The new updates that the Financial Accounting Standards Board has just released for goodwill and interest rate swaps make good on its promise to follow up on the suggestions of the Private Company Council that FASB’s parent organization, the Financial Accounting Foundation, established less than two years ago.
FASB endorsed the PCC’s recommendations last November to adjust the standards to give private companies an alternative for accounting for goodwill subsequent to a business combination and for certain types of interest rate swaps, and then issued the actual Accounting Standards Updates last week (see FASB Adjusts Standards on Goodwill and Interest Rate Swaps for Private Companies).
Brian Marshall, a partner in the National Accounting Standards Group at McGladrey, sees a number of potential benefits for private companies that elect the new accounting alternative for goodwill. Private companies can now choose to amortize goodwill on a straight-line basis over 10 years. They can also choose to test goodwill for impairment at either the entity level or the reporting unit level instead of being forced to test goodwill at the reporting unit level. Plus, they can test goodwill for impairment only when there is a triggering event instead of having to test it every year.
In addition, they can test and measure goodwill for impairment by comparing the fair value of the entity or reporting unit to its carrying amount instead of needing to perform a two-step goodwill impairment test that requires them to worry about hypothetical business combination accounting for the purpose of measuring an impairment loss. “You no longer have to do an annual impairment test,” Marshall pointed out.
There are also expected to be less triggering events because the carrying value is being reduced throughout due to amortization. “Today’s tests can be complex in that it’s a two-step test,” said Marshall. “You first compare the fair value of a reporting unit to its carrying value, and then if the fair value is less than carrying value, you have to move on to the second step.”
With the hypothetical business combination accounting required in Step 2, businesses have to determine the fair value of all assets and liabilities, which often involves bringing in a valuation specialist, making the whole process time consuming and expensive. “If you don’t have to do hypothetical business combination accounting, there can be some advantages for companies,” Marshall pointed out. “There would be a reduction of some costs because it’s simplified.”
Faye Miller, also a partner in McGladrey’s National Professional Standards Group, believes the FASB update for interest rate swaps will prove equally useful to private company accountants. Under the old standards, derivatives such as interest rate swaps needed to be recognized on the balance sheet at fair value, with the changes in fair value recognized through the income statement, unless the entity elects and qualifies for hedge accounting. However, lenders often require an entity that wants to borrow at a fixed rate to enter into a variable-rate borrowing with a separate interest rate swap agreement to obtain the desired fixed rate.
“I think that many would agree that the accounting rules surrounding derivatives are some of the most complex accounting rules there are,” said Miller.
While hedge accounting is generally better at avoiding income statement volatility and reflecting a fixed rate of interest in the financial statements, the old accounting standards for achieving hedge accounting could be pretty complicated. The updated standards will provide certain private companies with an option to apply a simplified hedge accounting approach to convert their variable-rate borrowing to fixed-rate borrowing. They will now have the ability to make the election on a swap-by-swap basis and assume there’s no ineffectiveness with the hedge relationship. Private companies will also be able to elect to measure the swap at settlement value instead of fair value.
Miller pointed out that many small companies are forced to agree to variable-rate loans because banks don’t want to have long-term fixed rate interest exposure on their books. Private companies may have wanted a fixed-rate loan, but instead end up with a variable-rate loan and a swap. But they would still have to put it on their balance sheet at fair value and if they can’t apply hedge accounting, they can get a lot of volatility.
“The fair value of the interest rate swap can go up and down,” she said. “Generally, everybody would like to achieve hedge accounting so the income statement impact is equivalent to a fixed rate of interest. The problem with getting hedge accounting is there are stringent upfront requirements that you would have to qualify for and then there is a continuous need to assess the effectiveness of the hedge every quarter, which can require some sophisticated computations. This new standard not only permits the assumption of effectiveness but also gives private companies additional time to make an election to apply hedge accounting.”
It’s also not uncommon for a private company that has limited resources to be unaware of the upfront documentation requirements, Miller noted. “They often don’t know they have to do this upfront election unless someone comes in at the end of the year and advises them, and it’s difficult to do it,” she said. “It’s a big improvement to have this.”
Entities will now have until the date on which the annual financial statements are available to be issued to complete the required documentation to elect the simplified approach.