“Do we really need to report all this? I have no idea what an ‘uncertain tax position’ means, or what relevance it has to my business and its financial statements. Why do I need to consolidate a related party entity that owns the building of which my bank and I are fully aware? I just acquired a competitor, and now you tell me I have to do a costly study to separate goodwill from other intangible assets?” These can be common reactions from small and medium-sized businesses when they are preparing financial statements. Preparing financial statements in conformity with U.S. generally accepted accounting principles (GAAP), and all the requirements that come with GAAP reporting, can sometimes cause an undue administrative and financial burden on some small and medium-sized entities (SMEs).
Fortunately for these types of businesses, there is now another alternative. In June 2013, the American Institute of Certified Public Accountants (AICPA) released its Financial Reporting Framework for Small and Medium-Sized Entities (FRF for SMEs). This new reporting framework is a principles-based framework that provides a new method for preparing streamlined financial statements for privately held businesses.
So, what is a “Financial Reporting Framework”, or “FRF” and what is a “Small or Medium-Sized Entity”? All financial statements are prepared in accordance with an FRF. An FRF is a defined set of criteria used to determine measurement, recognition, presentation and disclosure of financial statement elements. GAAP and International Financial Reporting Standards (IFRS) are other examples of FRF’s in addition to the new FRF for SMEs. The definition of an SME is more nebulous. The AICPA intentionally did not place a quantitative limit on size when developing the new FRF. However, SMEs share certain characteristics, as outlined in the preface of the FRF for SMEs; these characteristics include
- Being a for-profit business
- Not having a regulatory requirement to use GAAP
- Having no plans of going public
- There are no overly complicated transactions
- Users of the financial statements have direct access to the entity’s management
- The entity does not have significant foreign operations
- The entity does not operate in an industry that is involved in transactions that require highly specialized accounting guidance, such as financial institutions and governmental entities
- The entity is owner-managed
- Management and owners rely on a set of financial statements to confirm their assessments of performance
- Users of the entity’s financial statements are most interested in cash flows, liquidity, financial position strength and interest coverage
- The financial statements support applications for bank financing when the lender does not base lending decisions solely on financial statements, but also on available collateral or other evaluation mechanisms not directly related to the financial statements
One of the advantages to using the FRF for SMEs is that it provides an alternative for owner-managed businesses that may not require GAAP financial statements. Using this framework can potentially provide more meaningful financial statements, while reducing unnecessary complexity and cost that can be associated with GAAP. Some of the ways in which using the new framework accomplishes this are:
- Using historical cost as a measurement basis, rather than fair value
- Having a far less complex methodology for accounting for things such as derivatives, hedging activities and share-based compensation
- There is no need to consolidate Variable Interest Entities
- There is no disclosure or accounting requirement for uncertain tax positions (which many have referred to as a “roadmap for the IRS”)
- There is no requirement for reporting comprehensive income
- Goodwill is amortized over the same period as for income tax reporting – 15 years (no more costly impairment analysis)
- A choice to elect not to account for deferred income taxes
All of the above examples and the differences between the principles under the FRF for SMEs and GAAP, can save small businesses a significant amount of time, aggravation, and money.
Another attractive characteristic of the FRF for SMEs is that it is a framework that has undergone public comment and professional scrutiny from the accounting community. Unlike other special purpose frameworks, such as cash basis or income tax basis accounting, the FRF for SMEs is composed of specific accounting principles that will provide a consistently applied methodology, while still allowing a cost-beneficial alternative to GAAP reporting.
One key distinction to note between the FRF for SMEs and GAAP is that the FRF for SMEs is not “authoritative”. What this means is that, although the new framework has been subjected to public comment and professional scrutiny, it has not been approved, disapproved, or otherwise acted upon by any senior technical committee of the AICPA or the Financial Accounting Standards Board (FASB), and has no official or authoritative status like GAAP. However, the new framework is based on consistent principles and can provide more meaningful financial reporting information for small and medium-size entities and the users of their financial statements.
The new financial reporting framework for privately held companies will make financial reporting much less complex, and less costly, for those companies, while still providing useful, relevant information for both management and third party users of their financial statements. This will be a welcome relief for owner-managed businesses, which are the backbone of the U.S. economy. In addition, financial statements that provide useful and pertinent information affecting lending decisions should be a welcome sight for lenders and other third party users of financial statements. Companies considering a change should ensure that all users (especially bankers) are on board.
For more information on affordable financial reporting for small businesses, contact Jim Suttie by leaving a comment below or by calling 440-449-6800.