This site explains why the key assumption behind Generally Accepted Accounting Principles (GAAP) is inappropriate for cooperative businesses. The assumption that the business is a going concern implies it will continue operating in the future. It is inappropriate for cooperative not because they are expected to fail, but because they provide the wrong values for routine transactions the cooperative engages in. These transactions involving payouts to members are not required in non-cooperative businesses. The proper accounting is a modified cash basis accounting that includes tangible assets on the balance sheet for payouts to current members, and a deferred payment based on GAAP accounting when members depart.
Ownership in Cooperative and Non-cooperative Businesses
The primary financial distinction between cooperative businesses and non-cooperative businesses is in the ownership transactions. Member ownership in a cooperative grants the right to profits while a member. These profits are either distributed to the members immediately, or held by the cooperative on behalf of the members for distribution at a later date. Cooperative ownership often also includes owning a portion of the next asset value. There are two types of net asset value transactions that take place in a cooperative. The first is an investment a member makes in the cooperative, which increases the net asset value. This occurs when a member joins the cooperative and pays the buy-in. This also takes place through the reinvestment of member patronage (profits) back into the cooperative. The second transaction is the payout of the net asset value of the cooperative. This payout occurs through the distribution of patronage to the members, or the repurchase of their equity stake when they leave. Both transactions for the investment and repurchase of the investment by the cooperative occur between the cooperative and its members. There is no secondary market for member shares, as they cannot be traded between third parties
The internal capital account is an accounting entry that tracks the portion of the net asset value each member of the cooperative owns. A member has their internal capital account credited when they make an investment. A member has their internal capital account debited when the cooperatives pays out retained earnings or repurchases their shares when they leave
A non-cooperative business typically issues equity which carries future profit rights, the right to control the business, and a claim on the net asset value. There are also two types of equity transactions
between a non-cooperative business and its investors: 1) sales of equity to investors and 2) share buy backs. The business may also declare a dividend to be paid to share holders which reduces the net asset value by the amount of the dividend. Shares may also trade in a secondary market between private parties that are distinct from the company. In the case of share issuance the net asset value of the business increases by the amount of the share sale. In the case of share buybacks the net asset value is reduced by the amount of the buyback. Share repurchases in a non-cooperative business are optional and done only at the management’s discretion.
In contrast, a cooperative business is generally required to make payouts to its members either when earnings are present (patronage), or when a member departs the cooperative. These
payouts are generally stipulated in the bylaws. Unlike a non-cooperative business, the repurchase of member investments upon departure are not optional in a cooperative. Further, these transactions occur regularly during the normal course of cooperative business. These cash disbursements require the cooperative to have realized earnings.
There is another financial difference between cooperative businesses and non-cooperative businesses that arises in startups. Virtually all modern startups lose money initially, regardless of their structure. In a cooperative startup these losses translate into expected investment losses for the members as the business losses in the startup period are passed to the member owners. As joint owners, cooperative members appropriate all profits and losses in proportion to their economic participation in the business.
This is a key distinction from a non-cooperative business which will also lose money, but whose losses will not necessarily translate into investment losses for the shareholders. Thus there is no expectation of investment loss in a non-cooperative startup, despite the certainty that the business will lose money initially. The value of a non-cooperative business is an estimation of the future discounted earnings. So long as the future earning are perceived to be higher at a later date, the share price will rise. This can and does occur despite actual losses in non-cooperative startups.
The expectation of an investment loss in a cooperative startup, even if temporary, is a radical departure from all other investments which are only expected to increase in value when they are made. In modern finance the whole concept of an expected investment loss is notably absent. This conceptual blind spot exists within the cooperative community as well where various techniques are used to hide
the issue.
Members of a cooperative business can receive patronage when there are payouts from the cooperative. This requires the cooperative to have both realized earnings (payments have to be received) and
liquidity (available cash). Non-cooperative business owners can profit by selling their shares to a third party, and this profit can be achieved without the business dispersing funds. Payments from a non-cooperative business are not required for the owners to make money, nor are earnings.
