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Friday, October 25, 2013

A Simpler Option for Financial Reporting


For decades, private business owners and the users of their financial statements have been voicing dissatisfaction with the increasing complexity of generally accepted accounting principles (GAAP).

In the past 15 years, we’ve all had to contend with the following changes:

  • Recognition of stock-based compensation, generally requiring the use of the Black-Scholes method and significant estimates to determine the value of private company stock.
  • Consideration of impairment of goodwill and other long-lived assets.
  • Hedge accounting for derivatives, including interest rate swaps.
  • Elimination of the “pooling of interests” method of accounting for business combinations.
  • Variable interest entities.

In recent years, the Private Company Practice Section (PCPS) of the American Institute of Certified Public Accountants has increased pressure on the Financial Accounting Standards Board (FASB) to establish a new standard-setting body for private companies that would simplify reporting. The FASB responded by establishing the Private Company Council, which many in the industry found unsatisfactory.

PCPS, fortunately, has developed an alternative, the Financial Reporting Framework for Small and Medium-Sized Enterprises (FRF for SMEs or the “Framework”). The Framework is similar to the International Financial Reporting Standards for SMEs, which I wrote about in Armanino’s The Bottom Line, Tax Planning Edition 2009. There are now even more reasons to consider an alternative to the FASB’s GAAP, with a home-grown option available and the lease accounting exposure draft (see Michael Bossi’s “Lease Accounting” article in The Bottom Line, Tax Planning Edition 2010) still looming.

Like the International Framework, FRF for SMEs provides a number of common-sense simplifications from current GAAP:

Consolidation: Companies can choose whether to consolidate subsidiaries or account for them using the equity method. Variable interest entities do not exist in the Framework.

Income Taxes: Companies can choose whether to account for income taxes using actual payables, or the deferred tax method. There is no evaluation or recognition of uncertain tax positions.

Lease Accounting: Operating leases will remain even if the FASB adopts the proposed new lease accounting standard. Given the very extreme impact that this proposed standard, if implemented, would have on many companies, this alone is a compelling reason to consider a change.

Intangible Assets: Companies must establish a finite useful life and then amortize. There is no need to consider impairment unless assets are no longer used. Goodwill is amortized over 15 years, as is required for income tax purposes.

Financial Assets and Liabilities: Companies use a historical cost approach unless investments are held for sale. Derivatives require only disclosure, with recognition at settlement. No hedge accounting. There is no disclosure required related to the fair value hierarchy.

Stock-based compensation: Disclosure only.

No comprehensive income.

In addition, one of the key tenets of this new Framework is a focus on simplicity and stability. The Framework should provide bankers and other financing sources with traditional accrual financial statements without complex changes for leases, intangible assets and other non-cash activities. The Framework emphasized historical cost of the fair value methodology favored by the FASB in recent years. While updates will appear, they are expected to be infrequent.

The new framework is not for everyone. First, companies considering adoption may need to educate their bankers, and possibly modify loan covenants, in order to report in this manner. Secondly, a company using FRF for SMEs must fit the profile described.

Some key criteria include:

  • There are no regulatory reporting requirements requiring use of GAAP statements (Single Audit, NFP, franchise?)
  • The company operates in an industry that is not subject to highly-specialized accounting guidance, nor does it engage in complex transactions.
  • Key users of the financial statements have direct access to management.
  • The focus of interest is on cash flows, liquidity, the strength of the balance sheet and interest coverage.
  • The entity has no intention of going public.

Generally, we expect that this will be a good alternative for manufacturers and distributors, real estate entities, service providers and companies in the hospitality sector. However, it will require discussions with the users of the financial statements, particularly bankers. Loan covenants and acquisition agreements generally require the use of GAAP, so covenants may need to be modified or agreements worded to allow the use of the Framework. The gains in simplicity and understandability are likely to be worth the effort.

For decades, private business owners and the users of their financial statements have been voicing dissatisfaction with the increasing complexity of generally accepted accounting principles (GAAP).

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