By Amanda Langholz
With year-end financial statements wrapped up for 2021, it’s smart to look ahead and recognize common pitfalls affecting those statements before you meet with your auditor. Certain items are frequently overlooked or misunderstood and can have important ramifications for your balance sheet and overall operations.
The more knowledge you have ahead of time about Generally Accepted Accounting Principles (GAAP), the more confidence you can have in your financial statements. Your organization will benefit from greater efficiency and time-savings and more informed decision-making when you’re aware of pitfalls ahead of time. Stakeholders of GAAP financial statements should always expect transactions to be recorded and disclosed in a consistent manner.
Financial statements are prone to errors and misunderstandings in these nine key areas:
1. Accounting for leases
Most companies are aware of the accounting pronouncement (ASC 842) that is effective in 2022 for private companies and will likely have a significant impact on how we account for our operating leases. But that’s another story for another day. What doesn’t change with lease accounting is the proper recognition of lease expense for leases that have rent escalations during the term of the lease.
Some leases have varying payment terms throughout the life of the contract. Even when rents are not consistent, the lease expense should be recognized on a straight-line basis throughout the life of the lease. The total payments expected to be made throughout the life of the lease should be divided by the total periods in the lease to calculate the straight-line amount to be expensed during each period.
Lease terms may have stipulations where rent escalates during specific times of the year that the company uses the leased asset, but if the lessee gains possession of the leased asset at the beginning of the lease term, the lessee should recognize the lease expense on a straight-line basis.
2. Variable interest entities
Many errors begin at understanding the definition of a variable interest entity (VIE). In relation to the reporting entity, the related entity meets the definition of a VIE if the reporting entity has the power to direct the activities that most significantly affect the economic performance of the VIE and has the obligation to absorb losses or the right to receive benefits of the entity that could potentially be significant to the VIE. If the entity meets those requirements, it has a controlling financial interest and may need to be consolidated in the financial statements.
Just like any rule, there are exceptions. The most common exception is for entities under common control. There are many questions to answer when determining if the entity needs to consolidate a VIE, so it is important to understand all of the inputs to this decision.
3. Debt issuance costs
When a company assumes new debt or refinances debt agreements, many times large fees are associated with these transactions. In most cases, these fees should not be expensed, rather they should be capitalized and amortized over the term of the loan.
Additionally, a recent accounting standard changed the way these debt issuance costs are presented. In the past, we would show these amounts as an asset in the balance sheet; however, under current GAAP, we are required to net these debt issuance costs against the related debt. This can be tricky when trying to agree the debt balances to the outstanding balance per the bank, and it can also have an impact on the current and long-term classification of debt balances in the balance sheet.
It’s also crucial to track which pieces of debt the costs relate to because if applicable pieces of debt are paid off in the future, the remaining balance of the related debt issuance costs should be written off as expense during that same year.
Companies need to be aware of the accounting for debt issuance costs not only when incurring these costs in the initial year, but also in future years when presenting these costs on the balance sheet, income statement and in the footnotes.
4. Unrecorded liabilities
Unrecorded liabilities are an area to watch out for when preparing your financial statements. Without recording them, financial statements can be misleading to users. If we know the areas to watch for, we can avoid these errors.
In addition to the standard accrued liabilities of bonuses, unused vacation pay, accounts payable and profit sharing, other liabilities are often unrecorded. These include:
- Technology debt: While a highly customized product is advantageous in that it can be tailored to the needs of your operation, your ability to take advantage of off-the-rack upgrades may be limited and requires you to invest heavily in your internal IT associates, whether or not they are truly needed 100% of the time. The result is an unrecorded “liability.”
- Deferred taxes for passthrough entities: S corps, partnerships and other pass-through entities have historically been an attractive mode of conducting business partially due to the ability to avoid “double taxation” by passing the income (and thus the tax liability) to the owners. Since these entities do not record income taxes, they certainly don’t have deferred income tax issues, right? Actually, GAAP says “no.” In reality, deferred taxes for pass-through entities is a very real number. Had the company been tracking this deferred liability, this conversation could have been anticipated and likely managed more appropriately. While these liabilities are not “real” at the organization level for pass-through entities, they are very “real” for management when determining the proper level of annual distributions.
