Traditional accounting principles form the foundation for a new approach to financial reporting that the AICPA is developing for small and medium-size entities (SMEs) and released for public comment Thursday.
The proposed Financial Reporting Framework for SMEs (FRF-SME) is designed to emphasize familiar accounting concepts such as historical cost and the matching of revenues with costs.
“Current accounting standards have moved away from historical costs and more to fair value,” said David Morgan, CPA/PFS, who chairs the task force that is developing the framework. “One goal of the FRF-SME is to move to a simpler historical cost framework.”
Morgan, a managing partner with Lattimore Black Morgan & Cain PC, in Brentwood, Tenn., served on the Blue-Ribbon Panel on Standard Setting for Private Companies and has been working for years to advocate for simple financial reporting options that meet users’ needs without being unnecessarily costly for small businesses. Now he is playing a key role in developing a framework that can be used by businesses whose financial statements are not required to be prepared in accordance with U.S. GAAP.
He said the principles that serve as the basis for the proposed FRF-SME align with the needs of bankers who are the primary users of small business financial statements and provide the capital for the owner-managers of small companies. A time-honored feature of accrual-based financial statements is that they report costs when they are incurred and report revenue when performance is achieved, and reasonable assurance regarding measurement and the collectability of the consideration exists. The matching of revenue and costs also is a concept that has stood the test of time.
An emphasis on the use of historical costs is among the cost-saving features of the proposed framework. Fair value accounting grew in stature following the 1980s, when overvalued assets on balance sheets were blamed for the savings and loan crisis. But fair value accounting has been the target of numerous critics, from members of Congress, who said mark-to-market comparisons played a role in the recent financial crisis, to small businesses that often find fair value measurements irrelevant. Lenders and other users of SME financial statements largely find fair value measurements in the financial statements of little use owing to a number of reasons, including their focus on cash flows and their long-term perspective on the SME. The proposed FRF-SME adheres to a general principle that historical cost is the most useful measurement basis for the users of SME financial statements and the most cost-beneficial approach for owner-managers of SMEs to follow in the preparation of their financial statements.
Ken Odom, CPA, a member of the FRF-SME task force who serves many small business clients as a practitioner for Rabren, Odom, Pierce & Hayes PC, a one-office firm in Andalusia, Ala., said fair value accounting standards require his firm to get real estate appraisals for clients and costly expert valuations on certain investments and derivatives used by some businesses.
“We’re not going to have to do that within this financial reporting framework, and that’s going to be a big plus,” Odom said.
The entire proposed framework—and resources associated with it—are available at a new website dedicated to the framework. The comment deadline is Jan. 30. What follows are hypothetical examples that demonstrate accounting and financial reporting principles proposed in the FRF-SME.
Practical and less complicated goodwill accounting
Morgan used the hypothetical example of an acquisition by a small publishing company to show why using historical costs can help small businesses. The publisher purchases a smaller publishing company from an owner and operator who is retiring after 40 successful years in the business. The purchasing company acquires intangible assets and a significant amount of goodwill that the retiring owner had built.
In June 2001, FASB Statement No. 142, Goodwill and Other Intangible Assets, ended the practice of automatically amortizing goodwill to expense in GAAP financial statements. It required intangible assets and goodwill to be placed on balance sheets and assessed annually for impairment. The FRF-SME does not require an assessment of goodwill impairment but rather requires that goodwill be amortized over the same period as that used for federal income tax purposes—or if not amortized for federal income tax purposes, then a period of 10 years. In doing so, the FRF-SME allows a more relevant, less complicated and cost-beneficial approach to goodwill accounting for SMEs.
No VIE consolidation
The proposed Framework for SMEs will not require consolidation of variable-interest entities (VIEs) into companies’ financial statements, sparing them what Morgan calls “the single worst piece of accounting standards I ever saw applied to private companies.”
A hypothetical example shows why this will be helpful to small businesses. The owner and operator of a local pizza parlor decides to expand to a second location. Through her LLC, securing a loan from a local bank, she purchases a building that had been used by another restaurant that had gone out of business. Her LLC leases the building to her company.
