The private company accounting Super Bowl

(Editor’s note: This is the first of two parts.)

During 2013, the scene was set for significant future changes in financial reporting for private companies, all of which will affect manufacturers. The changes centered on the desire to simplify, and therefore reduce the cost, of accounting for private companies. The question is, however, is simple good enough?

I’d like to take you through a quick journey of recent financial reporting developments, and share the opinion that in some ways, simple is not good enough and which of the competing methods of financial reporting is most likely to win the day. We’re nearing the Super Bowl, so perhaps the best way to explain the accounting developments is to use an analogy to predict the winner and what it will mean to manufacturing companies.

On one side, we have the “National Conference” entrant, known as the American Institute of Certified Public Accountants (AICPA). This last June the AICPA struck first by releasing its Financial Reporting Framework for Small and Medium-Sized Entities (“FRF for SME’s”).

The FRF for SME’s condenses the existing GAAP literature into a 188-page framework, which by its nature leaves significant room for reporting company and auditor judgment in how to apply the framework. It’s similar to the debate over international accounting standards (“IFRS”) versus U.S. GAAP. The FRF for SME’s is a principles-based approach (like IFRS) as opposed to a rules-based approach (U.S. GAAP). The easiest way to think of the difference is that U.S. GAAP makes heavy use of bright line standards for making reporting decisions, and less judgment.

The AICPA framework is considered an “other comprehensive basis of accounting,” or OCBOA. As an auditor, I can still sign an audit opinion on OCBOA financial statements, but the financial statements are not prepared in accordance with accounting standards generally accepted in the United States, and therein lies the rub.

The American conference has its own entrant into the Super Bowl private company accounting race, in the form of the Financial Accounting Standards Board (FASB), which is the primary creator of U.S. GAAP. The AICPA’s release of the FRF for SME’s seemed to inspire the Financial Accounting Foundation’s (the mother ship of the FASB), Private Company Council (“PCC”) to speed up its own mission to make life easier for private companies.

At the beginning of July 2013, the FASB exposed for public comment the first series of proposed accounting standards updates as a result of the PCC’s work, and much work has been done since that point.

While a common goal of both the AICPA and the PCC is to simplify financial reporting for private companies and therefore win our accounting Super Bowl, a very significant difference is that any standards that result from the PCC will be considered U.S. GAAP while, as mentioned above, the AICPA framework is OCBOA.

Instead of trying to revise an entire financial reporting model, the PCC’s approach is to hit certain areas of financial reporting in order to simplify the accounting. So here is the PCC’s progress to date:

Interest rate swaps – These financial instruments have become more and more common in business as a means to attempt to change a variable interest rate on debt into a fixed rate and thereby reduce the risk exposure from variable interest rates. The problem is that an interest rate swap meets the definition of a derivative, which are very complex instruments to account for.

It is not uncommon that a manufacturer enters into one of these agreements and does not realize the complexity until it comes time for the audit. At that time, under U.S. GAAP, accounting alternatives no longer exist. Although the PCC, playing for our American Conference side, proposed two alternative approaches to accounting for interest rate swaps, the “combined instruments approach” has gone back for additional research.

The “simplified hedge accounting approach,” however, is finalized and approved by the FASB. As the name implies, the simplified hedge accounting approach, if a company qualifies for its use, will simplify the accounting for an interest rate swap by allowing the company to measure the designated swap at settlement value instead of current fair value. By doing this, the reported interest expense should more closely reflect the effective interest rate of the combination of the variable rate debt and the interest rate swap.

Goodwill – This accounting alternative has also been finalized by the PCC and approved by the FASB. Since 2001, goodwill – an intangible asset value created during an event such as an acquisition – has not been subject to amortization, but instead has been required to be tested annually for impairment. This generally requires companies to hire an external valuation specialist. The FASB had already issued a standard that simplifies the annual impairment test by allowing companies to first look at qualitative factors in order to determine if the annual impairment test is required. The accounting alternative will allow private companies to begin amortizing goodwill again, generally over a period of 10 years, and it also provides further simplification for any ongoing impairment tests.

Both the simplified hedge accounting alternative for interest rate swaps and the goodwill accounting alternative are expected to be issued as formal Accounting Standards Updates by the FASB this month and will become effective for fiscal years beginning after Dec.15, 2014 with early adoption permitted.

Monday: Part Two