chapter 05
How to Avoid GAAP Guidelines Violations
Get Accounting HelpMistakes in applying GAAP guidelines, known as violations, can have significant consequences. In addition to the costs incurred to correct your records, violations can lead to poorly informed business decisions, damage your credibility with third parties and result in regulatory consequences.
Top 5 Areas Where SMBs Violate GAAP Guidelines
1. Revenue Recognition
ASC 606 provides a seemingly straightforward process for recognizing revenue as you earn it, but its application is often surprisingly complex. Many SMBs misapply the standard, making mistakes like:
These mistakes can cause you to recognize portions of your revenue too soon or too late, overstating earnings in one period and understating them in another. That may lead income statement users to think your business is more or less profitable than it is.
To avoid revenue recognition violations, learn how ASC 606 is commonly applied to your specific industry. You can also hire accountants with the expertise to handle the function or provide ASC 606–specific training to your existing team.
2. Inventory Valuation
Inventory valuation is another complex aspect of GAAP compliance where mistakes can easily occur. Some of the most common errors SMBs make include:
Inaccurate inventory valuation inflates or underrepresents your company’s assets. That may mislead users of the balance sheet into believing your financial position is more or less favorable than it is. In addition to well-trained accounting staff, internal controls are the key to preventing inventory violations. Practical ones to implement include:
- Regular cycle count requirements for samples of inventory throughout the year
- Obsolescence procedures for identifying and disposing of slow-moving inventory
- Segregation of inventory purchase authorization, custody and accounting duties
3. Accrued Liabilities
GAAP guidelines require that you accrue liabilities on the balance sheet for expenses you’ve incurred but not yet paid. This is another highly complex aspect of accrual accounting, and errors often occur, such as:
Failing to accrue a liability for unused employee vacation time
Deducting accrued liabilities for tax purposes before satisfying the all-events test
Failing to update accruals when actual expense amounts become available
Like improper revenue recognition, accrued liability violations primarily cause you to misrepresent your earnings. The most significant danger may be in underreporting expenses, making your business seem more profitable than it is. In addition to accrued liability training, you can minimize violations by implementing internal controls like:
Checklists for month- and year-end accruals to ensure all are accounted for
Periodic reconciliation of accrued liabilities to actual expense amounts once paid
Software that can automatically record recurring accrued liabilities like payroll
4. Changes in Accounting Principle
A change in accounting principle generally refers to switching methods of recording or reporting financial information. It would include changing your inventory valuation method from LIFO to FIFO. Whether you’re motivated by some expected benefit or required to comply with new regulations, it’s often challenging to change principles. Some of the easiest and most significant mistakes include:
Since accounting methods are so fundamental to your financial reporting, the consequences of these kinds of violations are far-reaching. Misapplying a new method retrospectively could cause all your financial statements to be misleading. This makes it especially important to prevent mistakes rather than trying to fix them later. Some of the best ways to do that include:
5. Footnote Disclosures
GAAP guidance requires that you make specific disclosures in the footnotes accompanying your financial statements. They give users essential context and help explain your accounting decisions. Violations typically involve omitting necessary disclosures, such as those required for:
Without these disclosures, it can be impossible for users—especially external ones, like lenders and investors—to understand your financial statements as a whole. As an example, the notes are the only place they can learn your inventory valuation method. Investing in disclosure management software is an excellent way to ensure you provide all the necessary information.
These are some of the most common areas where GAAP compliance mistakes occur, but they’re far from the only ones. When in doubt, an audit expert can also help you navigate the requirements. Working with an experienced expert is often the best way to prevent costly violations.
Violation 1: ValleyTech recognized revenue for a long-term contract upfront, well before the performance obligations were fulfilled. It led to a $150,000 revenue overstatement for the year.
Violation 2: ValleyTech neglected to accrue earned vacation time for its 30 employees, resulting in a $50,000 understatement of its liabilities for the year.
Violation 3: ValleyTech incorrectly applied FIFO to certain products in its inventory and LIFO for others, leading to material inconsistencies in its inventory valuation at the end of the year.
Consequences: ValleyTech was privately owned, but it was actively looking for venture capital backing. Upon providing its financial statements to a prospective investor, these GAAP violations were discovered, ruining the potential deal.
Solution
ValleyTech hired a fractional CFO with extensive GAAP accounting experience to help their in-house team correct these violations and promote compliance going forward. The business implemented the following changes:
Revenue Recognition: ValleyTech identified the performance obligations in the long-term contract and recognized revenues only for the ones they’d fulfilled, reversing the $150,000 overstatement. It also invested in ASC 606 training to bring their in-house team up to speed.
Vacation Accruals: ValleyTech accrued the necessary vacation liability onto the books, reversing the $50,000 understatement. It also invested in software that would automate the process going forward according to their payroll numbers and vacation policy.
Inventory Valuation: ValleyTech adopted the FIFO method across all product lines and restated its previous financial statements using FIFO.
NOTE: This case study is hypothetical but based on real-world challenges that SMBs often encounter during their transition to GAAP compliance.
