Six GAAP standards no one wants to talk about
The relationship you have with your financial statements and the users of those financial statements is similar to any other relationship — the key to success is open, honest and timely communication.
Sometimes you have to address the tough topics. It’s not easy, but unlike our personal lives, generally accepted accounting principles (GAAP) standards have written rules.
These GAAP standards can help guide you in your decision-making process as you encounter sensitive topics in which you may lack experience. These six topics have become more commonplace and important as businesses have been operating in uncertain times over the last several years:
1. Asset impairments
Sometimes changes in operating conditions raise doubts about a company's ability to fully recover the carrying value of a particular asset.
Changes in operating conditions include:
- A significant decrease in the asset's market price.
- A significant adverse change in the asset's use or in its physical condition.
- Significant adverse changes in legal factors or business climate, including an adverse action or assessment by a regulator.
- Costs to acquire or construct an asset that significantly exceeds original expectations.
- Current-period operations or cash flow loss combined with a history of operations or cash flow losses.
- A projection or forecast showing continuing losses associated with an asset.
- The expectation that a long-lived asset will, more likely than not, be sold or disposed of significantly before the end of its previously estimated useful life.
When it’s determined that the carrying value will not be fully recovered, the asset is considered impaired. Assets subject to impairment could be accounts receivable, contract assets, inventory, debt and equity securities and more.
Accounting for impaired assets differs depending on what you intend to do. If you want to continue to use or hold the asset, it will be recorded as impairment loss. If you plan to dispose of the asset, it becomes assets held for sale.
How to address impairments in your book of accounts
For impairments, an updated cash flow projection model may have to be completed. An impairment loss should also be recognized for the amount by which the carrying amount of the asset exceeds its fair value — but only if the carrying amount is not recoverable.
The carrying amount of a long-lived asset is not considered recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and disposition of the asset. Estimates of future cash flows used to test an asset's recoverability should include only the future cash flows directly associated with, and expected to arise, because of the use and disposition of the asset. Exclude interest charges that will be expensed when incurred.
An impairment loss for an asset to be held and used should be reported in income from continuing operations before income taxes in the income statement. For a nonprofit organization, report it in the statement of activities.
What about intangible assets?
Slightly different rules govern accounting for intangible assets. In general, you never write up the value of an intangible asset, unless it is deemed to be impaired. Additionally, you are required to test these assets for impairment annually or upon a triggering event.
A triggering event could be a change in macroeconomic conditions, adverse industry changes, unfavorable cost factors or a decline in financial performance. Other entity-specific events such as loss of key management, personnel or customers; change in strategy; decision to sell or dispose of assets or litigation can also be triggers.
One exception to the rule on annual impairment tests is goodwill. If you have elected the Private Company Council alternative to amortize goodwill, you do not need to test it annually for impairment unless a triggering event has occurred.
Another exception is provided by a newer accounting standard, ASU 2021-03. It allows for private companies to assess goodwill impairment only at interim or annual reporting dates if a triggering event occurred during that reporting period.
2. Discontinued operations
While performing business performance analysis, did you decide to stop producing a business product, close a specific location or wind down a subsidiary? If so, the rule about discontinued operations may apply to your business.
A discontinued operation is a component of an entity that has been disposed of or meets the held-for-sale criteria.
A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. A component of an entity may be a reportable or operating segment, a reporting unit, a subsidiary or an asset group.
The transaction represents a strategic shift, meaning completely exiting a major line of business. For example, consolidating three plants into one is not considered a strategic shift.
Disposals that could be strategic shifts would be moving out of:
- A major geographic area.
- A major line of business.
- A major equity method investment.
- Other major parts of an entity.
And that strategic shift must have a major effect on an entity’s operations and financial results.
Examples of a major effect include:
- The sale of a product line that represents 15% of total revenues.
- The sale of a geographical area that represents 20% of total assets.
- The sale of an equity method investment that represents 20% of total assets.
- The sale of all the entity’s retail outlets that historically provided 30–40% of net income. (Recently, numbers closer to 15% also qualified.)
- The sale of an 80% stake in a product line that accounts for 40% of total revenue.
How to report discontinued operations in your financial statements
The net income, after tax, attributable to discontinued operations is lumped together in one line item and presented toward the bottom of the income statement. Costs associated with an exit or disposal of a discontinued operation are required to be included in the results of discontinued operations.
For all periods presented, on the face of the cash flow statement, you can present either:
- Total operating and investing cash flows of the discontinued operations.
- Depreciation, amortization, capital expenditures and significant operating and investing noncash items of the discontinued operation.
If held for sale classification is met, you should present assets and liabilities of the discontinued operation separately in the balance sheet, for all periods presented. If held for sale classification is not met, do not make any reclassifications on the balance sheet until disposal.
You’re also required to disclose information about significant continuing involvement with a discontinued operation after the disposal date. Continue to make these disclosures until the results of operations of that discontinued operation are no longer presented in the income statement.
3. Assets held for sale
In addition to holding assets, changing of certain operating conditions can result in the decision to dispose of assets.
Once these six GAAP criteria are met, a long-lived asset or disposal group, can be classified as held for sale:
- Management, having relevant authority to approve the action, commits to a plan to sell the asset or component.
- The asset or component is available for immediate sale in its present condition.
