Auditing Special Purpose Frameworks: Auditing Investmentsby
Auditing investments requires understanding applicable standards in the reporting framework selected by management of an entity, just as it is with auditing procedures in other major financial statement classifications. This article will present major differences between U.S. GAAP and the FRF for SMEs affecting the audit of investments.
Generally accepted accounting principles in the United States for investments are included primarily in these pronouncements:
- ARB No. 51, ( FASB ASC 810): Consolidated Financial Statements
- APB Opinion No. 18 (FASB ASC 323-10; 325-20): The Equity Method of Accounting for Investments in Common Stock
- SFAS No. 115 (FASB ASC 320-10; 942-320): Accounting for Certain Investments in Debt and Equity Securities
- SFAS No. 141 (R) (FASB ASC 805): Business Combinations
- SFAS No. 157 (FASB ASC 820-10): Fair Value Measurements
- SFAS No. 159 (FASB ASC 825-10): The Fair Value Option for Financial Assets and Financial Liabilities
- SFAS No. 160 (FASB ASC 810): Noncontrolling Interests in Consolidated Financial Statements
- FIN No. 46 (R) (FASB ASC 810): Consolidation of Variable Interest Entities
- SFAS No. 167 (FASB ASC 810): Amendments to FIN 46 (R)
While it is beyond the scope of this article to cover the contents of these standards in detail, common areas of difference under the AICPA's Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) will be discussed below.
U.S. GAAP: Goodwill is not amortized but, instead, is tested for impairment (by a qualitative or two-step quantitative method) at least annually or when a triggering event arises, such as going concern or other profitability issues affecting a subsidiary.
FRF for SMEs: Goodwill may be amortized using the federal income tax time period or 15 years. No tests for impairment are required for long-lived assets, tangible or intangible.
U.S. GAAP: Indefinite-lived intangible assets are tested for impairment with qualitative or two-step quantitative methods similar to goodwill. Definite-lived intangible assets are amortized over their useful lives and long-lived intangibles are also tested for impairment as a result of certain triggering events indicating possible impairment.
FRF for SMEs: All intangible assets will be assigned estimated useful lives and amortized over that period. No tests for impairment are required for long-lived assets, tangible or intangible. Any long-term assets no longer used are written off. Management may elect either to expense development phase intangibles or to capitalize their costs.
U.S. GAAP: Financial assets and liabilities are classified in the balance sheet based on management's intentions—that is, to trade, hold for sale, or retain until maturity. Trading securities and available-for-sale securities are valued at fair value. Unrealized appreciation or depreciation for trading securities is recorded in operating income; for available-for-sale securities such amounts are recorded in comprehensive income. Held-to-maturity securities are carried at amortized cost.
FRF for SMEs: Investments in entities over which a company has significant influence are accounted for under the equity method. All other investments are accounted for based on historical cost, except for securities held for sale, which are valued at market value (changes are included income). Income from investments should be presented separately or disclosed in the footnotes. Equity method investees should follow the same method of accounting as the investor. An entity's share of any discontinued operations, changes in accounting policies or corrections of errors, and capital transactions of an equity method investee should be presented and disclosed separately.
Fair Value Accounting
U.S. GAAP: The definition of fair value in the accounting standards is "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." The standards provide guidance on valuation techniques (market approach, income approach, cost approach) and the hierarchy of inputs (levels one, two, three) for determining fair value.
FRF for SMEs: The term "market value" is used instead of fair value. The definition is: "The amount of the considerations that would be agreed upon in an arm's length transaction between knowledgeable, willing parties who are under no compulsion to act." Since the FRF for SMEs uses a cost approach primarily, measurement using market values is limited to business combinations, some non-monetary transactions, and marketable equity and debt securities that are available for sale.
U.S.GAAP: Generally, derivatives are accounted for as assets or liabilities and are measured at their fair values; changes in fair values are accounted for based on the use of the derivative. An entity is permitted to use hedge accounting.
FRF for SMEs: This framework requires a disclosure approach only with recognition at settlement on a cash basis. Disclosures include:
- The face, contract or notional principal amount (upon which payments are calculated).
- The nature, terms, cash requirements, and credit and market risks
- The entity's purposes in holding the derivatives.
- At the reporting date, the net settlement amounts of the derivatives.
Hedge accounting is not permitted.
Consolidation and Subsidiaries
U.S. GAAP: An entity having a controlling financial interest (normally more than 50 percent ownership) in another entity is required to consolidate the subsidiary. When the entity cannot maintain significant influence over the operation of the subsidiary, such as in the case of external events like bankruptcy, the subsidiary would not be consolidated. For investments in variable interest entities, investors that have the power to significantly influence the operations of such entities will usually be deemed "primary beneficiaries." In such circumstances, primary beneficiaries are required to consolidate variable interest entities. Either the equity method or cost method would be used otherwise.
FRF for SMEs: Management can elect to consolidate more than 50 percent-owned subsidiaries or account for them using the equity method (if it exercises significant influence over the entity). When significant influence is not exercised over the subsidiary, the cost method should be used to report the investment. Equity and debt securities that are available for sale, however, should be recognized at market values with changes in such values included in periodic net income.
U.S. GAAP: The acquisition method of accounting is required. The acquisition-date fair values of assets, liabilities, goodwill, and non-controlling interests in an acquired entity are used for measurement in financial reporting.
FRF for SMEs: This framework essentially requires the acquisition method of accounting using acquisition-date market values. However, it permits management to elect to account for an intangible asset either separately or as a part of goodwill. General disclosures similar to U.S. GAAP are required for material and immaterial business combinations.
Push-Down (New Basis) Accounting
U.S. GAAP: There is no requirement to permit new-basis accounting for acquired entities.
FRF for SMEs: When an acquirer gains more than 50 percent control of an entity, the assets and liabilities of the acquired entity may be comprehensively revalued in its financial statements, assuming the new values are reasonably determinable. This results in similar values being used in the acquired entity's financial statements and the acquirer's consolidated statements.
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