Dec 4th 2012
By Scott Appel, CPA
As they grow their private companies, one of the last things - if not the last thing - owners want to spend time and money on is complicated financial reporting requirements. Sure, if a company plans to go public, there are good reasons to comply with US Generally Accepted Accounting Principles (GAAP), but many others want to focus on growing their companies.
In the long battle between "big" and "little" GAAP, not much progress has been made in helping smaller companies with few intentions of going public - those entities that are not forced to use GAAP reporting. Private companies and users of their financial statements complain that GAAP requires accounting and reporting that is not relevant or useful in decision making. They argue that GAAP is overly complex and leads to unnecessary costs in financial statement preparation and in performance of audit, review, and compilation services.
The most common objections include: (1) GAAP requiring two sets of financial statements and self-report "uncertainties" about income taxes, (2) paying for costly appraisals for mark-to-market assets such as securities and real estate at "fair value," and (3) having to report on consolidated entities.
Help is on the way. Frustrated over the lack of progress by the powers that be - in this case, the Financial Accounting Foundation (FAF), the body that oversees the Financial Accounting Standards Board (FASB) - to come up with a workable set of rules for private companies, the American Institute of Certified Public Accountants (AICPA) underwent its own process to produce one. The AICPA formed a task force of practicing accountants and AICPA staff with small business experience. After taking into consideration a broad range of comments from business and professionals, the task force has published its proposed Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs).
What is FRF for SMEs and how does it help me?
The AICPA framework is a reporting system that should be popular with both companies and their banks. There are more than twenty million SMEs in the United States that do not have to comply with GAAP because they are not public, although many private companies prefer to follow GAAP rules. The AICPA does not have any authority to require use of its framework; however, after its expected release as a final document in the second quarter of 2013, the AICPA is hoping that it will become a widely used standard. The rules can be utilized in every industry, and by either incorporated or unincorporated entities.
For private companies, much of GAAP is too complicated and does not apply to them. The proposed framework blends traditional accounting methods with income tax methods in an effort to minimize the difference between companies' financial statements and tax returns. In terms of disclosure, GAAP concerns itself with a myriad of reporting requirements, while most private companies only report to their banker. The FRF for SMEs still provides a meaningful set of financial statements. Bankers take more of a cash flow approach, and the framework intends to provide that.
For example, according to the AICPA fact sheet, the new framework will be used by owner-managers "who rely on a set of financial statements to confirm their assessments of performance, and of what they own and what they owe, and to understand cash flows." The framework includes information on other collateral that the owner-manager might pledge to secure a loan that is not available on current financial statements.
Other features of the new framework
In addition to the above, the FRF for SMEs:
- Will allow entities to follow the taxes-payable method when accounting for income taxes, "thereby mirroring what is reported on an entity's tax return," the AICPA says. Thus, there will be no concept of deferred taxes.
- Will use historical costs rather than fair value as a basis for valuing assets. This drastically simplifies the accounting process, thereby making it less expensive to produce financial statements.
- Will not use complicated GAAP procedures to account for derivatives, hedging, or stock compensation.
- Will not require expensive and time-consuming mark-to-market analysis.
- Will not include the GAAP concept of other comprehensive income. Changes in equity will only reflect equity contributions, distributions, and net income or loss.
- Will follow a traditional approach to lease accounting, in which cases leases will not have to be capitalized and subject to depreciation and amortization; rather, they will flow through to the income statement.
- Does not follow the GAAP concept of consolidating variable interest entities. The classic example is when a company owner holds the building or land the company uses through another entity and leases it to the company. GAAP might require the books of both to be consolidated into one, where the FRF for SMEs does not.
- Does not follow GAAP related to goodwill and intangibles. Goodwill should be amortized over the same period as for federal income taxes or, if not amortized for income taxes, over ten years. For intangibles, if an entity cannot make a reasonable estimate of the useful life, the life should be presumed to be ten years.
Although we expect the new framework will be widely adopted by private companies, businesses should always consider the users of their financial statements before choosing a reporting method. The framework might not meet everyone's needs, such as in the case of a company that expects to go public within a few years, or when a company has users who demand GAAP accounting.
Additionally, the FASB is still working on its set of recommendations for private company users. And while the two bodies have done a significant amount of work together on the AICPA standards, the FASB's Private Company Council may produce something different, and ultimately, the FASB is the dominant rule-making body in accounting.
Nonetheless, for users of private company financial statements, the AICPA standards promise to be relevant, useful, efficacious, and less expensive to produce.
- Privately Held Companies Are Overwhelmingly in Favor of Separate Reporting Standards
- FASB Is Viewing Private Company Standards through a Different Lens
About the author:
Scott Appel, CPA, is the partner-in-charge of the Orange County office of Hein & Associates LLP, a full-service public accounting and advisory firm with additional offices in Denver, Houston, and Dallas. He specializes in SEC reporting and regularly consults with both public and private companies on matters related to GAAP compliance. Scott can be reached at email@example.com or (949) 428-0288.