- State and local taxes (SALT): Many organizations in the past have ignored the impact of state and local taxes. As businesses expand into new markets across states, the SALT implications on a balance sheet may be much more relevant.
- Stock-based compensation and deferred compensation agreements: Just because these agreements are tricky doesn’t mean we can ignore them. Any time a company is liable for future compensation or promises future equity participation, disclosure and recognition is almost always required. It’s important to brush up on your accounting for these agreements because they are becoming more and more popular, and most times, they will have very significant impacts to financial statements.
5. Revenue Recognition (ASC 606)
Revenue Recognition (ASC 606) went into effect for private entities with year ends beginning after December 15, 2019. Since implementing the standard, some common areas of misunderstanding have emerged, from identifying performance obligations to implementing a software or tracking system.
To avoid misunderstandings, the sales and accounting teams need to be in constant communication regarding contracts and what those contracts entail.
Some companies have noticed revenue recognition changing from point-in-time recognition to over-time recognition. As more organizations recorded revenue over time, having a system to track progress has become more important than ever. Whether it’s an automated system within the accounting software or a manual system as simple as a spreadsheet, the key to tracking progress successfully is understanding system limitations and having proper controls in place.
6. Statement of cash flows
The three categories in the statement of cash flows (operating, investing and financing) can be complex to evaluate, leading to mischaracterizations. And those mistakes may include overlooking the “fourth” category known as the non-cash section of the statement.
This category is often missed and improperly included in the statement of cash flows as if cash changed hands. One example is auto dealer-provided financing. When purchasing a new vehicle via the issuance of a note payable, there is a tendency to show the gross purchase price and the new note balance in full within the investing and financing areas, respectively. Yet, actually, no cash changed hands in this transaction; someone simply signed a document.
7. Related party transactions
Understanding who a related party is and the nature of the relationship is most important for proper classification and disclosure in the financial statements.
A related party is any of the following:
- Any party that either directly or indirectly controls, is controlled by or is under common control of a company
- Investees accounted for by the equity method
- Trusts for the benefit of employees (i.e., pension and profit-sharing trusts)
- Principal owners of the company
- Management of the company and members of the immediate family or principal owners or management
- Any party with which the company may do business if either party to the transaction does or can control or significantly influence the management or operating policies of the other party to an extent that either party might be prevented from pursuing its own interests
- Any party that can significantly influence the management or operating policies of other parties to a transaction, or that has an equity interest in one of the transacting parties and can significantly influence the other party to an extent that either of the transacting parties might be prevented from pursuing its own interests
Once the related parties to the company are defined, consider the classification of related party balances. It may be required to present related party balances on the balance sheet separate from the rest of the balance sheet (i.e., separating related party receivables from accounts receivable for presentation). Disclosure of the relationship and transactions during the year is also required in the footnotes to the financial statements.
8. Inventory overhead application
One area often overlooked when valuing inventory is overhead. It’s simple to consider the direct costs associated with the inventory for valuation, but GAAP requires overhead to be capitalized. Inventory overhead can be improperly allocated or missed entirely, which can lead to the financial statements being misstated.
Overhead is calculated by allocating fixed and variable costs. Fixed overheads are items that generally don’t change based on production quantity. Some examples of this are rent, property taxes or salaries.
Variable overhead allocation should increase in proportion to units produced. Some examples of this could be supplies, utilities or fuel. Overhead costs can be allocated based on machine hours, labor hours or other methods. It is important to be consistent in the approach taken to allocate overhead.
9. Footnote disclosures
Financial statement footnotes provide greater context into how the company has accounted for items and events that occurred during the year. GAAP requires specific disclosures that give readers of the financial statements the full story to make informed decisions.
Make sure statements contain sufficient footnotes to provide not only the “what” of a situation but also the “why.” They should include information on related party relationships and transactions, insights about the concentration of credit risk, the basis used for significant financial estimates, and debt maturity schedules, among other topics.
How Wipfli can help
Having accurate and timely financials sets your organization apart in your industry. They are a key asset in decision-making whether you’re an owner, board member or investor. Contact us to learn more about ways we can help you with your next audit or financial review.
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