Differences Between the Proposed FRF and Current GAAP
The proposed FRF contains significant differences from current GAAP. There is much more use of historical cost basis in accounting for assets, as opposed to the migration to fair value that GAAP has made over the last several years. Some other differences include accounting for income taxes, goodwill and other intangible assets, other comprehensive income, financial instruments, investments, and consolidation of variable interest entities.
The new reporting framework will take a much more practical approach to accounting for income taxes, including an alternative that will permit the elimination of deferred income tax accounting and eschewing the concept of determining uncertain tax positions. This should be a welcome relief for the management of SMEs, as well as the users of their financial statements, who often disregard these concepts in determining bank covenants, for example.
In addition, the proposed FRF will allow companies to again amortize goodwill and other intangible assets over the same lives as those used for income tax reporting. Under GAAP, goodwill is considered an indefinitely-lived intangible asset, not subject to amortization, but one that must be tested for impairment on at least an annual basis. Other intangible assets, such as start-up costs and organization costs, are treated as period expenses under GAAP. Using the new FRF, to defer and amortize these intangibles will make it easier to compare financial statements and tax returns.
Other comprehensive income is a concept under GAAP that measures the increase or decrease in the fair value of assets. For example, if a business owns securities that it classifies as “available-for-sale”, the change in the fair value of these securities is recorded as other comprehensive income or loss, which is reflected as a separate line item in the equity section of the balance sheet, but is not an element of the income statement. Under the proposed FRF, other comprehensive income would not be recorded, and instead the change in fair value (if recorded at all) would directly impact the income statement.
Perhaps the most significant difference between the new framework and GAAP that impacts many SMEs is the consolidation of something called Variable Interest Entities (“VIEs”). The FASB created this GAAP requirement in part as a reaction to some of the fraudulent schemes perpetrated by some public companies in the early part of this century. In a case of unintended consequences, many SMEs are also caught in this wide net, being “forced” under GAAP to consolidate entities that were often set up for tax planning purposes that have little to do with the operating entities with which they are associated. A prime example of this is an operating company that leases the building in which it operates from an entity set up for family planning purposes. The building is owned by an entity owned by the same parties that own the operating company. Under GAAP, there would be a requirement to consolidate the operating entity and the entity that owns the building, as the building entity would be considered a VIE. This may not necessarily be useful to the users of an SME’s financial statements, and often causes more confusion and expense to the owners of the SME, since the operations of the building may not be part of the borrowing agreement with the lender.
The proposed framework takes a more practical approach, and does not require the consolidation of VIEs. This can relieve a significant burden on owners of SMEs, who would otherwise have to incur additional expense to analyze whether or not to consolidate potential VIEs.
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