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Reporting standards evolving to help private companies: Can little GAAP best big GAAP?January 17, 2014
During 2013, the scene was set for significant changes in financial reporting for private companies and evolved into a battle between standard-setting bodies. All the changes centered on the desire to simplify, and therefore reduce the cost of accounting for private companies. The question is, however, is simpler good enough, and which standards should private companies adopt?
Smaller, private companies have long complained about having to adhere to the same rigorous accounting standards as the giant multinational public companies. The standards outlined in generally accepted accounting principles (U.S. GAAP) are complicated, expensive and not relevant to the everyday needs of private company financial statement users. In response, different standard setting bodies have their own ideas about how to address the issue, leaving private companies and their users in some confusion about which standards to live by.
These alternatives are important because reported financial position and operating results are potentially greatly affected as well as the cost of complying with financial reporting requirements.
Breaking down the issues
On one side, we have the American Institute of Certified Public Accountants (AICPA), an organization that primarily deals with audit standards-setting, but stepped out of its normal work to encourage private company relief in accounting standards. This last June the AICPA struck first by releasing its Financial Reporting Framework for Small and Medium-Sized Entities (“framework for SME’s”). Any effort to exempt private or smaller companies from some of the most rigorous U.S. GAAP standards is called Little GAAP.
The framework for SME’s condenses the existing GAAP literature into a 188-page framework, which by its nature leaves significant room for reporting company and auditor judgment in how to apply the framework. The easiest way to think of the difference is that U.S. GAAP makes heavy use of bright-line standards for making reporting decisions, and less judgment.
The AICPA framework is considered an “other comprehensive basis of accounting,” or OCBOA. OCBOA includes tax basis and other non-GAAP types of financial statements. As an auditor, I can still sign an audit opinion on OCBOA or little GAAP financial statements, but the financial statements are not prepared in accordance with accounting standards generally accepted in the United States, and therein lies the rub.
The Financial Accounting Standards Board (FASB) is the primary creator of big, or U.S. GAAP financial reporting standards. The AICPA’s release of the framework for SME’s seemed to inspire the Financial Accounting Foundation’s (the mother ship of the FASB), Private Company Council (“PCC”) to speed up its own mission to make life easier for private companies.
At the beginning of July 2013, the FASB exposed for public comment the first series of proposed accounting standards updates as a result of the PCC’s work. Instead of trying to revise an entire financial reporting model like the AICPA, the PCC’s approach is to hit certain areas of financial reporting in order to simplify the accounting. Here is the PCC’s progress to date:
Interest rate swaps
These financial instruments have become more and more common in business as a means to attempt to change a variable interest rate on debt into a fixed rate and thereby reduce the risk exposure from fluctuating interest rates. The problem is that an interest rate swap meets the definition of a derivative, and has to be recorded at “fair value”, which requires complex calculations that involve predicting future events.
It is not uncommon that a company enters into a swap and does not understand the accounting complexity. Additionally, some companies are surprised to find that an interest rate swap hedge agreement was routinely written into its loan documents. The situation can result in a non-cash increase or decrease to earnings. For example, an 8 percent variable rate loan is hedged and fixed at 8 percent by swapping out another loan. Market interest rates decline 1 percent, so the fair value of the company’s obligation increases and it has to record a charge to earnings even though its interest payment has not changed.
Previously, accounting alternatives to fair value treatment did not exist. That has changed. The “simplified hedge accounting approach,” is finalized and approved by the FASB. The new rule allows the company to measure the designated swap at settlement value instead of current fair value. By doing this, the reported interest expense will reflect the actual interest paid, and the complexities of the fair value reporting have been removed.
This accounting alternative has also been finalized by the PCC and approved by the FASB. Since 2001, goodwill – an intangible asset value created typically from an acquisition – has not been subject to amortization, or writing down the book value of the asset over its assumed useful life, but instead has been required to be tested annually for impairment, then potentially written down depending upon the results of the prescribed impairment test.
This generally requires companies to hire an external valuation specialist, which can be costly. The FASB had already issued a standard that simplifies the annual impairment test by allowing companies to first look at qualitative factors in order to determine if the annual impairment test is required. The accounting alternative will allow private companies to begin amortizing goodwill again, generally over a period of 10 years, and it also provides further simplification for any ongoing impairment tests. So, for example, if $1 million of goodwill is recorded after an acquisition, a company will write down $100,000 per year, which will flow through to net income. It allows for more predictability and will likely require fewer valuations.
Both the simplified hedge accounting alternative for interest rate swaps and the goodwill accounting alternative are expected to be issued as formal Accounting Standards Updates by the FASB in January 2014 and will become effective for fiscal years beginning after Dec.15, 2014 with early adoption permitted.
Ok, so which wins, little or big GAAP?
The method of accounting that ultimately wins is what works on a practical level, and that has to start with the primary users of financial statements. Although his thoughts may not represent the banking industry as a whole, I believe this insightful comment by James Tanzillo, senior vice president, commercial banking group, Vectra Bank Colorado, will reflect the opinions of many bankers. I asked him if he thinks banks would accept audited financial statements that are not prepared in accordance with Big GAAP? Tanzillo replied:
“My initial thought would be no, without some regulatory guidance, meaning from the regulators of banks. I could potentially see a scenario where banks require both traditional GAAP and the new GAAP statements being required.
“The idea of Big GAAP versus Little GAAP makes sense and sounds appealing. I just wonder how that can be efficiently incorporated into an industry of standards, with decisions based on historical information. The ambiguity that these changes could introduce may be difficult to initially deal with, until the industry receives some regulatory guidance,” said Tanzillo.
The good news for companies is that we are seeing a directed effort to reduce the complexities of complying with financial reporting requirements, which should reduce costs. As we can see, rather than attempt to develop an overall separate set of accounting standards for private companies, the PCC has developed an agenda to address practical issues, so more standards so more standards are expected to be issued in the near future.
Because of the sentiments represented by the banker’s statement above, I believe the FASB’s PCC will prevail as the more favorable model for private company standards because they still will be considered to be prepared in accordance with U.S. GAAP, whereas the AICPA’s framework will not. In order to chart their futures, companies should follow more closely the policies of the PCC.
Greg Pfahl, CPA, is an audit partner in the Denver office of Hein & Associates LLP, a full-service public accounting and advisory firm with additional offices in Houston, Dallas and Orange County. Pfahl can be reached at email@example.com or 303.298.9600.