Financial Statement Due Diligence: GAAP Accounting Preferred

by Kemp H. Hanley

I like cash, after all, who doesn’t? But I’m talking about financial statement presentation today. The cash-basis, while it may be the simplest presentation method, is not necessarily best for financial analysis of a product sponsor.

As a due diligence firm, FactRight reviews a lot of financial statements. In a broad sense, financial reporting presentations consist of generally accepted accounting principles (GAAP), International Financial Reporting Standards (IFRS), and other comprehensive bases of accounting. Others include tax-basis, cash-basis, and the modified cash-basis, which we can refer to as; do-whatever-suits-our-purpose (DWSOP) financials. FactRight has seen them all.

The basic challenge for anyone assessing financial statements for various sponsors and investment programs is, of course, consistency. Not that it is all about making analysis easier, but it would be helpful if there was one consistently applied method of financial reporting presentation. Unfortunately, that will just never be the case.

Determining what you’re working with

Keep in mind, financial statements can be cash-basis or accrual-basis. To determine which you are looking at, you can often find a label on the statements themselves to tell you the basis. In the absence of a label, if you see accounts receivable or prepaid expenses and/or accounts payable or deferred revenue in the liabilities on the balance sheet, or bad debts on the profit and loss statement, these indicate the accrual-basis has been used.

Often, emerging investment managers entering the broker dealer/RIA distribution space will present us with cash-based financials. Typically, these investment managers are smaller, private firms who initially ran on the cash-basis because it is easier (read: cheaper) to manage internally and simpler to understand. For these managers, cash provides a tangible measure for realizing transactions. These financial statements also provide an easy connection for calculating the amount of income tax the business owner needs to pay.

Surprisingly, the cash‐basis of accounting can be easily engineered by accelerating or deferring the timing of the receipt or disbursement of cash, and statements are focused more on a company’s short-term than the long-term financial position. As such, they may not be a thorough or accurate measure of a company’s true economic condition.

Be wary of modified cash

Occasionally, FactRight reviews modified cash prepared financials. This is a joy. One example is the financial statements of a company that recorded revenues and liabilities on a cash-basis, did not amortize but did depreciate, and had assets that included unrealized performance-based promote fees, Kinda cash, kinda not.

There is no single accepted method of applying a modified cash‐basis of accounting due to the arbitrary nature of the modifications applied. The only way modified cash-basis financial statements can be meaningful is when they are compared with similar financial statements, which is nearly impossible, as many preparers have considered the modified cash‐basis of accounting as a free‐for‐all, neglect of any standardized rules. In other words, it is hard to find similarly prepared modified cash-basis financial statements.

GAAP brings consistency… and notes

Generally, emerging investment managers that start out using a cash or modified-cash method eventually move to accrual-basis accounting, or GAAP, when it comes time to prepare financials for users outside of the company, like banks, broker-dealers, and third-party due diligence firms, such as FactRight.

While it is not without its drawbacks, GAAP accounting is the favored method of accounting for most businesses because it offers a representation of a company's finances that may be most directly compared to the finances of its competitors and is considered a best practice. GAAP financial statements are generally comprehensive, informative, and familiar to external users. FactRight encourages emerging managers to transition to the use of GAAP or accrual-based financials as soon as they have achieved the scale of operations to do so.

In FactRight’s experience, companies that present us with cash or tax‐basis financial statements omit substantially all disclosures required under GAAP. If such disclosures were included in the financial statements, they might influence our conclusions about the entity’s financial position, results of operations, and cash flows. The omission may not necessarily result in misleading financial statements provided. However, for due diligence professionals, the notes provide useful information about a company’s accounting policies and detail on certain line items.

One must keep in mind, tax-based financials are prepared simply to minimize the tax burden on a company and show as little taxable income as possible within the constraints of the appropriate tax codes. Accordingly, tax-basis accounting is not intended to necessarily reflect the economic reality of a company. Remember in 2018 Amazon paid no federal taxes, yet it is hard to imagine that they were not profitable. Cash-basis financials on the other hand can serve a purpose because bills cannot be paid with accounting income and “cash is King” as they say. Cashflow must always be analyzed, even within the context of GAAP financial statements. The objective of GAAP-based accounting is to reflect the economic reality of a company in a format that is comparable to its competitors.

In the end, what are we trying to accomplish in our financial review? We are trying our best to determine if the sponsor has the financial wherewithal/capacity to continue to support the investment programs they are bringing to market. What is the sponsor’s financial strength and liquidity? Can the sponsor weather a downturn? Are there multiple sources of revenues and are they reoccurring or transactional? Under GAAP, we know the sponsor is using best practices and consistency in their financial presentation and that helps us have confidence in our financial analysis.


Contact Information:

Kemp H. Hanley

Chief Financial Officer

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