Audit, Compliance and Risk Blog

On July 1, 2013, the FASB issued three proposals designed to reduce the complexity of certain accounting requirements for private companies. While that is certainly the intent, some unintended consequences may result as discussed below.

Background

For the past few years, private companies have been seeking relief from some of the complexity in standards issued by the U.S. accounting standard-setter, the Financial Accounting Standards Board (FASB). Such standards result in U.S. generally accepted accounting principles, commonly known as “U.S. GAAP.” As discussed in my prior blog article, “Separate ‘Baby GAAP’ Board for Private Companies Rejected in the U.S.,” the parent organization of the FASB, the Financial Accounting Foundation (FAF), considered but rejected another body to develop U.S. GAAP for private companies. Rather, it believed that GAAP should continue to be developed by one body in the United States, and thought the FASB was the right organization for this effort. However, the FAF did create the Private Company Council (PCC) to make recommendations to the FASB on to how make U.S. GAAP for specific situations less burdensome and complex for private companies.

As structured, the PCC works jointly with the FASB to mutually agree on a set of criteria to decide whether and when exceptions or modifications to U.S. GAAP are warranted for private companies. Based on those criteria, the PCC reviews and proposes exceptions or modifications to U.S. GAAP (existing and in-process items) to address the needs of users and preparers of private company financial statements. Once exceptions or modifications are approved by the PCC, the FASB considers them and decides whether to ratify them. If they are ratified, the FASB follows its normal exposure period to solicit feedback from constituents before the changes are incorporated into U.S. GAAP via an accounting standards update to the FASB’s Codification.

Initial Proposals from the PCC

As a result of the above-described process, the first group of proposals to change U.S. GAAP for private companies was issued by the FASB on July 1, 2013, in the following three proposed accounting standards updates to the FASB Codification:

• Derivatives and Hedging (Topic) 815, Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps

• Business Combinations (Topic) 805, Accounting for Identifiable Intangible Assets in a Business Combination

• Intangibles—Goodwill and Other (Topic) 350, Accounting for Goodwill.

The FASB is seeking comments on each of these proposals through August 23, 2013, and stakeholders are being encouraged to provide feedback. The FASB did not propose any effective dates in these proposals, hoping stakeholders would provide suggestions. A brief summary of each of these proposals is provided below.

Derivatives and Hedging

The proposal for derivatives and hedging would allow private companies, as defined, specifically excluding financial institutions, to use one of two simpler methods to account for certain interest rate swaps that are entered into for the purposes of economically converting variable-rate borrowing to fixed-rate borrowing. As proposed, there is the “combined instruments” approach and the “simplified hedge accounting” approach. Under both approaches, the periodic income statement charge for the interest expense would be similar to the amount that would result if the entity had directly entered into fixed-rate borrowing, instead of variable-rate borrowing and a swap.

Intangible Assets Resulting from a Business Combination

The proposed amendments for intangible assets resulting from a business combination would be available to qualifying entities that must apply the acquisition method in Topic 805, Business Combinations. An entity that elects the accounting alternative provided for in this proposal would be subject to all of the related recognition, measurement, and disclosure requirements within the accounting alternative. The accounting alternative, if elected, would apply to all business combinations entered into after the effective date.

An entity within the scope of the proposed amendments that elects the accounting alternative would recognize separately from goodwill only those identifiable intangible assets that arise from contractual rights with noncancelable contractual terms, or that arise from other legal rights, whether or not those intangible assets are transferable or separable. An entity would be required to disclose qualitatively the nature of identifiable intangible assets acquired but not recognized as a result of applying this accounting alternative.

Goodwill Resulting from a Business Combination

The proposed amendments for goodwill resulting from a business combination would be available to qualifying entities that recognize goodwill in a business combination. An entity within the scope of the proposed amendments that elects to apply the accounting alternative in this proposal would be subject to all of the related subsequent accounting and disclosure requirements within the accounting alternative. The accounting alternative, if elected, would apply to all existing goodwill and to all new goodwill generated in business combinations entered into after the effective date of this proposal.

Specifically, an entity within the scope of the proposed amendments that elects the accounting alternative would amortize goodwill on a straight-line basis over the useful life of the primary asset acquired in a business combination, not to exceed 10 years. A primary asset is the long-lived asset that is the most significant asset of the acquired entity. Goodwill would be tested for impairment only when a triggering event occurs that would indicate that the fair value of an entity may be below its carrying amount. Moreover, goodwill would be tested for impairment at the entity-wide level rather than at the reporting unit level. The goodwill impairment loss, if any, would represent the excess of an entity’s carrying amount over its fair value. The goodwill impairment loss would not exceed the carrying amount of goodwill.

Possible Unintended Consequences of Proposals

The PCC obviously has good intentions. It currently has 10 members that serve private companies in one way or another—private company owners and managers, auditors, and others that serve this key market. However, assuming the FASB finalizes the proposed accounting standards updates allowing a “carved-out” group of private companies to avoid certain accounting followed by large public companies, do these companies really want to go down this path? What happens if in 5 years the owners decide to take the company public via an Initial Public Offering (IPO)? It happens all the time.

Based on the track record of the Securities and Exchange Commission (SEC), it would not accept the financial statements of an entity that followed the accounting in any of the three proposals. The SEC believes that all companies, including those just becoming subject to its oversight, should follow the same accounting rules because IPO pricing typically gives some weight to historical earnings per share amounts—for example, some IPOs are valued in part as a multiple of historical earnings. Accordingly, a company following the proposed accounting rules for private companies would have to “recreate” its numbers using “regular” U.S. GAAP for 5 years as it creates its IPO to file with the SEC! Not an easy task, particularly since that effort will require judgment as to what the company would have done in various scenarios. Of course, the company could concurrently keep two sets of books, but what would be the purpose of that—to keep accountants fully employed?

Yes, private companies have been looking for less onerous accounting for years, and maybe this effort will accomplish that goal. However, before such companies celebrate the pending victory, they should consider the possibility of going public someday. Look at Apple Inc. and Steve Jobs. When Mr. Jobs started that company he probably wasn’t thinking about being a public company, and now Apple is one of the largest public companies in the world! Further, many owners of privately held companies sooner or later want to sell or cash out their business and retire, and they frequently use the IPO market to do so.