Accounting and Auditing Alert: Private Companies Get Possible New Option for Financial Reporting

By William M. Stocker III  |  August 6, 2013  |  Download PDF

The AICPA has announced a new option for small business financial reporting. The “Financial Reporting Framework for Small- and Medium-Sized Entities” is intended to ease reporting for smaller, privately held, owner-managed businesses that aren’t required to abide by Generally Accepted Accounting Principles (GAAP). This alert details the framework and provides an overview of three FASB-endorsed proposals from the Private Company Council that would ease accounting requirements for privately held companies.

Introduction

The American Institute of Certified Public Accountants (AICPA) has announced a new option for small business financial reporting. The “Financial Reporting Framework for Small- and Medium-Sized Entities” (SME framework) is intended to ease reporting for smaller, privately held, owner-managed businesses that aren’t required to abide by Generally Accepted Accounting Principles (GAAP). The framework is intended to help these businesses clearly and concisely report what they own, what they owe and their cash flows.

Currently, some entities that are not required to use GAAP choose to prepare their financial statements in accordance with the method of accounting that they use for income tax reporting. They generally do this for ease and lower cost. A problem is that the income tax rules are based on government policies for determining how much tax an entity and/or its owners are to pay. The SME framework, on the other hand, is designed to give better information about the entity for purposes of financial decision-making than would be the case with using the income tax basis.

Background

The SME framework draws on a blend of traditional methods of accounting and some accrual income tax methods to address the issues and concerns stakeholders currently encounter when preparing financial statements for SMEs. The AICPA believes the SME framework to be a cost-efficient solution for management, owners and others who require financial statements that are prepared in a consistent and reliable manner in accordance with a non-GAAP framework that has undergone public comment and professional scrutiny. The most frequently used special purpose frameworks — the cash basis and tax basis of accounting — haven’t undergone such public exposure and professional scrutiny.

Still, the SME framework has no official or authoritative status. In addition, the AICPA has made it clear that the SME framework isn’t meant to replace GAAP — it’s for those entities that do not require GAAP reporting.

The framework's advantages

According to the AICPA, the SME framework provides efficient, meaningful financial statements without needless complexity or cost. In contrast to GAAP’s prescriptive, detailed standards and voluminous disclosure requirements, the new option is a streamlined framework providing the financial information that’s relevant to owner-managed SMEs and their external stakeholders (including lenders), focused on the performance of the SME and its assets, liabilities and cash flows. Key measures of a business and its creditworthiness that will be reported include profitability, cash available and assets to cover expenses.

The framework is constructed of accounting principles that are particularly suited for a typical SME. To this end, among other things, it:

• Uses historical cost as its measurement basis, allowing SMEs to avoid complicated fair value measurements, (only equity and debt instruments held for sale are recorded at fair value),
• Reduces financial statement (“book”)-to-tax differences,
• Does not require complicated accounting for derivatives (record at cost, record gain or loss at settlement), hedging activities (no special recognition) or stock compensation to employees (no expense is recognized , although details are disclosed),
• Allows consolidation only of entities that are controlled by the reporting entity, variable interest entities (VIEs) are not recognized, the reporting entity can choose to use the equity method for all subsidiaries rather than consolidate,
• Allows the entity, as a policy option, when recording business acquisitions (business combinations) to not record specifically identified intangible assets but rather subsume them in goodwill,
• Eliminates impairment testing of goodwill and intangible assets, although the remaining useful life of intangible assets (which could be zero) must be estimated at each reporting date as the basis of amortization,
• Requires amortization of goodwill, generally over 15 years, and
• Targets its disclosure requirements to provide typical users of financial statements with the relevant information they need while recognizing that those users usually can obtain additional information from management if they desire.

It also provides a degree of flexibility to allow SMEs to appropriately communicate their situations to financial statement users with those users’ specific needs in mind.

Who should use the framework?

Although the framework doesn’t specifically define “SME” or provide quantified size criteria, the AICPA has identified several characteristics of typical entities that could use the SME framework. Such an entity:

• Is not subject to regulatory reporting requirements that essentially require it to use GAAP-based financial statements,
• Does not intend to go public,
• Is for-profit,
• May be owner-managed, meaning a closely held company where the individuals with a controlling ownership interest are substantially the same people who run the company (as opposed to public companies where the ownership and the management are clearly separated),
• Has owners and managers who rely on a set of financial statements to confirm their assessments of performance, cash flows, what they own and what they owe,
• Does not operate in an industry where its involved in transactions that require highly specialized accounting guidance (for example, financial institutions or governmental entities),
• Does not engage in overly complicated transactions, and
• Does not have significant foreign operations.

The AICPA’s cited characteristics also consider the users of the entity’s financial statements. It indicated the framework could be appropriate if key users have direct access to the entity’s management and users are primarily interested in cash flows, liquidity, statement of financial position strength and interest coverage. It could also be appropriate if the entity’s banker doesn’t base lending decisions solely on financial statements, but also on available collateral or other evaluation mechanisms not directly related to the financial statements.

The framework is appropriate for entities in most industry groups and both unincorporated and incorporated entities. Moreover, the AICPA has stated that it does not intend to exclude entities that aren’t owner-managed from using the framework. Indeed, entities that have nonowner operational management may find the framework to be a wise choice for their financial reporting needs.

Additional GAAP options for private companies

On the same day the AICPA’s SME framework was released, the Financial Accounting Standards Board (FASB) endorsed three proposals from the Private Company Council (PCC) that would ease accounting requirements for privately held companies. The PCC is focused on modifications to GAAP for private, for-profit companies that need or are required to have financial statements prepared in accordance with GAAP.

Both FASB and the PCC operate under the auspices of the Financial Accounting Foundation. They are working together to identify opportunities to enhance the relevance to users and reduce the cost and complexity of preparing private company financial statements under GAAP.

The endorsed proposals would:

• Provide relief from requirements that certain intangible assets acquired in a business combination, such as a merger, be separately recognized,
• Allow the amortization of goodwill and a simplified goodwill impairment model, and
• Allow two simpler approaches to accounting for certain types of interest rate swaps when a private company intends to economically convert the interest rate on its debt from variable to fixed.

The PCC has also issued a proposal to exempt private companies from consolidating VIEs with which the company is engaged in common control leasing arrangements. This proposal has not yet been considered by the FASB for endorsement.

The AICPA has stated that its framework complements the PCC’s efforts to modify GAAP for private companies.

Regulatory status

Each state regulates certified public accountants in its jurisdiction and their involvement with financial statements. It is unclear whether the New York State regulations permit CPAs to be “associated” with financial statements prepared in accordance with the SME framework. We are working on having the Board of Accountancy’s position clarified.

Moving forward

Since use of the SME framework is optional, there is no effective date for its implementation. Even with the clearance of any regulatory hurdles, businesses, however, will need to carefully consider which alternative is best for their circumstances before making any changes. We would be pleased to help you chart the best course for your financial reporting.

For more information

If you have questions, please contact William M. Stocker III, Partner-in-Charge of the Professional Practices Group, at 212.503.8875 or by email at wstocker@markspaneth.com or an Marks Paneth professional.

About Marks Paneth & Shron

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