GAAP Accounting for Business Owners: Build Buyer Trust Before an Exit

Speaker A: It's important because, you know, I've seen companies where they. Once you get better financial information, it's not just about financial reporting. It's about managing your business better. When you realize that product A is more profitable than product B, you might refocus your selling efforts and not spend so much time on product B. You will actually have a more valuable business because you have better financial information. So it isn't just about the reporting. It's about making your business more valuable either for yourself or to recognize that, uh, in a transaction that you would

Speaker B: help them with, two businesses show the same profit. One sells very quickly at a premium and the other struggles to close. Often the difference is not the business itself, it's how the financials are presented. Today we are going to talk about GAAP accounting and why it matters more than most business owners even realize. Welcome to Business beyond you, the one stop hub for insights, conversations and perspectives. Business owners need to build businesses that last beyond them. Hi, I'm Sara Maziri, M and A advisor in the state of California and my guest today is Diane Wittenberg. She is an audit partner at Haskell White LLP from. With more than 40 years of experience serving public, private and nonprofit organizations, Diane specializes in audit advisory, M and A, IPO and sox, uh, compliance services. And there isn't anyone more qualified to help us understand the importance of GAAP accounting and financial transparency. Dan, I really appreciate you joining us in this episode of Business beyond you.

Speaker A: Thank you, Sarah. It's a pleasure to be here.

Speaker B: Awesome. Uh, so let's start. Can you explain in simple terms what GAAP accounting really means in the context of running a business?

Speaker A: Sure. Uh, yeah. Think of, uh, US gaap, which stands for Generally Accepted Accounting Principles as the official rulebook for financial statement presentation in the U.S. it's a standardized way to record the revenue when you earn it and expenses when you incur them, not necessarily when the cash comes in or goes out. It turns your financial statements into a more meaningful document that shows the true profitability of your business, not just your bank account.

Speaker B: Okay, so when was. Let's start from the history. When was this GAAP accounting started and what problem were they trying to solve at that time?

Speaker A: Yeah, yeah. It was created to ensure consistency across companies. Integrity, comparability. Without it, uh, one company could call $100,000 loan or a deposit as revenue and another company could call it debt. Uh, there's just no comparability. It would be impossible for lenders or buyers or users of the financials to know what's real or true. So it solves the problem of unreliable or inconsistent or creative accounting in order to build trust with the stakeholders.

Speaker B: So before I get more detail into the concept of GAAP and how do you prepare financials? You have been in this for so long and you have seen a lot of businesses being sold, bought, I'm sure. So when a buyer look at a business and they see that they have financials that are prepared based on gap accounting versus a business that the financials are just, just there, what is the difference they see? How does it really affect their um, you know, how they look at this business?

Speaker A: Yeah. Uh, GAAP compliant financials will tell investors or lenders or buyers that you're running a professional mature operation that isn't hiding anything. It says your business is ready for the next level, whether that's taking on debt or being acquired. It just shows a level of professionalism and integrity within your financial statements.

Speaker B: So yeah, you know, a lot of times I tell um, the sellers that, yeah, I know your business is a lot of different things for you but, but for the buyers it's a money making machine. And of course the windows to that money making machine is the financial. So if you don't put a good financials in front of them, whatever is behind the scene, it doesn't even matter.

Speaker A: They can't see it.

Speaker B: You said that gap accounting is really, really a game changer. So um, let's dig a little deeper into the difference between uh, typical financials and gap based financials. What are the main differences we can see between them?

Speaker A: The main differences would be, I would say the biggest one is cash to accrual. It's a cash basis is just going to show, uh, when money changes hands versus GAAP or accrual basis is going to show and reflect when the economic activity actually happened. So when you earned the revenue and when you incurred the spent expense, not when you received the cash or paid the cash.

Speaker B: So for a lot of businesses, uh, after they do the job, they send an invoice, let's say it happens in December and I get my money in January of next year. So in GAAP accounting, which is accrual, based on what I understand, that income is recorded in this year, but in cash it's really recorded in next year. That is this correct?

Speaker A: It is correct. It's more complicated than that. But to simplify it, yes, for revenue recognition we have what's called performance obligations, which is essentially what you need to do to earn that revenue and you get to recognize the revenue when or as at a point in time or over time, the performance obligations are completed and you have done what you need to do to earn that revenue.

Speaker B: M. The same thing is for the costs, I assume. Correct. If I buy a bunch of material now and I pay for them, but I use them in the future, the same thing applies, correct?

Speaker A: Correct. Um, and there's different things that you would pay for. And so it might be a large asset. And I've seen some businesses where they're going to expense a large asset purchase when it should be capitalized, put on their balance sheet, and depreciated over time. Or, or you could be buying inventory and you want to make sure you're capitalizing and putting all the right costs into your inventory so that your gross margins are properly reflected. So with your cash disbursements, it's not necessarily just your operating expense that we're talking about. It could be a lot of other things as well.

Speaker B: Um, Diane, I know it's a little, uh, farther than the GAAP accounting, but can you talk a little bit about what is the difference between a, uh, normal financial versus a reviewed financial versus an audited financial? The same thing that you guys do. What is the difference between them? Which one is more reliable when you look at the financials? Yeah.

