The Gap in GAAP – Is It Really Immaterial?

This article highlights five items that are often overlooked in applying generally accepted accounting principles (GAAP). Certain rules tend to be ignored due to lack of awareness, impracticality of application, or assumptions related to materiality. We often fall back on the thought that “it’s not material and will all even out over time.” However, that doesn’t always hold true. You need to do the math! The concepts are familiar, but chances are you will learn some aspect of GAAP that was unfamiliar to you. Consider the following items and take a second look at your entity’s application of GAAP. Now, on to the quiz!

Depreciation Lives and Methods

True or False: Straight line depreciation is required by GAAP.

There is nothing easier than GAAP fixed asset depreciation accounting. Straight line over an asset’s expected useful life – right? Well, not exactly. GAAP actually requires the cost of a fixed asset to be spread over the expected useful life of the asset in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the asset in a systematic and rational manner. If the expected productivity of the asset is relatively greater during the earlier years of its life or maintenance charges tend to increase during the later years, then straight line depreciation may not fit this definition. Instead, the declining balance or other accelerated methods may be more appropriate. It seems many assets would meet the criteria of being more productive in earlier years or having higher maintenance in the later years, so straight line for GAAP should not be an automatic answer. Often, accountants default to straight line because they reason the expense will even out over time or the difference compared to an accelerated method will not be significant. However, in cases where a piece of equipment is either heavily or lightly used upon being placed in service, straight line may not be the best default method. Or if technology is rapidly changing or a company leaves a line of business and an impairment analysis is required, the timing of the depreciation and impairment charge could be materially impacted.

Similarly, accountants have traditionally disregarded tax depreciation for GAAP purposes. A reasonable position since GAAP specifically states if the number of years specified by the Accelerated Cost Recovery System of the Internal Revenue Service (IRS) for recovery deductions for an asset does not fall within a reasonable range of the asset’s useful life, the recovery deduction should not be used for GAAP. However, implicit in this guidance, one can infer that there may be times when tax depreciation is acceptable for GAAP purposes. One measure of determining how material the selection of depreciation lives and methods are to an entity is in the accounting for asset dispositions. Does an entity routinely recognize gains or losses on asset disposals? While the result is affected by several factors, gains could indicate that lives and methods are depreciating assets too quickly, while losses may indicate the opposite. Of course, gains could also indicate the entity didn’t apply an appropriate salvage value to the asset—another overlooked GAAP concept. Time spent upfront determining an appropriate asset life and depreciation method will produce the best answer for GAAP.

Answer: False.

Straight Line Rent

True or False: Straight line rent is required by GAAP.

Organizations typically have one or more leases. Proper accounting requires reading the entire lease agreement and understanding all the terms and conditions. Rent incentives in the form of “free rent” for the initial month(s) of a lease as well as rent increases over time to reflect the anticipated effects of inflation or time value of money are typical in many leases. Regardless of what payment stream the lease calls for, GAAP is fairly clear on straight line being the acceptable method of recognizing rent expense for the lessee and rent income for the lessor. In this context, straight-line rent is determined by computing the total amount of lease payments required under the agreement and dividing that by the number of months in the lease term. The expense then is level over the entire term. However, few leases call for fixed straight-line rent payments. Increasing rent payments would only be recognized as expense (or income) according to the payment schedule, when the increase in rent corresponds to leasing additional property. In all other instances, straight line is the rule. Following the rule typically results in a lessee recognizing a deferred rent liability in the early years of the lease as the lease payments are less than the straight-line lease expense. Whether or not the straight-line rule differs materially from the contractual terms is dependent upon, among other factors, the length of the lease and the nature and dollar amount of the incentives or rent increases. The larger the spread between the highest and lowest rent, the more likely the difference will be material. As is the case for most GAAP, you should always “run the numbers” to make sure you are applying GAAP appropriately. And while we’re talking about rent, you should also consider the impact of the new accounting standard on leases, ASU 2016-02, Leases, effective beginning in 2020 for private calendar-year companies (2019 for SEC filers).

Answer: True.

Betterments

True or False: Betterments should always be capitalized and depreciated over the new useful life of the asset.