Going Concern Assumption
The accounting assumption that a business is a going concern means it is expected to continue operating into the foreseeable future. For auditing purposes the going concern assumption takes the foreseeable future to be one year. The going concern assumption is one of the key assumptions upon which Generally Accepted Accounting Principles (GAAP) is based. The going concern assumption has the practical effect of delaying the recognition of certain expenditures and smoothing earnings overtime. While this may make sense for a non-cooperative business where the owners have a claim on all future profits, it makes little sense in a cooperative where the owners only have profit rights during the finite time while they are members
The going concern assumption leads to two GAAP features that are poorly suited to cooperatives. The first is the definition of what is considered as asset. The second is the timing of when accounting entries are recorded.
An asset for accounting purposes is defined as a resource that meets the following three criteria:
1) Something that is controlled by the entity
2) Something that results from a past event
3) Something that is expected to give rise to future economic benefits
This definition of assets allows for intangible assets to appear on the balance sheet. Intangible assets are defined as “an identifiable non-monetary asset without physical substance.” Some examples
are: “computer software, patents, copyrights, advertising, brands, trademarks, and development expenditure on new products” (Lubbe, 2006). Another type of intangible asset is goodwill. Goodwill
is an intangible asset that is purchased and cannot be internally generated. The value of intangible assets is usually amortized over time, with certain types of intangible assets subject to impairment or
periodic revaluation instead
There are two principles that govern the timing of accounting entries. In accrual accounting the matching principle says expenses are matched to the period in which the purchases are utilized, consumed, or sold. This is not necessarily the period when they were paid for. This leads to some expenses being capitalized on the balance sheet as assets. This effectively delays the recognition of many expenses. Capitalized expenses function as a type of intangible asset. The revenue principle says revenue is matched to the time of product delivery when a sale is functionally completed, not necessarily when the payment is received
Accrual accounting differs from cash based accounting where expenses and revenue are recorded when paid or received, respectively. Cash based accounting is discouraged and only permitted for small businesses. Some of the limits for cash based accounting include: C corporations or partnerships with annual revenue < $5M, S corporations or sole proprietorships with annual revenue < $1M, and family farms with annual revenue < $25M. Cash based accounting is useful for businesses with no inventory such as those in the service sector.
Cooperative Problems Created by GAAP
There are four different types of cooperatives: worker cooperatives (owned by the workers of the firm), consumer cooperatives (owned by the purchasers of goods or services), producer cooperatives (owned by produces to process or market their goods), and purchasing cooperatives (owned by the buyers to aggregate purchasing power). Hybrids of multiple types of cooperatives also exist
Worker cooperatives differ from other types of cooperatives in the following ways:
- The members are individuals (people) unlike some producer or purchasing cooperatives where the
members may be businesses - There are relatively few members in a worker cooperative, unlike consumer cooperatives
- The member buy-in (investment) is often significant on a personal finance scale, unlike consumer
cooperatives - The member shares are not insured (risk free), unlike credit unions
- The members are directly providing labor to the cooperative often as their primary source of income
These features of worker cooperatives exacerbate the accounting problems faced by all types cooperatives. Worker cooperatives will be used here for illustrative purposes, though the results apply
to cooperatives generally.
One of the failures of accrual accounting under GAAP is illustrated with the following example. Assume a new worker cooperative with five founding members is started. They each contribute $20k to the venture for a total of $100k of financing. As part of the business they sign a lease and spend $75k to build out the space. Then one of the members leaves.
Financially the cost of the building renovation is capitalized on the balance sheet and amortized over an extended period of time. Since cash was swapped for an asset (a largely intangible asset in this case)
there is no immediate loss associated with the expense. Since there is no financial loss according to GAAP, the departing member’s investment is redeemed in full for $20k.