Speaker A: An audited financial is the highest level of assurance. Uh, in an, in an audit, we corroborate the numbers with not every, not 100% of the transactions, but on a sample basis. We corroborate with third parties. We'll do confirmations with banks and debt holders, and we'll look at invoices and a lot of third party documents. So an audit is, is the highest form, the highest level of assurance. A review is the next level down. And a review. We're looking at the numbers and we're looking at analytics and we're looking at how they relate to each other. Like, for example, revenue and your accounts receivable is integrally related and how things are moving in what direction and if they make sense. And we're talking to management and we're doing different analytical procedures, but we are not in a review. We are not corroborating to any third party documents. And then the lowest level is just a compilation where we take management's numbers and we put them in a financial statement form and we can ask questions and say, you know, were these done in accordance with gaap? And did you do this? Did you do that? But, but really it's just taking management's numbers and compiling them to be in A form, the proper form and presentation for GAAP financials. Um, but without any testing, no analytics, no corroboration whatsoever.

Speaker B: Okay, so for public companies, you guys do that audit, which is the highest

Speaker A: level for public companies, uh, on the annual filing on your 10k, they are audited financial statements. For a public company's quarterly filings, which is the 10Q, those are reviewed.

Speaker B: Okay, got it. Okay, so let's get back to our smaller size, not go to public, but for a company that doesn't have a GAAP accounting, let's say that I decide that. Okay, so I understand that if I have really good financials, um, my broker can make competition between the buyers and I can sell my business at a higher price. So it makes sense to go to somebody like Diane and ask to get help to turn my financials to GAAP accounting. What does that process look like? Is it a one time doing something or gradually we move to that. What is the process of moving from normal financials cash basis to that gaap, uh, based financial?

Speaker A: Yeah, GAAP can be pretty complicated in some areas, but in a very simplified description for the purpose of this podcast, I would say it's a transition from cash basis to accrual basis. Uh, it's going to require setting up all the proper accounts, accounts payable, receivable, some inventory management, revenue recognition schedules. You might need a deferred revenue account in your liabilities. Um, it can be complicated, but you can take it step at one step at a time and then it is manageable.

Speaker B: Okay, so we need to, if they want to do it correctly, they have to set up some systems and then go there. Um, a question that comes to my mind. Um, do they have to like for example, a manufacturing business that they manufacture in different products, Does Gap need them to, um, assign the related cost of each product to that product, that level of detail or it's not needed.

Speaker A: So you would have your inventory and it's usually FIFO cost basis with first in, first out. Uh, and then there's indirect costs that go into your labor that you would apply, that would go into your cost of goods sold to come down to your gross profit line item. Um, and so that does require some tracking of allocation of overhead. Um, is that the question you were asking?

Speaker B: Is the indirect question? Yeah. Let's say that I produce like 40% of my products are product A and 60% is product B. Do I have to assign the material that I buy for products A to a category that shows it's related to this?

Speaker A: Yes. So, so if let's say, uh, let's say product A has more labor involved, then it's going to get more labor costs. You should be allocating the right amount of labor to the right product.

Speaker B: So the result will be, I will find out which one of these products have the better margin. Because you know, sometimes the problem that I have is that the buyers come in and they want to see, see that different products or services that business have, which one is, has a better margin. And uh, accounting just everything is together. So I was asking if they apply this gap accounting, will I get that answer or not?

Speaker A: Yeah, it's important because, you know, I've seen companies where they. Once you get better financial information, it's not just about financial reporting, it's about managing your business better. When you realize that product A is more profitable than product B, you might refocus your selling efforts and not spend so much time on product B. You will actually have a more valuable business because you have better financial information. So it isn't just about the reporting, it's about making your business more valuable either for yourself or to recognize that in a, in a uh, transaction that you would help them with.

Speaker B: Exactly. You know, believe it or not, sometimes I ask the seller to give me a year to day financial because the buyer is asking and they don't have it after several months. So they always ask how are they even managing this business if they don't have the year to day financials for like four months before now? You know, it's especially very interesting when you deal with larger, uh, buyers, you know, because they are accustomed to having those financials. Right, interesting.

Speaker A: And you know, I understand it can be intimidating for a smaller company who perhaps can't afford a full time CFO and a big accounting department. But there's ways to get around that. There are companies that do outsourced bookkeeping where you just pay for what you need on a fractional basis. There are fractional CFOs where you just pay for what you need. So I understand the dilemma that smaller businesses face, but it really is an investment in their business. Don't think of it like an expense. Think of it like an investment in your business. And because ultimately you will get more, it takes risk away for the buyers. It gives the buyers more money, um, the seller, it gives the seller, seller more money, a higher multiple, um, because it's taking away some of the risk. It gives the buyers more information is what I was.

Speaker B: Yes, exactly, Diane. Really, thank you so much for joining us and sharing all of this knowledge. With us, um, briefly, tell us about your company's services and what kind of help you provide in case somebody wants to reach out to you. What is the best way to reach out to you? That would be great to share.

Speaker A: Uh, sure. Well, um, as you said, I'm an auto partner with the firm of Haskell White. We're a full service accounting firm. We've got over 100 employees. We serve middle market, public and private businesses. Uh, you can go to our website, www.hwcpa.com. you can see all about all our different services there, um, as well as my bio. And I'm fairly certain there will be a link to send me an email if you'd like. But to make it easier, it's dwhittenbergwcpa.com. so D W I T T E n B e r g@hwcpa.com.

Speaker B: awesome. And we will add the information under the video in case somebody wants to reach out to you. Thank you so much again and I wish you the best.

Speaker A: Yeah. Thank you, sir.