At a Glance
Main Takeaway
Most banks and investors require companies to report their financial statements in compliance with Accounting Principles Generally Accepted in the United States of America or U.S. GAAP.
Next Step
While GAAP compliance is necessary to minimize accounting mistakes and maintain trust, these six GAAP standards are critical in order to avoid loss of investor confidence and potential compliance issues.
What is GAAP?
The Generally Accepted Accounting Principles (GAAP) are a set of accounting standards debated and published by the Financial Accounting Standards Board (FASB). A company is GAAP compliant when its financial records and statements follow all standards and principles under GAAP. Professional accounting teams can help companies comply with GAAP standards through audits and assurance services.
The Six Commonly Forgotten GAAP Standards You Should Follow
Following these six GAAP standards and best practices will help your organization improve its decision-making processes, particularly during uncertain or unpredictable financial periods.
1. Addressing Impairments of Long-Lived Assets
This standard outlines accounting and reporting rules for long-lived assets. Under U.S. GAAP, an organization must recognize an impairment loss of a long-lived asset if its carrying amount (e.g., the balance sheet’s book value) is not recoverable.
How Asset Impairments Happen
A significant change in operating conditions can impact a company’s ability to recover the carrying amount of a specific asset.
Examples of typical changes in operating conditions include a drop in the asset’s fair market value, adverse changes in the asset’s physical condition (e.g., the asset is damaged, worn-out, or in need of repairs), or adverse environments, such as a hostile business climate or unfavorable legal and regulatory changes.
Asset impairments can also occur if an asset’s acquisition or building costs exceed initial expectations or when it consistently experiences cash flow or operational losses, thus impacting the inherent value of the asset’s market value.
How to Address Asset Impairments
ASC 360-10 recommends addressing tangible asset impairments by following these four essential steps:
- Identify impairment indicators: GAAP-compliant organizations should evaluate their long-lived assets’ operating conditions periodically for indicators of potential impairment. Identifying these indicators depends on industry standards or a measurable economic impact of the underlying asset.
- Conduct impairment testing: If potential impairment indicators have been found, the company must perform impairment tests periodically to determine whether the carrying amount exceeds its fair market value. If it does, the company must recognize an impairment loss. Determining fair market value can involve significant judgments, but often becomes apparent when business conditions suddenly shift.
- Adjust the carrying amount: The company must record the impairment loss as an expense in its accounting reports, reducing the asset’s carrying amount to its recoverable amount and the actual fair market value of the asset.
- Disclose the impairment: GAAP compliance requires companies to disclose impairments in their financial statements and the indicators that led to the impairment decision. If an impairment loss has been recognized, the company must record it on its balance sheet and as a loss on its income statement.
2. Disclosing Assets Held for Sale
A potential consequence of changes in operating conditions is selling or disposing of productive assets. A company asset must meet six specific criteria at or prior to the balance sheet date to qualify as held for sale:
- The company management has designed and committed to a plan to sell the asset.
- The company does not intend to change the sale plan significantly or withdraw it soon.
- The asset or component must be immediately available for sale in its present condition (e.g., can be sold “as-is”).
- The company is making active efforts to find a buyer.
- The company is actively marketing the asset for sale at a price reasonably close to its fair market value.
- The company believes the sale of this asset is probable and expected to happen within a year.
Once an asset has been categorized in the company books as held for sale, the asset’s carrying value will not receive any further depreciation or amortization. The company should assign a value to assets held for sale for which they are likely to be sold.
How to Disclose an Asset Held for Sale
During any period in which a company has assets held for sale, financial statements must disclose information regarding these assets:
- A complete description of the circumstances leading to the expected disposal of each asset held for sale
- The intended manner and timing for that disposal
- Any losses recognized
If not separately presented in the financial statement, you should also include the following information:
- The carrying amount of the major classes for each asset and liability categorized as held for sale
- Gains or losses must be presented on the line item corresponding to each asset when sold
3. Reporting Discontinued Operations
If your organization has decided to stop a specific business operation, follow the rules and best practices regarding discontinued operations reporting. Companies must report discontinued operations on their financial statements.
To determine whether a company can classify an operation as discontinued, it must meet three criteria:
- Disposal rule: The operation must have been disposed of or held for sale, indicating the company no longer intends to operate that component or business unit.
- Line of business or geographic area: The operation must be a part of the company that either represents a separate, distinguishable major line of business or a major geographical location of operations. The line of business or geographical area must have its own operations and cash flows associated with operations, making it easy to distinguish from the rest of the company.
- Elimination rule: Disposing of this discontinued operation should eliminate all associated cash flows and operations associated with the disposal. Typically, this involves liquidating, abandoning, or redistributing all relevant assets.
Discontinued operations should represent a shift in the company’s overall strategy. For example, consolidating multiple production facilities into one would not qualify as a discontinued operation. However, leaving a significant geographic area, like closing a location that makes a specific product line, could qualify.
4. Following the Principle of Going Concern
According to the U.S. GAAP standards, the assumption of going concern assumes that a company will continue its operations in the foreseeable future, at least 12 months from the date the financial statements are issued after the balance sheet date. This implies the company has no intention or necessity to liquidate or significantly curtail its operations due to “going concern.”