Under GAAP, the building would be considered a VIE and subject to the requirements of ASC Topic 810, Consolidation (i.e., FIN 46(R)/FASB Statement No. 167). The standard could require the owner to consolidate the building with her operating company for the restaurant.
This adds complexity to the operating company’s financial statements, requiring what could be construed as an unnecessary placement of assets on the books that her banks do not wish to consider. When she sells the company one day, she may keep the building—or vice versa. When she applies for a loan to purchase equipment for the pizzeria’s kitchen, her bank’s loan officer asks her to provide a statement without the VIE included.
The proposed Framework for SMEs would not require the building to be consolidated with the operating company, and would prevent extra calculations and complexity for businesses that are not required to prepare GAAP financial statements.
“To force companies to push those together to be in compliance with GAAP really creates a set of financial statements that are not more useful,” Morgan said. “They’re less useful.”
Relevant lease accounting
Under the proposed FRF-SME, accounting for leases will follow a traditional accounting approach that is closely aligned with how leases are treated for income tax purposes. In this hypothetical example, a plumbing company with 30 employees makes almost daily use of a piece of equipment. The company has a five-year lease contract on the equipment with a provider.
Rather than automatically requiring that an asset and liability related to the lease be recognized on the balance sheet, the FRF-SME would account for the equipment in accordance with very familiar and traditional accounting rules after assessing whether the lease is an operating lease or a capital lease.
“You disclose the leases,” Morgan said. “All the information is there. If the bank wants to put them on the balance sheet, have at it. They can do the calculations. But the financial statements aren’t going to run through a bunch of gyrations to make them more complex than somebody might want them to be.”
Simplified and relevant information for users
The primary users of SME financial statements often are the banks that provide them with capital through loans. The proposed Framework for SMEs is structured to provide these banks with the information they need.
In a hypothetical example, a small business obtains financing on a floating-rate basis but would rather have the certainty of fixed interest payments, so it enters into an interest rate swap of its interest payment obligations. The swap is a long-term contract, and the owner-manager intends to hold it to maturity, which is often the case in the SME environment. Requiring mark-to-market accounting in those situations would not produce relevant information for this company’s lender and would add needless cost to preparing financial statements. In recognition of this, the FRF-SME does not require complicated derivative accounting and financial reporting or fair value accounting for interest rate swaps. Rather, the FRF-SME requires adequate disclosures about the swap to enable the lender and other financial statement users to understand the nature and terms of the swap.
The proposed FRF-SME has other qualities, too, that will make it attractive for SMEs. It is closely aligned with the accrual basis of accounting, in part because this provides much of the information banks need from small businesses that are not required to prepare GAAP financial statements. This provides an added benefit for small companies because their financial statement preparation can be easier and less costly.
“It gives them a framework that is based in traditional accounting theory,” said Chuck Landes, AICPA vice president‒Professional Standards & Services, who helped develop the framework. “And it incorporates some income tax methods so they’re not having to keep multiple sets of books—one set to give to their banks, and one set to file their income tax return.”
The proposed framework does not require the reporting of comprehensive income because many small companies do not deal with items such as available-for-sale securities and foreign-currency translations that figure into those calculations. The proposed FRF-SME also will provide for simplified pension disclosures and generally provide more principles-based accounting instead of detailed rules.
“It just makes things simpler,” Morgan said. “Simpler is usually better.”
The AICPA released its proposed Financial Reporting Framework for SMEs (FRF-SME). The framework is designed to provide useful information to users, including lending institutions that are primary users of financial statements of small companies, while minimizing the cost of preparing those statements. Comments on the framework are due Jan. 30.
Familiar and traditional accounting principles, such as historical costs and the matching of revenues and expenses, are the foundation of the proposed framework. Use of historical costs will prevent owner-managers from having to get expensive valuations that would have been required to meet fair value standard requirements.
The proposed framework is closely aligned with the accrual basis of accounting so small businesses will not have to keep one set of books for their income taxes and another for their lending institution.
Variable-interest entities (VIEs) will not be required to be consolidated in small business financial statements, and lease accounting will receive a traditional treatment under the framework as proposed.
Ken Tysiac is a JofA senior editor. To comment on this article or to suggest an idea for another article, contact him at email@example.com or 919-402-2112.
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