The auditing profession is facing an economic dilemma: Audits of financial statements in accordance with GAAP are being dropped by businesses unless they are required by law, such as for companies reporting to the Securities and Exchange Commission and large not-for-profits.
In addition, banks are frequently waiving a requirement for audited GAAP financial statements as borrowers complain about the costs. Instead they are using unaudited plain paper reports or tax returns to support loans.
I believe the excessive requirements of GAAP are a significant driver of the costs. GAAP rules have grown over the last few decades, adding many complex accounting rules and many required disclosures. I have found that bankers frequently gloss over the footnotes, as they are too long and difficult to actually be read. The GAAP standard rules and disclosures may, or may not, make sense for public companies, but all too frequently do not for small and midsized businesses.
FRF for SMEs
Three years ago the American Institute of CPAs issued the Financial Reporting Framework for Small and Medium-Sized Entities, or FRF for SMEs, which I believe, if adopted by a company, would reduce the cost of preparing, auditing and compiling financial statements by simplifying both the accounting and the disclosures.
The framework was developed by an AICPA task force made up of “professionals who have an abundance of experience serving smaller- to medium-sized enterprises,” according to the framework. Together, they developed a set of very sensible standards. This framework, which simplifies accounting rules, is intended to reduce the cost of preparation and, concomitantly, the cost of financial statements for small and midsized enterprises, and even provide other useful disclosures.
While the framework does not specifically state that the FRF for SMEs is authoritative, the AICPA issued it as an “Other Comprehensive Basis of Accounting.” The AICPA literature gives sample reports for audits, reviews or compilations that accompany any financial statements issued under the FRF for SMEs.
Although there is no set definition of an SME, the AICPA’s introductory description has specific exclusions, including public companies, companies considering going public, not-for-profit entities, and any companies with a required reporting framework, etc. But any company not excluded by the previous sentence may adopt the framework.
The AICPA literature describes the FRF for SMEs as being closer to income tax accounting. The differences between GAAP and income tax reporting are still sufficiently significant as to make any correspondence with tax accounting not a reason to adopt the FRF for SMEs. Also, the International Accounting Standards Board has issued its own, authoritative framework for small and midsized entities’ reporting under IFRS.
The areas of FRF for SMEs where there are significant reductions in accounting requirements, rules and required disclosures include the following:
1. GAAP is contained in over 6,000 pages of rules, including SEC rules, which are complex, frequently requiring cross-reference to various areas, and difficult to follow. The FRF for SMEs is contained in 188 pages of reasonably understandable English. GAAP has a 246-page glossary; the FRF for SMEs’ glossary is contained in only 16 pages.
2. The FRF for SMEs eliminates substantially all fair market value testing, in areas such as impairment, marketable securities, etc. There is no requirement to break down security portfolios by source of market value or testing for asset impairments. Financial statement measurements are generally all cost-based.
3. There is no requirement for reporting comprehensive income separate from net income.
4. Subjective principles are used in many areas where GAAP has fixed rules.
5. There is no industry-specific guidance in the FRF for SMEs. Preparers have to use their professional judgment and disclose the principles used in areas in which GAAP gives detailed instructions.
6. There is no requirement to account for equity-based compensation. Disclosure is sufficient. Stock or options given to non-employees in exchange for goods are required to be recorded in the financial statements as with GAAP.
7. Derivative accounting is limited to disclosure of amounts, terms, market risk, objectives for holding and the net settlement amount at balance sheet date.
8. The FRF for SMEs gives an option to adopt alternative simplified accounting for a large number of topics.
9. The AICPA promises changes to the FRF for SMEs only about every three years, and only if necessary, as compared to the Financial Accounting Standards Board, which makes frequent revisions.
The FRF for SMEs is a complete set of stand-alone accounting rules governing financial statement presentation. A careful comparison to GAAP shows many differences. Certain of the larger ones, which are described below, are outlined in the various AICPA guides to the adoption of the FRF for SMEs.
In addition, the framework gives guidance in some areas where GAAP does not. The many GAAP standards that seem irrelevant to issuers of financial statements of small non-public companies are not included in the FRF for SMEs, and there are options to follow simple standards or more complex standards as appropriate.
As the length of the FRF for SMEs is about 4 percent of GAAP, much of the detailed guidance and search for definitive requirements is eliminated. The AICPA preface guidance states: “Being a more intuitive and understandable framework for small business, owners and the users of their financial statements, the framework lays out principles that encourage the use of professional judgment in the particular circumstances of a transaction or event.” The framework, in the preface, states that it “eschews prescriptive, detailed standards and voluminous disclosure requirements.” As one studies the FRF for SMEs, one realizes that this framework is an intelligent and useful rewrite of the accounting standards with which we have all lived for many years.
The FRF for SMEs starts by stating a base for principles of accounting: the objective of financial statements, materiality as applicable to financial statements, when financial statements are available to be issued, their qualitative characteristics, and their relevance.
The framework also states that financial statements should be understandable and reliable. I believe none of these characteristics are covered in the GAAP Codification, although much is contained in the FASB Concepts Statements. I applaud the inclusion of these principles.