Economically the transaction has an impact that is missed by the financial description. Should another member wish to leave the cooperative they will be unable to redeem their investment in full. Since there was $100k total to start with, $75k was used to build out the space, and $20k to pay the member that left, only $5k in cash is left along with a $75k intangible asset. Any subsequent member
who departs the cooperative would have to wait until sufficient earnings were generated by the cooperative to repurchase their investment. Since the business is a startup in this example, the future
revenues are uncertain. Unlike the first member who left the cooperative, the remaining members are essentially stuck with their investment until future earnings are (hopefully) generated. The duration of an investment and the timing of payments matter, and in this case the remaining members had their investments functionally devalued when the first member left. Due to the capitalized expense, these actual economic effects are not captured with the current accounting system (GAAP). They permit the effective transfer of losses from the member who departed the cooperative to the remaining members.
Economically the investment losses were created when the money was initially spent as this action necessitated the generation of future earning and thus a delay in the possible repayment of investments. The capitalization of this expense under GAAP is the point at which the accounting description diverged from the underlying economic reality, not when the member departed
The build-out expense can be swapped with any other capitalized expense which is amortized to get the same effect. Other examples include a prepaid lease, certain advertising expenses, consulting
for strategic planning, or financing costs on fixed assets
The purchase of tangible assets will also require future earnings for member investments to be repurchased so long as those assets are held. However, it is often simple to sell tangible assets for cash. Their purchase results in a liquidity reduction, not necessarily a loss. On the contrary, many intangibles assets cannot be easily sold. Some categories of intangible assets like capitalized expenses have essentially no resale value
These accounting problems are exclusive to cooperatives which have an obligation to payout profits and repurchase shares of departing members. An accounting system should better reflect these underlying economic transaction
Asset Based Accounting
A cooperative accounting system needs to be fair to all members of a cooperative, given the regular turnover of membership and associated financial transactions. Accurate descriptions of investments from members, patronage distributions to memberships, and redemptions when members depart are required. The accounting system also needs to capture the unique cooperative startup dynamics. In the startup period, any expenses immediately increase the future earnings that are needed to pay back investments. While certain principles of GAAP are inappropriate for cooperative, some of
the mechanics such as the depreciation of real assets is still applicable. An accounting system appropriate for cooperative is described below. The system is called asset-based accounting and is very similar to modified cash basis accounting where assets are included on the balance sheet. Standard accrual accounting (GAAP) is also utilized in certain instances.
Asset-based accounting would only include real (tangible) assets on the balance sheet. This is well suited to cooperative startups that can only distribute future realized earnings. All expenses are written off immediately and fully when they are paid. There would also be no capitalized costs associated with the acquisition of tangible assets. These would include financing costs for acquiring machinery and various construction or maintenance costs. Intangible assets and goodwill will be excluded from the balance sheet. The economic rational is that the expenses and intangibles asset purchases represent the monetary gap that that must be filled by future earnings if investments are to be repaid
Note that the definition of an asset here is simpler and easier to apply than under GAAP. In asset based accounting, assets are all tangible and stripped of costs associated with their acquisition or maintenance. Assets are depreciated through the standard method.
All payments for assets would be recorded immediately. Assets would be added to the balance sheet when they are paid for and received. This conservative approach will delay the recorded acquisition of assets in some cases. Assets will come off the books immediately when transferred. Revenue is recognized when the payments have been realized and the product or service is delivered.
This is a conservative approach that will delay the recognition of revenue is some cases. Transactions of benefit to the cooperative such as the addition of assets to the balance sheet or the recognition of revenue will be delayed until the full transaction is complete
In a cooperative startup, losses under asset-based accounting will be more severe than under GAAP where additional expenses and costs are capitalized. Excluding capitalized expenses and other intangibles from the balance sheet gives an economically relevant description of the magnitude of the loss. Losses can only be offset by realized earnings. It is important to note that returns exceeding the startup losses by some factor are required for investing in a cooperative startup to make financial sense. This is because the founders investments are guaranteed to lose value during the startup period. The returns must be tied at least partly to the loss incurred, and not exclusively to membership, in case the founding member departs prior to the cooperative being profitable. While this is an economic and financial necessity for sustainable startup creation, tying returns to an investment loss as opposed to say, labor contribution in a worker cooperative, explicitly violates the cooperative principles
These asset-based accounting rules are the basis for create financial statements for the cooperative. It is a conservative accounting methodology reflecting the fact that cooperatives are required to make cash disbursements based on stated earnings. A conservative approach is important because once paid out, distributions are in practice impractical to claw back. Payments under asset-
based accounting are based only on realized earnings, not assumptions about the future
The remaining tasks are to define are how to distribute profits for patronage and repurchase members investments when they depart the cooperative
Patronage Rules:
- Patronage will be paid only after all startup losses are compensated (under asset-based accounting).
