By Rosalinda Villarreal
Many significant accounting standards updates have been issued recently, and it may make you wonder, do I have to adopt all these new standards?
In short, if your financial statements need to be prepared and presented in accordance with Generally Accepted Accounting Principles (GAAP), then yes. However, with any rule, there are always exceptions.
An overarching principle to keep in mind when preparing financial statements is the direct connection you have with the users of your financial statements because they are the stakeholders of your company.
And if you have stakeholders with an intimate knowledge of your business, you don’t foresee new users coming on board soon (acquisitions, refinancing, going public, etc.) and you have a relatively simple business structure, GAAP financial statements may not be the best avenue when preparing your statements.
The OCBOA alternative
An alternative to GAAP is preparing financial statements under a special purpose framework, commonly referred to as Other Comprehensive Basis of Accounting (OCBOA). OCBOA financials are used when preparing financials for external users and are assumed to be easier to prepare and understand than GAAP-basis financial statements.
Different types of OCBOA financials include:
- Cash basis: An accounting method that recognizes income and expenses only when cash is exchanged. The limitation of this method is that it omits many valuable assets and liabilities that might be crucial to a reader obtaining an understanding of the company.
- Modified cash basis: An accounting method that combines elements of the two primary bookkeeping practices: cash and accrual accounting. It follows cash basis for short-term items and accrual accounting for long-term items on the balance sheet. This method is not widely accepted in the industry, as it allows the preparer of the financial statement to pick and choose what items they are going to record and present, which defeats the purpose of having accounting rules in the first place.
- Income tax basis: A basis of accounting that the entity uses to file its federal income tax or federal information return for the period covered by the financial statements. This is the most common type of OCBOA financial statement and has much more value compared to cash basis or modified cash basis financial statements.
Why choose GAAP over OCBOA?
First things first, you may be required by either regulatory or legal compliance to produce GAAP financial statements. Sometimes OCBOA is not an option. OCBOA is only an option when there are no users of the financial statements (banks, investors, creditors, regulatory bodies, etc.) that are requiring GAAP financial statements.
Additionally, companies that may eventually go public, or are acquired by another public entity, have no other option but to prepare full GAAP-compliant financial statements.
There is a lot of value to GAAP financial statements. They create a sense of unity and conformity over OCBOA financials because GAAP-basis financial statements are considered more transparent with standardized assumptions. Comparing one set of financials to another similar company’s financials are more accurate under GAAP, as terminology, definitions and methods are standardized.
In addition, GAAP financials paint a more accurate picture at any point in time because they are on an accrual basis. Cash basis financials may be easier to account for and prepare, but they could be misleading to readers because they may omit significant liabilities that the company is obligated to fulfill.
GAAP financials help explain the details of your company’s operations. GAAP financials are supported by footnotes that are written to provide more detail into the company’s operations and go beyond the numbers and explain the business, expanding on details that the numbers don’t tell. They account for transactions that happened over the period reported and give insight and knowledge to management and its external users as to what to expect in the future.
However, like anything else of value, GAAP financial statements do not come without a cost. Preparing GAAP financial statements requires a significant amount of accounting knowledge, sophisticated systems and substantial time to accurately prepare.
A new standard under GAAP, effective in 2023, is known as current expected credit losses (CECL). This standard comes from Accounting Standards Update 2016-13. This new accounting standard introduces the CECL methodology for estimating allowances for credit losses. It’s intended purpose is to improve recognition and measurement of credit losses and reduce the number of impairment models used for financial assets.
Under the prior model (incurred loss model), companies could simply look at current conditions and historical loss experience to estimate their allowances for financial assets. Under CECL, companies must also factor in expected future losses. Thus, CECL is a more forward-looking allowance estimate.
But understand that CECL is not just “a banking thing.” CECL applies to any financial statements that have loans receivable, trade receivables, debt securities held to maturity, contract assets and other off- balance-sheet credit exposure, regardless of industry. It’s important to understand the various methodologies that may be used to estimate a CECL allowance and the standard’s applicability to nonbank entities.
GAAP will be ever changing, and there will never be a final update. Companies are always growing and evolving, and GAAP-basis financials will adjust for these changes over time, with more knowledge and understanding of how financial statements and related disclosures can most accurately allow readers to make informed decisions.
How Wipfli can help
The decision-making around what type of financial statements to prepare for your entity should take many factors into consideration, and all stakeholders and users of those financial statements should be involved in the decision. Wipfli professionals can help you determine the most appropriate approach for your organization. We can help you navigate the complexities of GAAP compliance and ensure the accuracy of your financial statements.
Contact us for support with your accounting and auditing needs.
Sign up for more information in your inbox or continue reading below: