Are You GAAP Ready? Tackling the Move from Cash to Accrual Accounting
Private companies or growing small businesses often face challenges when converting their financial statements reported on a cash basis to be compliant with generally accepted accounting principles (GAAP). This can be especially challenging when a company is acquired and must produce GAAP-compliant financial statements on a compressed timeline or if a company seeks financing outside the organization and must quickly comply with new debt reporting requirements. As companies change from cash accounting methods to accrual-based GAAP, there are several considerations for streamlining the process and properly preparing the business for these reporting requirements.
This accrual basis will better equip companies in their ability to manage and forecast third-party expenses in lieu of focusing solely on cash management.
There are many ways to approach converting financial statements reported on a cash basis to a GAAP or accrual basis, and gathering historical financial data, and related support will be vital to this process. A practical approach should include performing a thorough review of the transaction-level or general ledger details to understand the volume and nature of transactions requiring adjustments for accrual purposes. Additionally, assessing and focusing on high-risk areas (such as revenue or scenarios in which the company records large volumes of cash transactions) can assist accounting teams in narrowing their focus on the areas that will require substantial changes for the company.
While not an all-inclusive list, here are some of the most common impact areas companies should consider during the conversion process.
Revenue: companies will need to complete the adoption of ASC 606 – Revenue Recognition to ensure proper revenue recognition under the guidance. Implementation of ASC 606 can result in major changes for companies and can be a time-consuming process if a company has a large volume of complex contracts, unique pricing structures, or bundled offerings. Pain points often include the proper identification of performance obligations and allocation of revenue to the various units of accounting, which will inform the timing and amounts of revenue recognized. Revenue recognition matters can be particularly complex, and management should ensure detailed contract reviews are performed and evaluated under the standard and that the company puts technical policies into place because these items are often subject to heavy auditor scrutiny. Additionally, if a company records revenue upon receipt of cash, its deferred and accrued revenue balances will need to be established based on the policies and recognition guidelines adopted under ASC 606.
Accounts receivable: companies reporting on a cash basis typically recognize revenue upon receipt of cash without consideration of what should be recorded on the balance sheet related to open invoices due from customers. Management should work with accounts receivable teams to inventory all open invoices due from customers as of the conversion date, assess which of these invoices will be collectible, and record the appropriate asset balance on the balance sheet. Compared to cash-basis accounting, this change (and the implementation of ASC 606) will have post-adoption impacts on the timing and consistency of revenue recognition because the company will no longer be recording revenue upon receipt of cash, which can be unpredictable.
Accounts payable: similar to accounts receivable, companies reporting on a cash basis typically record expenses related to vendor invoices upon cash payment without consideration of what should be recorded on the balance sheet related to open invoices due to vendors. Management should work with accounts payable teams to inventory all open vendor invoices as of the conversion date and record the appropriate liability on the balance sheet. This is also an ideal opportunity for teams to review invoices and assess the existence of any prepaid assets for invoices outstanding or paid that relate to future services.
Prepaid expenses: given that expenses are recorded upon payment to vendors when reporting on a cash basis, prepaid balances will need to be established related to services that the company has paid for in advance. Management should establish a threshold in which prepaid invoices will be amortized and work with accounts payable teams to inventory any invoices that meet or exceed that threshold in which services have yet to be fully rendered as of the conversion date.
Recording accounts payable and prepaid expenses on an accrual basis will result in recognition that represents when the expenses were actually incurred versus when vendors are paid. This accrual basis will better equip companies in their ability to manage and forecast third-party expenses in lieu of focusing solely on cash management.
Payroll: when converting accounting from a cash basis to a GAAP basis, the primary change to payroll relates to accruals that will need to be recorded on the balance sheet related to payroll expenses (including related benefits and taxes) that have been incurred but not yet paid by the organization. Management will need to assess an appropriate accrual methodology (i.e., actuals versus an estimate based on prior period payroll expenses) and ensure the appropriate amount is included as a liability on the balance sheet. This includes evaluating whether accruals related to potential employee bonuses or vacation balances need to be recorded as well.
Management should also consider GAAP reporting implications related to stock compensation and award agreements, as the accounting for these arrangements can often be convoluted given the complexity of the respective guidance. Areas management should consider related to these arrangements include proper identification of the respective authoritative guidance based on the terms of the agreements, equity versus liability classification, appropriate valuation of the awards, and subsequent expense recognition.
Related insights: learn more about profits interests units (PIUs) and the accounting implications of these employee incentives.
Fixed assets: management will need to review the company’s fixed assets to ensure that all existing and in-use fixed assets as of the conversion date are reflected on the balance sheet. The assets must be accounted for at their acquisition cost as well as the related accumulated depreciation that is associated with the asset, and this should be calculated as if it had been depreciated on a GAAP basis from the initial asset purchase date. Depending on the size of a company’s fixed assets profile, this can be a significant effort for equipment-intensive companies.
Significant contract review: management should review and understand the GAAP accounting implications for significant contracts or agreements that would not be identified as part of the transaction-level review. For instance, if the company acquired an organization in prior years, its most recent financial statements might not indicate any activity related to the acquisition. However, these agreements should be reviewed under the lens of ASC 805 – Business Combinations to ensure the appropriate balances are recorded related to the transaction. Accounting for acquisitions can often be complex and may require the engagement of third-party valuation specialists.
Technical accounting considerations: it is critical to evaluate the impact of any major or pending technical accounting standards and related tax considerations that could potentially impact the organization’s accounting, such as ASC 842 – Leases. Successful adoption of ASC 842 begins with fully understanding the requirements of the new standard and establishing an appropriate approach and timeline, as implementation needs will vary based on the industry and nature of operations (e.g., decentralized versus centrally managed) and other factors. As part of a successful adoption process, companies will also need to consider and plan for the ongoing effort to account for the new rules going forward.
How the transition from cash accounting to GAAP impacts company processes
Given the significant effort required at the time of adoption and subsequent GAAP reporting expertise necessary to comply with financial reporting requirements, management should thoroughly understand the company’s reporting requirements and plan for adequate resources empowered to meet these challenges in a timely manner. This includes proactively training and educating existing staff on the new accounting methodologies and reporting requirements as well as assessing hiring needs for additional staff and engaging third party specialists. Management should also consider the need to streamline and automate accounting processes through the implementation of new technology, including reconciliation, financial statement, and general ledger software.
Transitioning from cash basis to GAAP reporting can be a complex and time-consuming undertaking that will impact not only how a finance and accounting team executes financial reporting but will also require CFOs and other leaders to understand how accrual accounting has impacted the business’s key performance metrics and compliance factors (including any controls scrutiny and auditor findings that often trigger such changes). Understanding key areas of impact, developing a plan to address them, and building sustainable processes going forward are critical factors when executing an effective transition.