for these instruments is pretty complex and almost always neglected in a pre-audit environment. GAAP rules require that options be valued on the measurement date (typically the date approved by the board) and the expense recognized over the service period of the award (typically the vesting period). The complexities in this accounting arise in the valuation of the award and the underlying assumptions used in that valuation, as well as the measurement date determination, the service period and estimates of award forfeitures.
Signing a lease is a big moment in a startup’s existence. This multi-year commitment signifies an optimism about the company’s future and creates an obligation likely larger than any previous commitment in the company’s past. Accounting for this lease is frequently overlooked. Free rent periods, rent escalation clauses, tenant improvement allowances and lease renewal options are just a few clauses that require adjustments to cash basis rental payments to comply with GAAP. This is another area where the rules are changing. In the near future, leases of any significant term will be recorded on the balance sheet as a “right to use” asset and a lease liability. Many companies don’t accurately capture the nuances of lease accounting under the current rules, and the rules are not getting easier.
Inventory has always been an accounting challenge. Inventory shrinkage, obsolescence, valuation and cutoff are specific areas of difficulty and judgment. The nature of the inventory can drive additional issues. A liquor retailer has more risk of shrinkage than a seller of heavy duty oilfield equipment. Conversely, liquor almost never has valuation issues, whereas oil patch inventory sometimes does.
*The Financial Accounting Standards Board (FASB) has changed the revenue recognition accounting rules, which will be effective for all companies in 2019 (earlier for public companies).
If you are interested in discussing further or have any questions, we would welcome the opportunity to discuss. Please don’t hesitate to contact our team at Holtzman Partners at 512.610.7200.