Following the principle of going concern requires a company to report whether there are any doubts or uncertainties regarding its ability to maintain a going concern. To determine these uncertainties, companies follow a three-step process:
Step 1: Obligations Test
The obligations test is an analysis of the company’s business obligations. It can be a quantitative or qualitative analysis. The purpose of this test is to determine whether there is any doubt the business can meet all of its financial or operational obligations in the next 12 months after the date the financial statements have been issued.
If no substantial doubt is raised, there is no need for further action or disclosure on the financial statement, as the company meets the assumption of going concern. Otherwise, move on to step 2.
Step 2: Alleviation Plan
If any substantial doubt the company can meet its obligations has been raised, company management must develop a plan to alleviate this doubt. The plan must be feasible, implementable within 12 months of the financial statement issuance date, and approved by stakeholders, and sometimes shareholders or the Board. It must include detailed steps and measures to mitigate the causes of doubt in going concerns.
Step 3: Disclosures and Implementation
After creating the alleviation plan, company management must disclose all details relevant to this plan in the financial statements. Required disclosures must include a complete description of all events and circumstances that raised doubt, an assessment of these circumstances and their likelihood, their significance to the entire business, and details of the alleviation plan.
The company must also disclose an assessment of the plan’s potential effectiveness. Suppose the alleviation plan has not been determined as an effective solution to alleviate doubt. In that case, the financial statement must also include clear disclosure of the existence of substantial doubt in relation to the company’s ability to maintain a going concern past the reasonable doubt.
5. Recording Contingent Liabilities
To report your company’s financial position accurately, you must disclose contingent liabilities.
What are Contingent Liabilities?
Contingent liabilities are potential obligations that arise from past or present events. However, they have uncertain outcomes, including possible future losses.
U.S. GAAP standards require companies to disclose material contingencies in the notes to their financial statements, even if the likelihood of their occurrence is uncertain. Material contingencies are those that have the potential to impact the company’s financial position or results materially. Material misstatements often arise when a company ignores its potential contingent liabilities, especially when it has various forms of moral hazard within its operations.
For example, a pending lawsuit, a warranty claim, or a tax dispute could all be considered contingencies. When the outcome of a contingency becomes probable and the amount can be reasonably estimated, they require a credit to the accrued liability account and a debit to the expense account. Identifying contingencies within an organization requires entity-level controls that allow all members of management to provide relevant communications to the financial reporting team.
No liability needs to be recorded if the contingency is remote or not readily estimable. However, the company must still make appropriate disclosures under U.S. GAAP in the financial statements to inform others about potential risks.
6. Preparing Statements for Liquidation
Preparing financial statements for liquidation involves following specific accounting principles and guidelines to reflect the financial position and results of a company ceasing operations.
- Assess the going concern: Before starting the liquidation process, management must evaluate whether the company can continue as a going concern. If the company determines it cannot continue its operations, it must start preparing financial statements using the GAAP liquidation basis of accounting. A liquidation basis is a GAAP-required basis of accounting when liquidation is considered imminent.
Liquidation is imminent when a plan for liquidation has been approved by the appropriate party (or imposed by other forces such as in an involuntary liquidation), and the likelihood is remote that execution of the plan will not be blocked by other parties and the entity will not return from liquidation.
- Identifying and valuing assets: Identify all the company’s assets, including tangible and intangible assets, investments, and other rights or interests. The company should value assets at their estimated liquidation value, which may differ from their carrying amounts on the balance sheet. Liquidation value is the amount that should be realized from selling the assets in an orderly liquidation.
- Recognizing and measuring liabilities: The financial statements should identify and record all known and potential liabilities. Liabilities may include outstanding debts, pending legal claims, and obligations to employees, suppliers, and other stakeholders. Liabilities should be measured at estimated settlement amounts and dates, which may differ from those recorded in the company’s books.
- Adjusting for impairments: Assets that are impaired, meaning their carrying amounts exceed their estimated liquidation values, should be recognized as impairment losses in the financial statements. Impairments reduce the value of the assets and should be recorded as expenses or reductions in the carrying amounts of the respective assets.
- Recognizing liquidation costs: Expenses directly associated with the liquidation process, such as legal fees, severance payments, and other winding-up costs, should be recognized in the financial statements as they are incurred. These expenses are typically classified as part of operating expenses or as separate line items on the income statement.
- Presenting financial statements: The financial statements prepared for liquidation purposes should include a balance sheet, income statement, and cash flow statement. The balance sheet should reflect the liquidation values of assets and the settlement amount of liabilities. The income statement should report the liquidation results, including gains or losses on asset sales, impairment losses, and liquidation expenses. The cash flow statement must separately detail cash inflows and outflows related to liquidation activities on separate line items from any ongoing operations during the liquidation.
- Disclosing contingencies and commitments: Companies must be as detailed as possible with disclosures during the liquidation process. They must disclose information regarding the liquidation plan’s nature, expected time to execute, all methods and assumptions used to determine amounts and settle liabilities, and any uncertainties that could impact timing or amounts.
Get Help with GAAP Compliance
Following these GAAP standards and recommendations is necessary to maintain your company’s GAAP compliance and create accurate, consistent, and transparent financial statements. Complete and compliant financial statements enable your stakeholders to manage risks and assess company performance more accurately.
Contact Windes Audit & Assurance team for help navigating the complexities of GAAP compliance and ensuring accurate financial statements.