Betterments – sounds like a very arcane word in 2017! However, many property, plant, and equipment policy notes state “expenditure for repairs and maintenance are charged to expense as incurred, whereas renewals and betterments that extend the lives of property are capitalized.” But how often is this recognized? What is a betterment? A betterment is an improvement to equipment or property that makes the asset more productive or extends its life. Betterments of real estate are easy to spot – adding a wing to a building or an additional loading dock to a warehouse. It’s harder to identify betterments to equipment and machinery. IRS rules state that the cost incurred for property is considered to be a betterment if it is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of a unit of property or is a material addition to a unit of property. In our current throw-away society, we are more accustomed to short-lived disposable items. But when an expensive piece of machinery needs work, the investment in capital will often improve the production or efficiency of the equipment or extend the useful life. These costs should generally be capitalized and depreciated. However, if the betterment only increases the life of the asset and does not improve the quality or quantity of production, then the cost should be recorded as a debit to accumulated depreciation (who remembers this from college intermediate accounting?). The debit is made to accumulated depreciation on the theory that the improvement extends the useful life of the asset and recaptures prior depreciation. We will continue to see repairs and maintenance expenses on an entity’s income statement, but keep a look out for betterments, treating them correctly may have a material effect on an entity’s operations.

Answer: False (not always).

Accrued Vacation

True or False: A vacation accrual is never recorded under a “use it or lose it” policy.

Summertime means vacation time. As workers strive for more work-life balance, vacation time is a valuable employee benefit. And GAAP has a say in how it should be treated for accounting purposes. GAAP uses the term compensated absences to encompass all employee absences, such as vacation, illness, and holidays. Specifically, absences for which employees will be paid. Both stated policies as well as customary practice need to be considered in determining accruals for compensated absences. GAAP states four conditions, if met, require accruing a liability for employees’ future compensated absences:

•  Obligation relates to employees’ service already rendered.
•  Obligation relates to rights that vest or accumulate. (Vested rights are those that will be paid even if an employee terminates. Accumulated absences are earned but unused rights that may be carried forward.)
•  Payment of the compensation is probable.
•  Amount can be reasonably estimated.

The GAAP principle is for a liability to be accrued in the year in which the benefit is earned. Let’s look at an example. If new employees receive vested rights to two weeks of paid vacation at the beginning of their second year of employment with no pro rata payment in the event of termination during the first year, when should the liability be recorded? If you think at the beginning of year two, that’s not GAAP. Since the two-week vacation benefit is considered to be earned by work performed in the first year, an accrual for vacation pay shall be required for new employees during their first year of service. What about employees who leave the company prior to the benefit vesting? Well, the rule says accrue if vested or accumulated. Until the vacation hours are forfeited, they do accumulate, so they represent an obligation for earned benefits and are subject to accrual. To avoid over accrual, an estimated forfeiture rate due to turnover should be considered in recording the liability.

Similarly, vacation hours that may not vest or get paid upon termination meet the accumulate criteria and should be accrued, along with factoring in a forfeiture rate if significant.

Sick pay gets a special mention in GAAP. The FASB Board shied away from requiring an accrual for nonvesting accumulating sick pay benefits. The issue relates to the low degree of reliability of estimating future illness-related absences. However, sick pay that vests or sick pay that accumulates and is customarily paid by the entity for non-illness-related absences should be accrued.

How material can all this be? Obviously, it depends on a number of factors such as the number of employees, pay rates, length of carryover period, policies, and customary practices. For most entities payroll is the largest, or one of the largest, expenses so payroll accruals can be material. It’s important to take a look at your entity’s policies for compensated absences to ensure the expense is being recorded in the period of service.

Answer: False

Imputed Interest

True or False: Zero interest loans are zero expense loans.

We’ve all seen and perhaps taken advantage of “zero interest” promotions at one time or another. Many consumer goods such as electronics, furniture, and appliances are advertised with this attractive offer. And so too certain business transactions are financed with no-interest notes. A great deal if you’re the recipient of the goods, right? In reality, the economic principle that you can’t get something for nothing is baked into GAAP rules related to interest. Specifically, when a note is exchanged for property, goods, or services, it represents elements of both principal and interest, whether or not stipulated in the note itself. The supplier economically is to be compensated for the use of funds over the term of the note that would have been received in a cash transaction. (GAAP provides guidelines on what interest rate to select in the event there is no established exchange price for the related property, goods, or services, including credit standing of the issuer, prevailing rates in similar transactions, etc.) So we again turn to materiality to determine whether the effort to impute interest and record the asset received at a net amount is necessary. A large company acquiring a vehicle or two may see fit to ignore the interest component. A transaction involving a significant portion of its fleet may cause that same company to come to a different conclusion. A medium-sized firm executing an acquisition with no-interest buyer financing paid over a period of years may find it needs to impute interest, which would alter the recorded values of assets acquired. Private equity financing may come with unique interest rate attributes, which depending on the magnitude of funding, could warrant looking at these rules. In short, remember to look beyond the written terms when considering the interest implicit in your contracts.

Answer: False.