In the Industry 4.0 era, here are 5 common GAAP violations impacting the financial performance of advanced manufacturers
Clayton & McKervey Posted 06/19/2019
Southfield, Mich. — While the manufacturing sector rapidly evolves to adapt to new and diverse Industry 4.0 technologies such as robotics and artificial intelligence, many companies are unaware that oversights in their accounting reporting may be costing their bottom lines. According to Kevin Johns, CPA and shareholder with Clayton & McKervey—a certified public accounting and business advisory firm helping growth-driven companies compete in the global marketplace—accurate GAAP (Generally Accepted Accounting Principles) reporting provides a common language with which companies can ‘speak’ on their financial performance.
“Any errors or omissions in applying GAAP—which is the most common accounting framework in the U.S. for preparing financial statements—can be costly in a business transaction,” Johns said. “These violations can cause inaccurate reporting for internal and budgeting purposes, as well as a reduced reliance on prepared financial statements for third-party readers—impacting credibility with lenders and leading to incorrect business decisions. Damaged credibility can furthermore cause a negative impact to the purchase price when going through a sale of the business.”
Johns compiled a watch list of five of the most common mistakes manufacturers make under GAAP:
1.) Escalating Rent
Many lessors offer incentives such as “free rent” at the beginning or the end of the lease arrangement. GAAP accounting requires that operating lease expenses be divided using the total rent payments over the lease term by the number of months in the lease to calculate monthly rent expense. Any difference between payments and expenses would be classified as either a current or non-current asset or liability on the balance sheet.
As manufacturers and entrepreneurs pursue Industry 4.0, they are growing revenue through the addition of equipment upgrades and fast-paced expansion fueled by the most recent tax law which provides generous tax write-offs through depreciation. Even though companies can now write off up to $1 million through section 179, and bonus depreciation laws are the best they have ever been (leading to a significant spread between tax depreciation and book depreciation), these accelerated methods do not comply with GAAP reporting rules. In addition, businesses often incorrectly apply the tax method of 39 years of depreciation for leasehold improvements, but GAAP stipulates that these improvements should be depreciated over the shorter useful life or lease term, including renewable options.
3.) Capitalization of Overhead Costs
Frequently, direct costs such as labor and raw materials are used to value the production of inventory, but a GAAP reporting requirement often overlooked is the capitalization of overhead. Overhead should be based on variable and fixed factors, both of which are founded on actual usage drivers and formulas constructed by capacity vs. production for cost allocation. By excluding or not applying overhead calculations, large inventory valuation errors can occur on the balance sheet and related cost of goods sold on the income statement.
4.) Accrued Vacation/Paid Time Off
Employers who have a “use it or lose it” policy, sometimes pay cash for unused vacation time at a certain point (i.e. anniversary date, specific calendar date or exiting the company). While a formal written plan does not by itself dictate a potential employer liability, an informal verbal and accepted policy is enough to trigger an employee’s potential right to compensation which might need to be accrued. Depending on the length of employee tenure and vacation time awarded, it is not uncommon that the liability associated with these policies can be significant—and even more pronounced when a client is selling a business. The buyer will factor this liability into the required working capital target as well as the computing enterprise value, as a multiple of earnings.
5.) Uncertain Tax Positions
FASB ASC Topic 740 established a threshold condition where a tax position taken in a previously filed tax return—or one to be taken on future tax returns—needs to be recognized on the current financial statements. To determine uncertain tax positions, there is a two-step process that must be recognized:
A “more likely than not” (more than 50%) approach that a tax position will be sustained under an IRS audit
The tax position is measured at the largest amount of tax benefit/expense that is greater than 50% likely
In addition, businesses operating outside of their “state of residence” could face an income tax liability in those states depending upon the nature and duration of the activity of the business. If the company does not register to do business nor register to file tax returns in these outside states, it would not preclude the GAAP financial statements from accruing the tax liability and disclosing it on the financial statements.
Other tax uncertainties to be considered are:
- Business expenses (meals and entertainment, unreasonable compensation)
- Valuation of deferred tax assets (net operating losses)
- Transfer pricing between foreign related parties
- Built-in gains tax (BIG) on conversion to an S-Corp
- Pending IRS examinations
- Framework for small and medium-sized entities (FRF for SMEs)
Many private, small- and medium-sized businesses find GAAP reporting challenging due to its complexity and their limited resources, said Johns, but this group may qualify for a non-GAAP substitute—Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs). More focused on cash flow, this accounting framework relieves eligible companies of the unnecessary accounting standards driven by GAAP pronouncements and required at Fortune 500 companies.
“For example, uncertain tax positions, consolidation of certain Variable Interest Entities (VIEs), accounting for unrealized gains and losses in derivative contracts, and goodwill impairment testing would not be required under the FRF for SMEs,” Johns said. “Changes to GAAP for recent FASB pronouncements, such as accounting for leases and revenue recognition, would also be not applicable under this accounting framework. Companies should review the best option with their accountant.”
About Clayton & McKervey
Clayton & McKervey is a full-service CPA firm helping middle-market entrepreneurial companies compete in the global marketplace. The firm is headquartered in metro Detroit and services clients throughout the world. To learn more, visit claytonmckervey.com.