Increasing Audit Profits Series No. 5—Helping Clients Select the Least-Costly Reporting Framework

Apr 15th 2011
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Because of the increasing complexity of U.S. GAAP, some CPA firms are suggesting the use of alternative reporting frameworks for some clients.  Here is a brief discussion of the most common alternatives.

Other Comprehensive Bases of Accounting (OCBOAs)

OCBOAs most commonly include the modified cash basis and the income tax basis of accounting.  While any reporting framework must include all disclosures necessary to prevent the financial statements from being misleading, most of the complex disclosures of “rules-based” U.S. GAAP can be avoided.  Many smaller reporting entities prefer the income tax basis because it parallels income tax reporting and is easier to understand.  Some users of the financial statements also prefer the income tax basis for the same reason.

International Financial Reporting Standards (IFRS)

Some reporting entities in the agricultural and other industries that have significant investments in land and other real property are considering adopting IFRS because of the option to value non-financial assets at fair value.  Other entities are considering adopting IFRS for Small and Medium Size Entities because the required principles-based footnote disclosures are considerably less than U.S. GAAP.  

Deciding Not to Apply a Generally Accepted Accounting Principle

When GAAP reporting is required by a user of an entity’s financial statements, the user and the reporting entity may agree to not apply a specific accounting standard.  Some entities and the users of their financial statements have agreed that application of FIN 46R (SFAS No. 167), Variable Interest Entities, and FIN 48, Uncertainty in Income Taxes, for example, do not meet their reporting needs and have decided not to comply with the requirements of these standards..  

When Non-compliance is Material

If the effects of non-compliance with accounting standards are material, management should disclose the non-compliance in its footnotes. The auditor would issue an opinion on the financial statements that is either qualified or adverse because of the GAAP departure.  Obviously, the user of the financial statements should agree to accept a modified audit report before the engagement begins.

When Non-compliance is not Material

If non-compliance effects are not material, no footnote disclosure or audit report modification would be necessary.  Some reporting entities, however, voluntarily disclose the immaterial non-compliance with certain standards to eliminate questions that knowledgeable financial statement users may raise about possible non-compliance.  

For example, I read the financial statements and footnotes of a Cooperative Association recently.  Note A contained nearly two pages of disclosures of the entity’s affiliated relationships that explained some of the related party entities would be considered variable interest entities under then effective FIN 46R.  The footnote went on to explain that the possible variable interest entities had not been consolidated because the effects on the financial statements of the reporting entity were not material.  

Applying Rule 203-1 of the AICPA Code of Professional Conduct

Rule 203 instructs an accountant or auditor reporting on financial statements to apply all principles of the applicable reporting framework.  However, Interpretation 203-1 states that when the application of a standard causes the financial statements to be misleading, management and the accountant or auditor can justify a departure.  

In the mid-1980s for example, SFAS No. 15 was issued to guide the accounting treatment of troubled-debt restructurings.  Among other things, this statement required loan modifications on the financial statements of debtors to be treated as gains in the income statement.  For reporting entities that had sustained years of losses, the deterioration of retained earnings and, in some cases, the elimination of stockholder’s equity, large gains from debt modification had significant “psychological” effects on the income statement.

In other words, entities that had losses from operations and were facing immediate threats to the continuance of their businesses were now showing large amounts of net income.  Some auditors believed the effects of SFAS No. 15 caused the financials statements of certain entities to be misleading and, after SFAS No. 15 was not applied in the financial statements, included a middle departure paragraph in their report justified under Interpretation 203-1.  Due to current economic times, similar situations may arise today.

Selecting the Appropriate Financial Reporting Framework

Management of a reporting entity is responsible for selecting the reporting framework that most appropriately reflects its financial position and results of operations.  Auditors must approve the appropriateness and reasonableness of the framework.  For many reporting entities, alternatives other than GAAP may be appropriate.  In addition, using alternative frameworks may result in less time to prepare and audit financial statements and footnotes.  Making these decisions long before the report date can result in significant time savings for reporting entities and increases in audit profits for CPA firms.

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