Don’t Get Lost in Translation

Generally, accounting firm national offices who are asked to deal with complex issues that require an in-depth technical GAAP analysis are only having to explain their results to other CPAs. Be it others in the firm or the CPAs of their clients. Business and industry CPAs, on the other hand, often have to explain these highly technical issues to non-CPAs. Non-CPAs then want to take those answers and do two potentially dangerous things. One, apply the same answer to all transactions that are the “same” and two, write down the rule in simple terms so they won’t forget it.

As CPAs we know that some parts of GAAP are very detailed and specific (can we say leasing), while others are more general. But no matter how GAAP is written, we all know that the specific facts and circumstances matter, and a slight change in facts can result in a big change in accounting. The problem is what may appear to be a similar transaction on the surface may not be the same when it comes to accounting. For a simple example let’s look at a purchase agreement where you are buying a piece of equipment for $400 and one year of maintenance for $100. You think both prices are high, but in particular you think the maintenance price is 30% above market while the equipment price is only 5% above market. You could work very hard to get the prices changed to $380 and $70 respectively, or you could just agree to get a $50 credit to be applied to the invoice. To the non-CPA these would seem to be similar transactions with the same economic results – I’m paying $450 for something that was originally quoted at $500.

The problem is the accounting for the two scenarios noted above is very different. Under the price reduction scenario, your capital expenditure is $380 and your expense is $70. Assuming a five year life on the equipment, your deprecation in the first year is $76, resulting in a total expense of $146 in year one. Under the general credit approach, GAAP would require that we allocate the credit based on what we did to earn it (in this case spend $500). That would result in $10 of the credit going to maintenance reducing it to $90, and $40 of credit going to the equipment reducing the price to $360. Assuming the same five year life, we end up with $72 of depreciation for a total expense of $162 in year one – 11% higher than in the first scenario. Similar transactions with the same economic effect, but two very different accounting answers.

The second problem comes when they want to make the rule into something simple for laymen to understand. In this case, they might say something like general credits get allocated over all of the purchases that generate the credit, but price reductions get recorded at the prices that are in the contract. As CPAs, we know that isn’t true either. Taken to an extreme, someone could lower the price of the maintenance to $0 but pay $450 for the equipment. Just as in life, accounting says you don’t get anything for free. In the case of a free good, GAAP would require that we allocate a portion of the cost of the equipment to the “free maintenance contract.” If the market prices were truly $380 and $70, as suggested in our example, then that is exactly how we would end up allocating the $450 paid for the equipment. But, to the non-CPA this would make no sense because “you told them” that the price in the contract can be used to specify how the reductions in overall cost get recorded.

As CPAs in business and industry it is our job to explain GAAP to the non-accountants; we just need to make sure we do it in a way that while easy to understand, doesn’t simplify it to such a degree that the company we work for ends up with the wrong answer.

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