NOT “GAAP LITE”
The FRF for SMEs is not intended to be just GAAP “lite” and differences from GAAP are not all reduction and simplification. Disclosures required of the FRF for SMEs that are not required under GAAP include, among others, the following:
- A list of the areas where estimates were used.
- A disclosure if there is a reasonable possibility that the estimate will change in the near term.
- The length of the operating cycle if it is other than one year.
- An accounting policy footnote that discloses accounting policies where there are acceptable alternatives.
- A footnote for debt that has been in default where the default was waived prior to the issuance of the financial statements.
- Disclosure of the amount of any inventory written down to fair market value.
- The FRF for SMEs discusses the appropriate placement of capitalized software, either as an intangible or property.
- For property, plant and equipment, a general description as to what costs should be capitalized.
- A description of the logic behind the selection of depreciation lives and methods.
- Disclosure relating to unincorporated businesses, including any DBAs, equity by class, separate accounts of members if maintained, and any difference in classes of members. As the framework is intended for small and midsized businesses, its disclosures relating to partnerships and limited liability companies are far more robust.
- Disclosures relating to operations including markets served, services provided, and their location.
The FRF for SMEs allows the financial statement preparer in a significant number of complex accounting areas the option to use the more complex requirements of GAAP or a less complex alternative:
- Development costs and startup costs can be capitalized or expensed depending on the policy adopted. GAAP requires capitalization for development costs and expensing of startup costs.
- Accounting for income taxes can be either cash or deferred tax accounting. GAAP requires deferred tax accounting.
- Companies can either consolidate subsidiaries or issue parent-alone financials listing the subsidiaries and carrying them at equity. GAAP requires consolidation.
- For a business combination, intangibles can be recognized as an identifiable asset or combined with goodwill. Market-based intangibles are not recognized.
- Accounting for defined-benefit pension plans has two alternatives: the current contribution method, which requires only funding or accruing the cost attributable to the current year, or the accrued benefit obligation methods, which are similar to GAAP (20.00). Various disclosures are required under either method.
- Certain of the rules alleviate the burden of previous difficult requirements:
- Derivative accounting is limited to disclosure of amounts, terms, market risk, objectives for holding and the net settlement amount at balance-sheet date.
- Long-lived assets held for sale continue to be carried at the original amount with gain or loss on disposition and related disposal costs charged to operations on disposition. Impairment testing is never required, even if the property is held for sale.
- Marketable securities are all carried at original cost unless “held for sale” in which case they are marked to market. “Investments that are held for sale are securities that management is currently attempting to sell,” the framework says.
- Consolidation is required only for majority-owned corporations. Variable interest entities do not have to be consolidated.
- The rules on business combinations are significantly simplified with a definition of non-goodwill intangibles and 15-year amortization for goodwill and intangibles. There is no requirement to assess impairment of any intangible.
- There is no requirement for disclosure of uncertain tax positions or open audit years unless there is a material contingency.
- A benefit of the FRF for SMEs is that the AICPA promises not to make frequent revisions. There have been none since the issuance of the framework in 2013. The accounting for leases and revenues has not been updated to adopt FASB’s new standards in that area. Also, some of the recent simplifications are not included, as the FRF for SMEs still requires separating deferred taxes between current and long term (21.59).
Chapter 3 states the requirements for transitioning from GAAP to the FRF for SMEs. Such requirements are reasonable bridging from GAAP to the FRF for SMEs and will require appropriate analysis by companies changing to the framework.
The above list, while admittedly long, is not a comprehensive list of either the required disclosures that are not required by GAAP or all differences between GAAP and the FRF for SMEs. Users will have to carefully consult the new framework before finalizing financial statements prepared under the FRF for SMEs.
The AICPA is strongly supporting the FRF for SMEs with the framework, free toolkits for accountants, preparers and users, checklists, and other practice aids all available for free on its Web site at www.aicpa.org/frf-smes.
Robert Durak, the institute’s director of audit and accounting technical services, says that there is informal support for the use of the FRF for SMEs, although no surveys have been conducted. Some companies previously using income tax accounting or GAAP are changing to the FRF for SMEs.
Further, no changes have been made in the FRF for SMEs since they were originally issued, and there are no current plans for an update to the FRF for SMEs. It appears that the framework will continue to require the traditional accounting for leases and revenue recognition.
The only significant cost of adoption is the learning curve for preparers and attesters. In view of the simplicity of the new framework, I do not believe that the cost of learning would be significant.
This is a fascinating approach to the creation of an alternative to GAAP. It is well done and is much easier to apply than GAAP. After its original issuance, the framework has not had significant publicity, although it has been taught in college at the graduate level. I have not yet seen any reports using FRF for SMEs. I have had limited discussion with bankers who indicate that, while they have not seen it being used, they would be amenable to its adoption.
In summary, the adoption of FRF for SMEs would result in significantly lower audit and preparation costs, as disclosures would be reduced and related time to audit the information is no longer required. And it might be better for financial statement users if financial statements are no longer cluttered up with irrelevant footnotes.