Why GAAP matters

Sadly I am not allowed to say too much about today’s meeting as the board was in executive session but the gist of the other accountant’s opinion is that economic reality doesn’t matter only the legal form of a transaction.

Really?

When pressed about how that could possibly be the case since contractors obviously have earned a certain amount of revenue based upon an economic theory, the reply was, “Well you can’t confuse for profit with non-profit.”

Really?

When asked how, when a contract shows the total amount due or, if you elect you can pay a sum each month over XXX number of months and it includes interest at Y%, this someone does not create a sum certain for accounting purposes,  there is not somehow some understanding that the sum certain is a receivable, the replay was, “The contract says it is revenue only upon the payment of the monthly amount.”

Really?

The board naturally is confused.  Rightly so.  Two professionals, two different opinions, one type of transaction.

Except that one professional has a position backed up by research on the application of GAAP and how the Accounting Standards Codifications call for the transactions to be recorded.  The other is an opinion based upon his 30+ years of experience so he doesn’t need to know GAAP.

Honestly, if I were the board I would fire us both.  Me for yelling at a dumbass accountant who thinks that if he appeases his fired client he will continue to reap referrals and the other accountant for being a dumbass and trying to provide accounting 101 lessons.

I was wrong to lose my temper.  At the end of the day the treatment we selected is appropriate and consistent with GAAP.  But there was almost $2,500 of billing listening to a lecture of how debits are on the left and credits are on the right.  I was infuriated not for myself but the fact that these board members have owned and run businesses, sat on boards and really do understand the basics of accounting theory.  They paid $2,500 to listen to a self-proclaimed expert prattle on how form matters over substance.

Each person in the room understands that Enron happened.  That WorldCom cost them and their friends dearly.  When no matter how you cut it, you can’t incur an expense without the expectation that there exists a pool of resources to pay the attendant liability. And one expects their financial statements to reflect the reality of that situation.

GAAP exists for a reason.  GAAP doesn’t reflect – or rather should not reflect – the mere form of a transaction.  GAAP reflects economic reality.  And it does matter.  Because the next time you go to buy a home and you look at the books and it shows zero receivable from the owners and a bank liability of any amount, please understand, you are likely facing a special assessment only no one wants you to know.  And, had those books been properly kept on GAAP, you would have known the problem exists.  You probably still would have bought but at least you won’t be able to say (with a straight face) that you weren’t warned.  Which is the whole point of a financial statement anyways – to help you make better investing decisions.

So, GAAP is GAAP.  If you are bothered by the fact that your accounting is complex, look to the reality of your transaction as it is likely complex.  The further you get from doing work and billing for it, the more complex you make accounting in addressing your transactions.  Don’t blame the accountants… We are simply the messengers.

Debit This, Credit That, isn’t that Accounting?

Sometimes all you can do is simply stare at a speaker and wonder what is going through his mind.  “Accounting says you have to debit receivables and credit revenues.”

Um, no.

Accounting makes no such claim.  Effective accountants (and auditors) know that often earning revenues is divorced from demands for payment.  Demanding payment is a contract right – your attorney might require a retainer, your roofer wants a deposit, you want to be paid for the feet of pipe laid; but none of these are revenues. Yet.

Accounting is about reporting the economic substance of a transaction.  Accounting has to look for features which support the premise that the efforts necessary have been expended and accepted by the buyer in order to record revenue.  It doesn’t have to be hard, but it does have to be consistently applied.

Take for example, that piping contractor.  Let’s say he has a contract to

  • Dig a 1,000 foot ditch for $20/foot
  • Lay 1,000 of 24″ concrete pipe at $18/foot
  • Backfill and compact the trench for a lump sum of $8,000

The contract requires that the contractor submit a schedule of values (work completed) in order to be paid.

On the first billing, the contractor submits the schedule for the 1,000 feet of ditch dug for $20,000.  The effective accountant does not immediately do this for the invoice:

  • Accounts Receivable       $20,000
  •     Contract Revenues                         $20,000

That is because the rules for recognizing revenues is not based upon something as arbitrary as a schedule of values.  The smart accountant understands that the true measure of the revenue for a contractor is based upon an analysis of costs expended to actual anticipated costs.  So the accountant creates a little spreadsheet:

Anticipated Period Actual
Contract Revenue Costs Gross Profit Costs % Complete Revenue Billings Over/Under CIE BIE
ABCD     46,000   35,000          11,000   6,500 18.57%       8,543   20,000          11,457     –   11,457

The Company incurred only $6,500 of costs in the period.  This represents less than 20% of the total anticipated costs for the project.  The reality is, the contractor front-loaded the bid.  This is perfectly acceptable – provided the owner accepts the schedule of values and is a great way to get project funds in early.  But, GAAP says to recognize the contract’s revenue based on the relationship between actual costs incurred and the estimated total costs to complete.

In this case, only 18.6% of the project costs were incurred so really only 18.56% of the contracts revenues are earned.  The remainder is considered unearned revenues or, in construction accounting parlance, Billings in Excess of Costs and Gross Profits.  The accounting principle is called the percentage of completion method of accounting for long-term construction contracts.  The rule says that the form – the schedule of values – is not the appropriate measurement for recording revenues: The comparison of actual to anticipated costs is the appropriate basis for recording revenues.  Economic substance over the form.  $8,500 not $20,000 for revenues.

Accounting is more than debits and credits.  That is, assuming you need to know what is actually happening economically in an enterprise.  Most non-employee investors in a business should be thinking about the true substance of transactions and how they impact today’s profits and tomorrow’s cash flows.  Revenues and profits generate true cash flow, not the other way around.  The effective accountant knows this is far more important than debits and credits.

