Once again, it’s time for annual financial statements to be compiled, reviewed, or audited and presented to comply with bank covenants. Banks and investors generally require year-end financials to be in accordance with generally accepted accounting principles (GAAP). While GAAP requirements are geared to best serve investors as users of financial statements, many private company users include bankers and owners who care about cash flow and ability to repay debt.
When deciding whether to employ income tax basis financial statements and GAAP, there are some key differences to consider. The basis of accounting will change based on your auditor’s opinion, but the type of opinion will stay the same. For the restaurant industry, differences between the two approaches are most noticeable with:
- Lease accounting
- Tenant improvement allowance
- Closed store reserves
- Gift card recognition
- Purchase accounting
For example, the income tax basis of accounting requires the recognition of rent, paid or to be paid. Conversely, GAAP recognizes rent expense on a straight-line basis over the term of the lease, thereby resulting in a liability, or deferred rent, on the balance sheet for the difference between rent paid and rent expensed. Overall, the adjustments required under GAAP result in non-cash adjustments to the books of record and a thorough understanding of the technical literature.
If you’re leaning toward income tax basis of accounting, a few benefits to consider include:
- A review or audit is less expensive for clients and easier to prep for, as less accounting assistance is needed from the CPA firm
- Results are often better aligned with EBITDA as it excludes non-cash transactions and focuses on the cash outflow as well as the ability to meet debt servicing requirements
- The P&L results better reflect the operating cash flow of the company by excluding non-cash transactions for continuing operations
- It has minimal impact on sales, cost of sales, labor
- The balance sheet will only include liabilities with cash outlay requirements
On the other hand,
- Results of income tax basis accounting will not include adjustments for impairment or closure of stores; however, disclosures will be made in the notes to financial statements
- Re-evaluation of debt covenants may be necessary; most banks allow for the non-cash element of deferred rent to be backed out of calculations
- In many private equity deals, GAAP financial statements are preferred
If you’re still not sure which accounting method will work best for your business, consult your owner, banker, investor or accounting professional.