Trends & Developments - October 2013 - Auditing Standards - Is 'Little GAAP' Finally Here?
The discussion about "Big GAAP" vs. "Little GAAP" has been going on for decades. Recently, a non-GAAP alternative with simplified rules for privately held entities called the Financial Reporting Framework for Small- and Medium-Sized Entities (the "FRF for SMEs™") was released. In addition, the Financial Accounting Standards Board ("FASB") is expected to issue new rules which will simplify certain GAAP requirements and reduce the amount of disclosure for privately held entities. Not only will "Little GAAP" be here, but there will be choices available.
The FASB was created in 1973 as the designated organization in the private sector for establishing financial accounting standards. These standards (generally accepted accounting principles or GAAP) are the framework around which financial statements are built. It wasn't long thereafter that we started hearing complaints about standards overload. It was stated that GAAP was developed with public companies in mind and that the complexity of the accounting principles and the required disclosures were excessive for the nonpublic entities. Articles were written, hearings were held, and committees were formed which studied the issue and published conclusions. But no official action was taken by the FASB and the "problem" continued to grow. However, in the past two years there has been a flurry of activity and perhaps a solution may soon be available.
But first, we need a little background. As previously mentioned, the FASB is responsible for promulgating the GAAP framework used to prepare financial statements. Often entities are not required to, or choose not to prepare their financial statements in accordance with GAAP. The alternative is to use an "Other Comprehensive Basis of Accounting" or "OCBOA." OCBOA represents frameworks other than GAAP around which the financial statements are built. Commonly used OCBOA are:
- Cash Basis
- Modified Cash Basis
- Income Tax Basis
- Contractual Basis
- Regulatory Basis
Each of these OCBOAs has their advantages and disadvantages, but they all carry the same disadvantage in that they are not GAAP. In 2012, the American Institute of Certified Public Accountants ("AICPA"), which is a national association of CPAs, decided to take on the standards overload by developing a new framework which would not be GAAP but would address the concerns of private entities. In June 2013 the AICPA released the FRF for SMEs, which was developed to provide consistent and simpler financial statements for small- and medium-sized entities that did not require financial statements prepared in accordance with GAAP.
The FRF for SMEs was developed because the market was asking for a framework tailored to private entities that was cost effective and did not require extensive disclosures that were often irrelevant to the financial statement users. The FRF for SMEs did not define a small- or medium-sized entity but it did include a list of characteristics of an entity that would consider using it. Some of the characteristics are:
- owner managed;
- does not have any contractual or other requirements to prepare GAAP-based financial statements;
- does not operate in a regulated or highly specialized industry (e.g., a utility or a financial institution);
- does not engage in many overly complicated transactions;
- does not have significant foreign operations;
- financial statement users are primarily interested in cash flow, liquidity and debt coverage; and
- key users of financial statements have direct access to management.
Some of the key attributes of the FRF for SMEs are:
- historical cost based;
- accrual based;
- disclosures are not excessive and are targeted to the financial statement users;
- concise and self-contained (the guidance is a little more than 200 pages);
- contains options to tailor the financial statements to the entity and for the user;
- does not require impairment testing for long-lived assets;
- does not recognize the concept of other comprehensive income;
- does not recognize the concept of variable interest entities ("VIEs");
- does not require recognition of all intangible assets upon a purchase acquisition; and
- requires amortization of goodwill.
The FRF for SMEs was available for use upon issuance and can be used now. However, one limitation that currently exists is whether it will be accepted by the financial statement users. Banks, bonding companies and other third-party users need to be comfortable with the FRF for SMEs before they will accept it -- especially banks, which must be satisfied that the regulatory agencies will accept financial statements prepared using this framework and that the financial statements will satisfy the risk profiles associated with the entity's financing. And, of course, the biggest limitation is that the FRF for SMEs is not GAAP. The future usefulness of the FRF for SMEs framework is in the hands of the third-party users, and it is too soon to tell what the level of acceptance will be.
So, is the FRF for SMEs the answer to the "Big GAAP" vs. "Little GAAP" question? Before we can answer that question, we need to explore the other alternative currently in process.
In 2009, the AICPA, The Financial Accounting Foundation ("FAF") (the parent organization of the FASB) and the National Association of State Boards of Accountancy ("NASBA"), established a blue ribbon panel to address how accounting standards can best meet the needs of the users of private company financial statements. The panel's report, released in January, 2011, called for fundamental changes to the system of standard setting, including the creation of a new board to be overseen by the FAF which would focus on recommending exceptions and modifications to GAAP to better respond to the needs of the private company sector. The panel did not recommend a separate, self-contained GAAP for private companies.
As a response to the recommendations of the blue ribbon panel, the FAF, in 2012, created the Private Company Council ("PCC"). The PCC has two principal responsibilities:
- Working jointly with the FASB, the PCC will review existing GAAP and propose alternatives within GAAP to address the needs of users of private company financial statements, and
- The PCC is the primary advisory body to the FASB on the appropriate treatment for private entities for new GAAP being considered by the FASB.