 

A Focus on Cash Flow

At a recent board and owner meeting, I was asked about cash basis of accounting being a better reflection of activity than GAAP.  This owner was an observer at a prior board meeting where I discussed this issue with the board so I think she wanted me to go on record in front of others.

GAAP, for all its flaws, is superior to the cash basis of accounting when it comes to reporting outside of management.  While I agree that GAAP can include requirements that are complex and perhaps outside the competency of management, that doesn’t mean that GAAP is inappropriate: It means that management is likely over its head.

Since this was a condominium association, I asked the board if management told them how much money owners had not paid for the reporting period.  The answer – Yes.  But it wasn’t included in the financial statements.  Management prepared a report showing how much money was collected and spent during the month, and then provided a separate statement with

  • How much owners hadn’t paid
  • How much in vendor invoices came in but were not paid yet

Also known as accounts payable and accounts receivable. The concern I have is not that they were doing this on a monthly basis but rather that management decided that this was an appropriate year-end reporting model as well.  This was the mistake.

Management could have made essentially three journal entries to ensure that the books and records accrued non-cash activity:

  • Record the due but unpaid assessments
  • Record the due but unpaid vendor invoices
  • Adjust the insurance for the amount that is considered prepaid

There is absolutely nothing wrong with keeping a set of management books and a set of financial reporting books.  It is, in fact, encouraged since decision-makers have different information needs.  Keeping separate books should not entail a great deal of work either.  Most software today is sophisticated enough to easily track cash in and cash out while at the same time tracking the amounts which have not been converted to cash.  The excuse that it is too much work is just that; an excuse.

But I would go further.  The board should receive a GAAP based balance sheet and statement of operations for each meeting.  But, management should also create special reports, or dashboards, for the various members of the board.  The treasurer is mostly worried about current cash receipts and disbursements.  The president, on the other hand, may be worried about reserve project expenditures in relationship to the reserve study.  It is most appropriate, indeed it should be considered essential, to give the information to decision-makers which is most appropriate for their particular needs.

GAAP fills a need for external reporting.  It is as complicated as the entity makes itself out to be.  Internal management reporting can be as simple and targeted as the user wants it to be and indeed should be.  The point of keeping the books on GAAP basis is to ensure that transactions are not overlooked at year-end; Otherwise both management and the auditor have to put more effort into the accounting than is likely warranted.  But if no one minds paying extra to address the conversion from one accounting basis to another, it is likely fine with the auditor.  I know it is fine with us.

Understanding Why Financial Reporting Exists

I was asked to answer a question on financial accounting concepts on Quora.   I felt that it is an issue worthy of sharing on my blog as well as we don’t often discuss why we have expectations when we prepare and audit financial statements – other than to say GAAP requires it.

The most basic concept underlying financial reporting (and the accounting procedures used to accumulate the data) is investment decision-making.  Everything Mahesh spoke to, and what I am going to elaborate on, is premised on the need for some information for investment decisions.

FASB and IASB have concept statements.  I am most familiar with US GAAP which is put out by FASB.  But I believe both standards setters agree overall on the concept of information necessary for decision making.

Ask yourself, if you were ready to make a decision to invest in a company, what information would you like to know?  Conceptually, the argument goes, you would like to know the business’ financial position – its balance sheet; its operations – profit and loss statement; and its cash flows.  These collectively make up the general purpose financial statements.
Oftentimes, the information presented on the face of one of those statements does not tell the whole story.  Take inventory as an example.  Lets say the statement of financial position says only that inventory is $1.0 Million.  As an investor, your decision to invest might change if you knew that the inventory was all finished goods: Or perhaps it is all work-in-process.  Knowing additional details which can impact an investment decision might still be necessary, the standards require additional disclosure – footnotes – to help investors put those statements into context and provide details that otherwise do not exist.
These statements do not exist in a vacuum.  They are the accumulation and summarization of thousands and millions of transactions.  And to ensure the necessary information is presented timely, is a faithful representation of what actually happened, and is relevant, the standard setters created accounting principles.

And to ensure that investors receive accurate information based on these guiding concepts, it is important that reported information be verifiable (can be audited successful) and comparable to others in similar situations.  This is why there are industry-specific principles and there is a focus on establishing an effective audit trail.  Investors should be wary where there is first, not an independent examination of the statements and second, where the underlying accounting is totally dissimilar to everyone else in the industry.  Sadly, it happens all too often.

If you are a small business and your bank requires you to prepare GAAP financial statements, it is important to understand that this is what they are looking for: Investment Decision information.  It doesn’t matter if the financial statements are prepared by your bookkeeper or audited by an independent CPA.  Your business is responsible for sharing financial information that the bank can use to make an investment (loan) decision.  You have an obligation to ensure it is accurate, tells the whole story, can be compared to other businesses that are in the same industry as you, and ensure that whatever is recorded can be independently verified.

You, management, are responsible for the accumulation, summarization and reporting of the information.  Management decides when to recognize revenues; or to have it be reported as unearned because the job isn’t done; Management decides if a product was actually sold; or was actually shipped to another warehouse across the country.  There is an undeniable tension between management sharing accurate accounting information and investors receivable actionable investment information.  You see this played out frequently in the press when you see a stock slide because a company missed its revenue target.

Accounting principles exist to put the concept into context.  Accounting principles are not complex or difficult to employ, business is moving farther and farther away from simple transactions of shifting values from producer to consumer.  Complex transactions make for challenging financial statements as investors cannot see where value begins and ends.  So ask yourself, do you really want to invest in a company where you can’t tell who owns what and who is owed what?  If not, demand that GAAP be followed; otherwise:

Caveat Emptor baby.