GAAP traps often occur when a business owner sells a company to a third party. The transaction is commonly memorialized by a Purchase Agreement. That agreement contains certain representations (or “reps”) and warranties.
Some of these are common sense and should pose no problem to someone who has operated a good business. The Accounts Receivable represent money that is actually owed to the company. Taxes have been filed on a timely basis. The seller doesn’t know of any pending litigation. The owner has the right and authority to enter into a sale agreement.
There is one, however, that is frequently required by attorneys who don’t understand privately held business, and agreed to by owners and their attorneys who don’t understand what they are guaranteeing. They are Generally Accepted Accounting Principles, or GAAP.
What is GAAP?
To start, the term “Generally Accepted” is misleading. It could easily be interpreted as “what everyone typically does.” Nothing could be further from the truth. GAAP is determined by two organizations, the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC).
Per Investopedia.com “GAAP is not law, though violating GAAP can have costly ramifications. Errors and omissions can impact a company’s credibility with lenders, investors, and other parties who rely on financial statements for an accurate picture of a company’s finances. The SEC does not take a kind view of companies that fail to conform to GAAP.”
Of course, the SEC is concerned mainly with publicly traded companies, and GAAP is intended to provide investors with consistent, reliable financial information on the companies whose shares they buy. Nonetheless, many attorneys have come to include GAAP financial statements as standard in all of their transaction agreements.
GAAP Traps
The problem begins when the agreement asks the seller to represent that the financial statements are in accordance with GAAP. The reaction of many business owners is “Sure. I record all my income, pay all my bills, and give a substantial portion of the rest to the IRS. That sounds like generally accepted accounting to me.”
But GAAP is designed for keeping tabs on giant enterprises. Here are a few areas that are required, but almost never accounted for in smaller companies.
Contingent liabilities in the event of a sales tax nexus. Companies that sell in states other than where they reside may owe sales tax on those sales. That is determined by a “nexus,” which is established by each state. In some states it is a total of $100,000 in sales in the course of a year. For others it is 100 transactions. Some states levy taxes if you reach either limit, in others it s both. The limits may be as much as $500,000 in sales and/or 500 transactions.
The GAAP trap is that companies are supposed to be booking a contingent sales tax liability on each sale in case they reach a nexus. When they don’t, that liability can be canceled at the end of the year.
Of course, most businesses know that they aren’t going to reach the nexus, and therefore never even make the entry only to reverse it. Nonetheless, they are in violation of GAAP.
Other GAAP Traps
Warranty liability. If you sell a product that is guaranteed in any way, part of that purchase price should be reserved to cover the cost of warranty claims. Ideally, the revenue is recognized over the life of the warranty. For most companies, the warranty cost is minimal, and they absorb any cost in the course of normal operations. Fine in practice, but (you guessed it) not according to GAAP.
Accrued expenses. As employees become eligible for paid time off, that liability should be carried on the balance sheet and adjusted each month.
Lease recognition. Beginning in 2022, long-term leases for both property and equipment must be recognized in full as liabilities. There is an offsetting “right of possession” asset to balance it out, with the liability reduced each month as rent is paid.
False Representation
There are others, but those listed here are commonly seen in almost every privately held company. Their financial statements fairly represent the profitability and strength of the business. The problems start when the seller signs a contract promising that it’s all done “according to GAAP.”
Owners are usually eligible for post-sale damage claims if they violate the representations and warranties. Be careful of the GAAP traps.
All true. It seems having a top corporate CPA literally audit their books as if it were public is a best practice.