The PCC proposals go through the same due diligence as FASB proposals. That due diligence includes the preparation and public exposure of an issues paper, the release of an exposure draft, public hearings, solicitation of written comments and re-deliberation throughout the process. The PCC does not have the authority to issue GAAP, so its final product is a recommendation to the FASB. The FASB then has the obligation to 1) reject the proposal and, along with its comments and concerns, send it back to the PCC for revision; 2) hold the recommendation subject to further research and review; or 3) concur with the recommendation and issue a revision to GAAP.
In July, 2013 the PCC issued the following three exposure drafts. The public comment period for each of these drafts ended on August 23, 2013.
- PCC-13-01A – Accounting for Identifiable Intangible Assets in a Business Combination.
- When a company makes an acquisition, the excess of the purchase price over the current value of the net tangible assets obtained is an intangible asset. GAAP requires that the intangible asset be allocated to relevant intangible assets with limited lives (e.g., patents, copyrights, customer lists, beneficial leases in place, etc.). Any unallocated amount would be classified as goodwill.
The proposal gives the option to private entities to allocate the intangible asset only to contractual intangible assets (e.g., patents, copyrights) with the unallocated remainder recorded as goodwill.
- PCC-13-01B – Accounting for Goodwill.
- Goodwill is not amortizable under GAAP. In addition, GAAP requires a series of annual impairment tests to determine if the recorded goodwill has continuing value.
The proposal gives the option to amortize goodwill over the life of the principal asset acquired in the transaction that created the goodwill, but in no case over a period greater than 10 years. In addition, the proposal gives the option to perform a less comprehensive test of impairment, and only requires the testing upon the occurrence of a defined "triggering event."
- PCC-13-03 – Accounting for Certain ReceiveVariable, Pay-Fixed Interest Rate Swaps.
- Often an entity enters into a variable rate financing arrangement with a financial institution. In order to reduce the risk inherent in a variable rate, the entity may enter into an interest rate swap agreement with a financial institution. The entity agrees to pay a fixed rate of interest over part or all of the term of the financing arrangement in order to reduce the risk of the variable rate. Depending on the movement of the variable interest rate relative to the agreed upon fixed rate during the term of the interest rate swap agreement, the entity either owes interest to or is due interest from the financial institution. The calculation of these relative positions at a given date can be difficult and there are complex rules related to the financial statement accounting for the transaction.
The proposal gives the option to use one of two easier methods to account for certain types of interest rate swaps. The two methods are known as the combined instruments approach and the simplified hedge accounting approach.
In August, 2013 the PCC issued the following exposure draft. The public comment period ends on October 14, 2013.
- PCC-13-02 – Applying Variable Interest Entity Guidance to Common Control Leasing Arrangements.
- GAAP requires that variable interest entities ("VIEs") (as defined) be consolidated with the financial statements of the primary beneficiary (as defined). Essentially, a VIE is an entity controlled by the reporting entity by means other than a direct controlling interest of the VIE's equity. A common private company scenario is when an operating entity rents real estate from a separate entity which is controlled by parties related to those controlling the operating entity. The operating entity does not own a controlling interest in the VIE but can exercise control or share in its economic gains or losses because of factors such as common control, guarantee of VIE debt or ability to influence transaction terms.
The proposal gives the option for private entities to be exempt from the VIE consolidation requirements for certain common control leasing arrangements.
At its meeting on September 30-October 1, 2013, the PCC finalized two proposals and sent them to the FASB for endorsement. PCC-13-01B – Accounting for Goodwill was sent to the FASB without change. PCC-13-03 – Accounting for Certain Interest Rate Swaps was amended to exclude the option of using the combined instruments approach and was sent to the FASB with only one accounting option, the simplified hedge accounting approach. The PCC also directed the FASB staff to conduct more research on the combined instruments approach for further discussion at a future meeting.
The FASB is expected to conduct further research on both of these proposals before it makes an endorsement decision. If and when the FASB will issue new GAAP containing these proposals is not yet evident.
The eventual issuance of new GAAP pronouncements which embrace the PCC proposals may, in fact, be the first installments of "Little GAAP." The issues covered by the first four PCC proposals match very closely with elements of the FRF for SMEs, and are issues that many private entities find problematic with current GAAP. So how is a business owner to choose?
In August, 2013, the AICPA and NASBA joined forces to create a decision tool for businesses. The Decision Tool for Adopting an Accounting Framework published by the AICPA contains a flowchart and lists of factors that should be considered and weighted when making a decision about the most appropriate financial statement framework to use. Use of this tool should lead the reader to a decision to use GAAP (or GAAP as modified in the future) or a special purpose framework (non-GAAP). These options -- cash basis, modified cash basis, income tax basis or the FRF for SMEs -- which were previously referred to as OCBOAs, are to be referred to as Special Purpose Frameworks or SPFs in the future.
So, is "Little GAAP" finally here? If you broaden the definition of "Little GAAP" to include options for private entities to use a GAAP framework or a non-GAAP Special Purpose Framework, then it may be here, or at least will be here after the FASB issues new PCC proposed GAAP. In any case, after decades of discussion, it appears that the accounting profession is finally beginning to address the needs of the private business entity financial statement users. It may be a small step, but it is a start.
Trends & Developments - October 2013