Reporting Standards Evolving to Help Private Companies

IMGCAP(1)]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?

Smaller, private companies have long complained about having to adhere to Big GAAP, or U.S. Generally Accepted Accounting Principles. They are complicated, expensive and not necessary to the everyday needs of private companies. In response, different and sometimes competing 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. It’s important because financial operations and results are potentially greatly affected.

As much as everyone wants to simply financial reporting and ease the burden on private companies, if they are not usable in practice, then they can’t be effective. Little GAAP is more attractive to private companies, but it may not be good enough to best Big GAAP in practical use. 

Breaking Down the Issues
On one side, we have the American Institute of CPAs. Last June the AICPA struck first by releasing its Financial Reporting Framework for Small and Medium-Sized Entities, or FRF for SMEs. This is commonly referred to as Little GAAP, perhaps in part because it’s supposed to provide welcome relief for the little guy.

FRF for SMEs 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. It’s similar to the debate over international accounting standards versus U.S. GAAP.

FRF for SMEs is a principles-based approach, as with international standards, as opposed to the rules-based approach of Big GAAP. 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. It’s synonymous with Little GAAP. 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 is the primary creator of Big GAAP, or U.S. GAAP. The AICPA’s release of FRF for SMEs seemed to inspire the Private Company Council, which operates under the auspices of the Financial Accounting Foundation, also the mother ship of FASB, to speed up its own mission to make life easier for private companies.

At the beginning of July 2013, 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, the PCC’s approach is to hit certain areas of financial reporting in order to simplify the accounting. So 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 variable interest rates. The problem is that an interest rate swap meets the definition of a derivative and has to be recorded at “fair value” market valuations—complex valuations that involve some predicting of future events.

It is not uncommon for a company to enter into a swap and not understand the accounting complexity until it comes time for the audit. Additionally, some companies are surprised to find that an automatic interest rate swap hedge agreement was routinely written into its loan documents, only to discover it later. The situation can result in recording a loss to net income. For example, an 8 percent variable rate loan is hedged and fixed at 8 percent by swapping out another loan. Interest rates may decline 1 percent, but the company has to honor the commitment to pay the 8 percent and thus has to record the difference of interest cost between 8 and 7 percent.

Prior to the new changes, accounting alternatives to fair value treatment did not exist. That has changed during an audit under U.S. GAAP. The “simplified hedge accounting approach” has been finalized and approved by FASB. As the name implies, it will allow a company to measure the designated swap at settlement value—usually the end of the year—instead of current fair value. By doing this, the reported interest expense should more closely reflect the effective interest rate of the combination of the variable rate debt and the interest rate swap.

Goodwill: This accounting alternative has also been finalized by the PCC and approved by FASB. Since 2001, goodwill—an intangible asset value created during an event such as an acquisition—has not been subject to amortization, or writing down the book value of the asset, typically over 10 years. Instead goodwill has been required to be tested annually for impairment, and then written off if there is a major compelling reason to do so.

This generally requires companies to hire an external valuation specialist, which might cost $15,000 to double or more. 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, and it will flow through to net income. It allows for more predictability and requires fewer valuations.

Both the simplified hedge accounting alternative for interest rate swaps and the goodwill accounting alternative were issued as formal Accounting Standards Updates by FASB last month and will become effective for fiscal years beginning after Dec. 15, 2014 with early adoption permitted (see FASB Adjusts Standards on Goodwill and Interest Rate Swaps for Private Companies).

Who 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,” Tanzillo added.

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. 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 will emerge at a rapid pace. Because of the sentiments represented by the banker’s statement above, I believe the PCC will prevail as the more favorable model for private company standards, despite the ideal of Little GAAP.

The accounting alternatives approach of the PCC will prevail as the more favorable model as the financial statements will still 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. He specializes in financial reporting for complex transactions, including initial public offerings (IPOs), private offerings, and mergers and acquisitions, and serves as a local leader for the firm’s alternative energy practice area. Greg Pfahl can be reached at gpfahl@heincpa.com or (303) 298-9600.

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