When looking at the numbers and comparing borrowers’ financial performances, you need to ensure that the financial statements you’re examining are all complying with the same accounting standards. If not, you could risk making decisions based on erroneous information. It’s important for lenders to understand the distinctions and be able to recognize when — and why — borrowers choose to use different reporting systems for their financial statements.
What is most common?
GAAP, or “Generally Accepted Accounting Principles,” is the most common financial reporting standard in the United States. The Securities and Exchange Commission requires public companies to follow it. Many lenders expect private borrowers to follow suit, because GAAP is familiar and consistent.
GAAP is also based on the principle of conservatism, which generally ensures proper matching of revenue and expenses with a reporting period. The principle also aims to prevent companies from overstating profits and asset values to mislead investors and lenders.
Compliance with GAAP can also be time-consuming and costly, depending on the level of assurance provided in the financial statements. As a result, some private companies opt to report financial statements using a special reporting framework. The most common type is the income-tax-basis format.
Tax-basis statements employ the same methods and principles that borrowers use to file their federal income tax returns. Contrary to GAAP, tax laws generally tend to favor accelerated gross income recognition and will not allow taxpayers to prematurely deduct expenses until the amounts are known and other deductibility requirements have been met.
What about tax-basis reporting?
In determining whether to use the tax-basis framework, borrowers need to decide if outside parties are going to rely on the financial statements. Tax-basis reporting may be appropriate if a business is owned, operated and financed by individuals closely involved in day-to-day operations who understand its financial position. But GAAP statements typically work better if the company has unsecured debt or numerous shareholders who own minority interests.
In addition, if management plans to sell the company, prospective buyers may prefer to perform due diligence on GAAP financial statements — or they may be public companies that are required to follow GAAP. The cost of generating GAAP financial statements is part of the equation as well. Preparation costs typically depend on how different the financial results would be under the two frameworks.
How are they different?
When comparing GAAP and tax-basis statements, one difference relates to terminology used on the income statement: Under GAAP, companies report revenues, expenses and net income. Tax-basis entities report gross income, deductions and taxable income. Their nontaxable items typically appear as separate line items or are disclosed in a footnote.
Capitalization and depreciation of fixed assets is another noteworthy difference. Under GAAP, the cost of a fixed asset (less its salvage value) is capitalized and systematically depreciated over its useful life. Borrowers must assess whether useful lives and asset values remain meaningful over time and occasionally incur impairment losses if an asset’s market value falls below its book value.
For tax purposes, fixed assets are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which generally results in shorter lives than under GAAP. Salvage value isn’t subtracted for tax purposes, but Section 179 and bonus depreciation are subtracted before computing MACRS deductions.
Other reporting differences exist for inventory, pensions, leases, and accounting for changes and errors. In addition, companies record allowances for bad debts, sales returns, inventory obsolescence and asset impairment under GAAP. But these allowances generally are not permitted under tax law; instead, they are deducted when transactions take place or conditions are met that make the amount fixed and determinable. Tax laws also prohibit the deduction of penalties, fines, start-up costs and accrued vacations (unless they are taken within 2½ months after the end of the taxable year).
What is best?
Both reporting methods are valid, depending on the circumstances. The decision of how to report financial information depends on the specific characteristics of the business. So it’s important for lenders examining a borrower’s statements to be aware of the underlying considerations that went into the decision — and how that decision affects the numbers.