- Patronage will be paid after payments to past members.
- When earnings under both asset-based accounting and GAAP are positive, patronage is capped at the lesser of the two earnings calculations
Patronage is paid after the startup losses are compensated because the initial investments actually lost money. The first priority is to offset the losses by a factor greater than one. The offset must be greater than on for an investment that is expected to decline in value to make financial sense. This must precede patronage distributions to members who join the cooperative after it becomes profitable, and who therefore did not suffered any investment losses. Also, payments to past members takes precedence over the remaining members. Past members are an outside party whose claims carry greater seniority. A conservative limit of the lesser of two earnings calculations is used. Since only realized earnings are recognized under asset-based accounting, that sets a functional limit on what can
be paid out.
GAAP accounting is used as a joint cap on patronage. In certain respects GAAP better reflects the current consumption of resources, some of which are not billed to later. GAAP could also show reduced earnings from the impairment or amortization of intangible assets and capitalized expenses. This is not captured under asset-based accounting. Using GAAP earnings as a cap also correctly accounts for sales of intangible assets which would show up as earnings under asset based accounting. The absence of a GAAP earnings constraint would unfairly favor a member who joined after an intangible asset was purchased, but before it was sold. Under under asset-based accounting the purchase of an intangible would be expensed (since it doesn’t show up on the balance sheet), but would result in earnings from its sale (since no asset would be coming off the books), resulting in unearned patronage for the member
Upon member departure, their internal capital account is paid out in parts. There is an initial payment followed by one or more deferred payments.
Initial Payment = Cash * (Internal Capital Account Balance) / (Total Assets
The initial payment is the amount a member is payed immediately upon departure. Cash is amount of cash (or cash equivalents) the cooperative is holding. The internal capital account balance is the amount owed to the member under asset-based accounting. Total assets are the total assets of the cooperative under asset based accounting. This permits the departing member to take only their
respective portion of the available liquidity when they leave, allowing other members to subsequently depart under identical conditions. The full value of the internal capital account cannot paid immediately unless the cooperative has no assets aside from cash or similar liquid assets
The remaining balance of the internal capital account will be paid down proportionally as the GAAP assets held when the member departed decline in value. This can occur through depreciation,
amortization, impairment, or sale. If perpetual assets exist such as land or securities, that respective portion of the internal capital account will be retained by the cooperative until written off or sold. To prevent a liquidity drain the deferred payments may not exceed the earnings of the cooperative. Payments to departed members have priority over future patronage distributions. Matching the timing of the internal capital account payouts to the use or sale of assets owned by the cooperative provides a definitive timetable for payments that are a direct result of financial decisions made by the members. It also ties responsibility for decisions that affect the cooperative after the member departs to the timing of their investment payout. For example, the purchase of overpriced asset or asset of minimal utility would would delay the return of their investment after they left
Deferred payments are made on the remaining balance of the internal capital account. The payments are deferred to prevent a quick reduction of liquidity that would adversely impact the remaining members. These deferred payments are capped by the lesser of the asset-based earnings or GAAP earnings when both earnings are positive, and are zero otherwise. The deferred payments are also capped by the max deferred payments which limits the amount of total deferred payments as a function of time.