- An active program to find a buyer exists.
- The sale of the asset is probable, and the transfer is expected to qualify as a completed sale within one year.
- The asset or component is being actively marketed for sale at a price that is reasonable in relation to its current value.
- Actions required to complete the plan indicate that significant changes to the plan are unlikely or that the plan will be withdrawn.
The long-lived asset should be reported at the lower end of its carrying value or fair value less cost to sell beginning in the period the held-for-sale criteria are met. Once classified as held for sale, depreciation and amortization should not be recorded for any long-lived assets included in the disposal group.
What disclosures are required?
For any period in which a long-lived asset or disposal group has been disposed of or is classified as held for sale, you must disclose the following in the notes to financial statements:
- A description of the facts and circumstances leading to the disposal or the expected disposal
- The expected manner and timing of that disposal
- The gain or loss recognized
- If not separately presented on the face of the statement where net income is reported, the caption in the statement where net income is reported that includes that gain or loss
- If not separately presented on the face of the statement of financial position, the carrying amount of the major classes of assets and liabilities included as part of a disposal group classified as held for sale (any loss recognized on the disposal group classified as held for sale will not be allocated to the major classes of assets and liabilities of the disposal group)
The carrying amount of the asset should be adjusted each reporting period for subsequent changes in fair value less cost to sell.
A loss should be recognized for any subsequent write-down to fair value less cost to sell. A gain should be recognized for any subsequent increase in fair value less cost to sell, but not in excess of the cumulative loss previously recognized.
4. Going concern
It is often misunderstood that the going concern assessment is mostly for auditors. But now it is officially management’s responsibility to assess their entity’s ability to continue as a going concern.
Management is required to present in the financial statement if there exists substantial doubt about that ability. To determine this, you can use a three-step approach:
Step one
Substantial doubt is raised when it becomes probable the entity will not be able to meet its obligations during the look-forward period, which is the 12-month period that begins on the assessment date.
Some examples of conditions and events that might raise substantial doubt include negative financial trends, deteriorating relationships with key partners, internal matters and external matters.
Typically, this can be a qualitative analysis, but it is better to have a quantitative analysis to back things up, especially if there is any uncertainty as to whether doubt was raised. If an entity determines there is no substantial doubt raised, no disclosure or other action is required.
Step two
If substantial doubt is raised, management must develop a plan to alleviate the doubt. The plan must be approved, feasible, probable of being implemented in look-forward period and able to successfully mitigate the conditions and events that raised the substantial doubt. This will likely require support from some more detailed forecasting.
Step three
Certain disclosures are required to be made in financial statements, regarding the plan:
- Conditions or events that raised the substantial doubt (before considering management’s plans)
- Management’s assessment of the significance of those conditions or events
- Management’s plans to alleviate the substantial doubt
The plan must also be assessed to determine if it can be effective. If not, the financial statement must include a clear statement indicating that there is substantial doubt about the entity’s ability to continue as a going concern during the look-forward period.
5. Liquidation basis of accounting
Once a business has made the difficult decision to liquidate, how and when does liquidation basis accounting get triggered?
Liquidation is the process by which an entity converts its assets to cash or other assets and settles its obligations and creditors in anticipation of ceasing all activities. An entity is required by GAAP accounting standards to prepare its financial statements using the liquidation basis of accounting whenever liquidation is imminent. And it should be applied prospectively.
What financial statements are required to be prepared under this method?
- Statement of net assets, or liabilities, in liquidation.
- Statement of changes in net assets, or liabilities, in liquidation.
What needs to be recorded and at what value?
- Assets are measured at the estimated amount of consideration the entity expects to collect in settling or disposing of assets in liquidation. This includes previously unrecognized items that the entity expects to sell, such as trademarks.
- Accruals from the costs to dispose of assets must be presented in the aggregate separately from those assets or items. Do not apply discounting in measuring the accruals, and do not net against the asset itself.
- Recognize liabilities based on existing requirements of applicable GAAP and adjust to reflect any change in assumptions resulting from the decision to liquidate. For example, due to timing, current and noncurrent might be affected.
- Accrue costs and income expected to incur or earn through the end of liquidation, if and when it has a reasonable basis for estimation. (Examples include payroll costs or income from preexisting orders that the entity expects to fulfill during liquidation.) Do not apply discounting for future expected revenue and expense.
What is required to be disclosed in the financial statements?
- A statement that the financial statements are being prepared under liquidation basis.
- A description of the entity’s plan of liquidation, including the date it was approved, how it expects to dispose of its assets and liabilities and the anticipated duration of the plan.
- The methods and significant assumptions used to measure assets and liabilities.
- The types of costs and income accrued in the statement of net assets in liquidation and the period over which those costs are expected to be paid or income earned.
6. Disclosing and booking liabilities and contingencies
In business, you come across many instances, such as lawsuits and tax liability, where you land in uncertain situations that could result in future losses.
There are different thresholds to making the determination of whether you stay silent, only disclose or record and disclose the liability. In addition to dealing with these known situations, there are some situations in which you might not even realize you have a liability.
How Wipfli can help
At Wipfli, our knowledgeable team can help you navigate the complexities of GAAP compliance and ensure the accuracy of your financial statements.
Contact us today for support with your accounting and auditing needs.
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