Spoiler alert: This is not your run-of-the-mill article discussing unrecorded bonuses, profit sharing, commissions and other accruals. Instead, we will be taking a deeper dive into a topic that often flies under the radar: your business’s economic liabilities, the ones that generally accepted accounting principles (GAAP) don’t require you to present and that are often overlooked in buy/sell agreements.
Let’s take a look at the top five examples:
1. Technological Debt
Technology can be a wonderful thing when you manage it appropriately and use it to your advantage. But if it’s managed ineffectively, technology can also be your worst enemy. Companies that are heavily invested in a highly customized product must understand the long-term costs of maintaining it. While you may be able to tailor these products to suit your specific needs, they may prevent you from taking advantage of “off the rack” upgrades and require a steeper internal IT investment that your company may not need — hence the unrecorded “liability.”
Similarly, if you are using an older system and have avoided upgrades by constantly plugging leaks — thereby creating unnecessary and inefficient workarounds — you must eventually evaluate the true cost of maintaining the product versus updating it.
You should also have a clear strategy for vetting software solutions; part of this strategy is considering how your systems “talk” to each other. In other words, the solutions you consider implementing should conform to the rest of your software packages in order to take advantage of the true efficiencies that technology can create, which will ultimately benefit your business.
2. Deferred Taxes for Passthrough Entities
Historically, owners have considered S corporations, partnerships and other pass-through entities as attractive modes of conducting business because of the ability to avoid “double taxation” by passing the income (and thus the tax liability) to themselves. Since these entities do not record income taxes, they certainly don’t have deferred income tax issues, right?
GAAP say “no” — but in reality, deferred taxes for pass-through entities are real, impactful costs. Companies must be aware of the ongoing book-to-tax differences that are often created by the owners’ ability to fully depreciate asset purchases for tax purposes. While GAAP does not require pass-through entities to present these “liabilities” on their balance sheets, they are very significant when making management decisions.
For example, take a company that has experienced several profitable years while making significant investments in property and equipment simultaneously. While the company is likely making large annual distributions to owners based on strong “book” net income figures, those owners are not incurring tax liability because they can take advantage of Section 179 and Bonus Depreciation. Now, fast forward to a year when the company is having a tough time; perhaps it’s showing a significant net loss and does not make any capital improvements. When the owners prepare their individual tax returns, they find they have significant tax liability because they had accelerated so much depreciation in the past. So, it shouldn’t come as a surprise to the business when the owners come knocking on the door asking for a distribution to cover their personal tax liability.
Had the company been tracking its deferred tax liability, it could have anticipated this conversation and likely managed it much more appropriately. Though they’re not “real” assets and liabilities at the company level, deferred tax assets and liabilities are tangible and impactful for pass-through entities’ management teams when it comes to determining the proper level of distributions annually. Calculating this liability annually is a best practice.
No, we’re not talking about the condiment you might add to your food for taste — we’re referring to state and local taxes (SALT). In the past, companies have somewhat relied on the “ostrich effect” when planning for SALT — in other words, they avoided the issue and simply buried their heads in the sand.
As a result, companies are often unprepared when “nexus” comes to light. Nexus can be created with several states depending on each state’s law and how you conduct business in that state. If you plan to expand your company into other geographic areas and take advantage of new markets, SALT should be high on your list of potential issues to plan for.
SALT often comes to the forefront of many discussions and is assessed by private equity groups when evaluating potential acquisitions and determining transaction prices. Many states will make a significant effort to find your business to determine whether you have nexus with them.
So, while you currently may have a big, fat zero on your balance sheet next to SALT, you might want to look a little harder. We have found it is much more advantageous for companies to self-report nexus because it can be much more costly if the state discovers it first.
4. Accrued Vacation
I know, you’re probably thinking, “Wait a minute … I thought we weren’t going to cover run-of-the-mill accruals?” There are more issues surrounding accrued vacation than just the GAAP requirement. Companies continue to misinterpret their own vacation policies, leading to incorrect inclusion or exclusion of accrued vacation from their balance sheets.
While most companies are not blatantly avoiding recording accrued vacation, they should take a closer look at their policies to verify that they match up with the accounting. In the end, the policy is what drives the accrual, regardless of management’s intentions. If you find your policy does not match up with the accounting treatment you desire, consider modifying your policy to ensure that what you are promising your employees is aligned with how it should be recorded, according to GAAP.
Lease accounting has not changed in several years. In fact, you could pick up a textbook from 1980 and find that the rules for recording leases on a balance sheet are very similar to those that are in place today.
However, as you have (hopefully) heard, there is substantial change coming to a balance sheet near you. While the new lease accounting may not be applicable to some companies for a few more years, it’s not too early to start learning the standards and taking inventory of the leases you have, regardless of how they’re currently treated.
Though these examples aren’t exhaustive, they illustrate how going beyond GAAP can help you understand what economic liabilities are looming, and what you need to do to resolve them.