if (asset based earnings and GAAP earnings) > 0, then Deferred Payment = smaller of (asset based earnings or GAAP earnings
if (asset based earnings or GAAP earnings) ≤ 0, then Deferred Payment = 0
Max Deferred Payments[time] = Capital Account * [1 – (departure assets[time]) / (departure assets)]
The max deferred payment limits the aggregate repayments to a member that has left the cooperative. It is applied in conjunction the earnings constraint on any deferred payment. The capital account is the member’s internal capital account minus the initial payment. Departure assets are the value of assets on the balance sheet under GAAP when the member departed. Departure assets[time] are the value of those same assets at the present time. This requires the additional task of tracking the future value of assets held by the cooperative when a member departs. The asset based earnings constraint on the deferred payment ensures a liquidity reduction does not occur. The max deferred payments constraint ties speed of payments to the utilization of assets owned by the cooperative when the member left. Economically this ensures that those assets contribute to realized earnings in the cooperative after the member departs. It functions as a check on a member’s decisions, which will continue to impact the cooperative after the member has departed. This roughly ties their financial returns to those decision for a defined period of time. The elimination of those assets from the balance sheet provides a natural time frame over which this should occur.
A cooperative could choose to make deferred payments to a past member annually until their full capital account was paid. Alternatively they could wait until all assets held when the member departed has dropped off the books and pay a lump sum then.
This system can be visualized through the example of the five worker cooperative members who paid to build out their leased space. Five initial members contribute $20k each and then spend $75k to build out a leased space. The member who departed would use asset-based accounting to calculate their initial payout. This would result a $75k loss of which their portion would be $15k ($75k / 5 members). So their internal capital account would have $5k of their original $20k investment. The immediate payment would be $5k (cooperative cash) * $5k (internal capital account) / $25k = $1k. A deferred payment of the remaining $4k from their internal capital account would be triggered on the expiration of the lease when the ‘asset’ consisting of the building modifications was fully amortized. Note that this system maintains fairness by allowing the remaining members of the cooperative to depart under identical circumstances
The departed member would also receive an additional compensation (>$15k) to offset the $15k loss. A formula for the amount of that compensation would be determined by the cooperative. That compensation would be paid concurrently with the others who incurred a loss. That compensation would also be capped each period by the lesser of the asset based earnings or GAAP earnings.
Benefits
The following is a summary of the benefits of this alternative asset-based accounting and payment methodology for cooperatives compared to the current situation under GAAP.
- Accurately captures the magnitude of the losses in a cooperative startup by excluding capitalized expenses and intangibles from the balance sheet
- Permits appropriate loss compensation
- Determines necessary investment amount
- Immediately recognizes losses resulting from those expenditures
- Determines necessary investment timing
- Is fair to members who depart at different times by preventing the transfer of losses between members
- Calculates realized earning which are the only type the cooperative can disburse through patronage or use to repurchase shares from members
- Provides a conservative calculation for payouts to past and present members preventing over payment
- Eliminates any benefit from departing the cooperative in anticipation of losses
- Ties past decisions to future investment returns for members that leave
Due to the unique nature of cooperative startups investment losses are expected and unavoidable for the founding members. Knowing the correct magnitude of that loss is essential if it is to be properly compensated for. Unlike other businesses, a cooperative needs to offset that loss with realized earnings if the founding members are to break even much less profit from their startup investment. Addressing these expected losses in a modern financial framework that ignores the existence of that circumstance is the key to achieve growth in the number and scale of cooperative startups, and worker cooperative startups in particular. By under-reporting these losses, GAAP accounting is actually hindering cooperative formation. The asset-based accounting system described here can alleviate that problem by better reflecting the underlying economic reality, ultimately boosting the growth of the cooperative movement
Bibliography
Lubbe, I and Watson, A, 2006, Accounting: GAAP Principles, Oxford University Press, Oxford.
Keiso, D, Weygandt, J, & Warfield, T, 2008, Intermediate Accounting, John Wiley & Sons, Hoboken.
Libby, R, Libby, p, & Short, D, 2007, Financial Accounting, McGraw Hill, New York.
Harrison, W, Horengren, C, 2008, Financial Accounting, Pearson Prentice Hall, Upper Saddle River.