GAAP Is More Than Academic
A frequent complaint I here when working with small business owners and not-for-profits is that GAAP accounting is too academic and doesn't provide any practical value to their organization. This typically comes up in conversation concerning stock option expensing, straight-lining rents or discount pledges receivables. Granted many of the more esoteric aspects of GAAP do come across as academic even to accounting professionals.
For time pressured business owners, managers and directors trying to gain an understanding of some of the more complex treatments for recording transactions in accordance with GAAP is next to impossible. This very problem is what has spurred the debate for big and little GAAP standards. One thing I try to point out to my clients though is that even though some of the accounting treatments under GAAP may at first appear academic, many of these standards provide both meaningful and practical information about the business for better decision making.
A good example is the percentage-of-completion method for recognizing revenue on long-term contracts. Many contractors at first may believe that cash basis is not only the simplest way to track their revenue and expense under long-term contracts but that it is the best. Under GAAP these contracts should be recognized using percentage-of-completion, which to many contractors may come across as onerous. But cash basis can result in extremely misleading financial statements which if the business owner relies on for decision making could result in costly or even disastrous results. One such example is the habit for many cash basis contractors to accelerate cash expenditures at or near year-end in order to reduce their income. Basically the financials show income so business owners rush to expend cash in an attempt to accelerate deductions to reduce income for tax purposes. They also try to delay receipts until after year-end to further reduce income. The combination can result in significant cash flow gaps hurting the organizations liquidity as well as potentially increasing bad debts from the deferred receivables. This is a good example where not using GAAP and a separate issue regarding a lack of knowledge about what tax reporting options are available for long-term contracts can have a negative impact on the financial health of an organization.
A second example relates to the concept of over and under billings. When presenting cash basis financials a large bank balance would likely lead a business owner to the conclusion that their organization is healthy. However, this same organization can look very different when GAAP's percentage of completion is applied. Percentage of completion requires recognition of the liability of overbilling on contracts. Assume the following, a contractor has one long-term contract valued at $3 million which they anticipate costs of $2.4 million to complete. The contractor has progress billed the client for $2.6 million to date. So under cash basis for example, a contractor might report $1 million in cash in the bank but under GAAP there may be $1.8 million in contract work that has been previously billed for but for which no actual work has been done yet. In other words, an organization has overbilled their customers for $1.8 million in work is now liable for delivering on the contract with only $400,000 left to progress bill. The reality in the example above is that this company is actually insolvent and they just don't know it yet! That's hardly academic and is about the most practical dose of reality a business owner can get.
For tips on improving efficiency and reducing risk, signup for the Controlzkit newsletter here.