February 27, 2014
In January 2014, the FASB issued the first two Accounting Standards Updates [ASUs] that make amendments to the FASB Accounting Standards Codification [ASC] to provide for accounting alternatives that can be used by certain private company reporting entities. Neither of the new accounting alternatives can be used by reporting entities that are public business entities [PBEs]. After release of this new guidance, questions have been raised as to whether certain reporting entities would fall under the FASB definition of PBEs, how the alternatives should be implemented initially, and whether use of the alternatives would be appropriate in certain circumstances.
Practice Note: In December 2013, the FASB released ASU 2013-12, Definition of a Public Business Entity, that added the definition of a PBE to the FASB ASC Master Glossary. That definition will be used by the PCC to, in part, determine which reporting entities qualify for use of the private company alternatives within U.S. generally accepted accounting principles [U.S. GAAP].
The first two Private Company Council [PCC] recommendations that were endorsed as final ASUs to amend the FASB ASC by the FASB are:
- ASU 2014-02, Accounting for Goodwill, that amends the guidance in FASB ASC 350, Intangibles – Goodwill and Other
- ASU 2014-03, Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps – Simplified Hedge Accounting Approach, that amends the guidance in FASB ASC 815, Derivatives and Hedging.
Practice Note: In addition to PBEs not being able to utilize the above-noted accounting alternatives, the guidance also cannot be used by not-for-profit [NFP] entities and employee benefit plans. Also, financial institutions are not allowed to use the simplified hedge accounting alternative that exists through the ASU 2014-03 amendments to FASB ASC 815.
Understanding Whether Reporting Entities are PBEs
Given the new definition of PBEs, it might be helpful for financial statement preparers to determine whether reporting entities qualify for using the private company accounting alternatives through addressing certain questions, where a “yes” answer to any of the following questions would have the result of reporting entities not being able to use the alternatives:
- Is the reporting entity required by the U.S. Securities and Exchange Commission [SEC] to file or furnish financial statements, or does file or furnish financial statements [including voluntary filers], with the SEC [including other entities where financial statements or financial information are required to be or are included in a filing]?
- Is the reporting entity required by the Securities Exchange Act of 1934 [the 1934 Act], as amended, or rules or regulations promulgated under the 1934 Act, to file or furnish financial statements with a regulatory agency other than the SEC?
- Is the reporting entity required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer?
- Has the reporting entity issued, or is the reporting entity a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market?
- Does the reporting entity have one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements [including notes to the financial statements] and make them publicly available on a periodic basis [for example, interim or annual periods]?
Practice Note: Although, by definition, reporting entities with immediate plans to go public or to be purchased by a PBE currently would not meet the definition of a PBE, it might not be practical to elect the accounting alternatives when, at a future date, those accounting alternatives will not be available. The reason is that the time and cost savings associated with using the accounting alternatives easily could be more than offset by having to recast financial statements not incorporating use of the accounting alternatives.
Among the reasons resulting in questions being raised about whether reporting entities can use the private company accounting alternatives is that certain private companies actually can be considered PBEs even though the private companies would not be considered public on a standalone basis. Some of the issues resulting in these questions serve as the basis for discussions in the remainder of this section.
Broker-Dealers. As discussed in the Basis for Conclusions in ASU 2013-12, brokers and dealers in securities that are regulated by Rule 17a-5 under the 1934 Act, as well as nonissuer broker-dealers filing with the SEC are considered to be PBEs. As such, broker-dealers are not allowed to use the private company accounting alternatives since they are required to provide financial statements or furnish financial information to the SEC.
Equity-Method Investments Held by PBEs. It is not uncommon for PBEs to hold financial interests in investee entities where the financial interests result in PBEs having the ability to exercise significant influence over the operating and financial policies of the investee entities. In these situations, PBEs would need to account for the equity method investments using the guidance in FASB ASC 323, Investments – Equity Method and Joint Ventures. As such, while the equity method investees might not be PBEs in their own right, they would be considered to be PBEs in that their financial information is included in the financial statements of investor entities that are PBEs.
Government Contractors. Government contractors that are not required to follow the accounting guidance established by the Governmental Accounting Standards Board [GASB] so that they follow the FASB guidance would be allowed to utilize the alternative accounting guidance, as long as they do not meet the definition of being PBEs. The government allows contractors to submit financial statements using an approved financial reporting framework, and U.S. GAAP would be an approved financial reporting framework.
Practice Note: Use of the PCC accounting alternatives within U.S. GAAP still results in a presentation that is in accordance with U.S. GAAP. The private company accounting alternatives should be addressed in the same manner as other alternatives that exist within U.S. GAAP. As examples, acceptable accounting alternatives for inventory exist as well as acceptable accounting alternatives for recording depreciation on fixed assets. Use of any of the acceptable alternatives results in financial statements being presented in accordance with U.S. GAAP.
Entities Subject to OMB Circular A-133 Audits. Reporting entities that are subject to OMB Circular A-133 audits that expend more than $500K annually in federal funds are required to present their financial statements using an approved financial reporting framework, unless otherwise stated in their government grants and contracts. Since U.S. GAAP is an approved financial reporting framework and use of these private company accounting alternatives results in a financial statement presentation in accordance with U.S. GAAP, reporting entities subject to OMB Circular A-133 audits would be allowed to use the private company accounting alternatives unless they are otherwise considered to be PBEs.
Practice Note: Since NFP entities are not permitted to utilize these accounting alternatives, the situation described above only would apply to for-profit entities that are subject to the OMB Circular A-133 audit requirements.
Other Governmental Units or Entities. Governmental entities that are required to follow the guidance promulgated by the GASB are not allowed to use the FASB private company accounting alternatives. Other governmental units or entities that are not otherwise considered to be PBEs would be allowed to elect use of the accounting alternatives.
Currently, when reporting entities qualifying to use the private company accounting alternatives need to provide financial statements to governmental agencies, use of the available accounting alternatives is acceptable. However, it could be that, at some future point, the Government Accountability Office [GAO] or other select government agencies [for example, the U.S. Department of Health and Human Services, U.S. Department of Housing and Urban Development, etc.] might not consider it acceptable for reporting entities required to provide financial statements to utilize the alternatives.
Practice Note: Exceptions could be written into government contracts that would prohibit the use of the accounting alternatives under U.S. GAAP. However, at this point, this result is not considered likely since, traditionally, governmental agencies have not rejected financial statements prepared according to U.S. GAAP, without regard to the specific accounting policies those reporting entities have elected for use in preparing their financial statements.
Establishment of Preferability Upon Initial Adoption
Private companies initially adopting the PCC alternatives within U.S. GAAP do not need to establish preferability for using the new accounting alternatives under FASB ASC 250, Accounting Changes and Error Corrections, in that the FASB intends for the use of the alternatives to be entirely elective. However, as discussed later, when private companies make the initial election in the year of adoption and then decide in a later reporting period to change that election, there would be the need to satisfy the preferability criterion within FASB ASC 250.
Practice Note: Using the guidance in FASB ASC 250-10-45-2, reporting entities are allowed to change accounting principles only if the change is required through amendments to the FASB ASC or when reporting entities can justify the use of an allowable alternative accounting principle on the basis that it is preferable. As noted above, use of the private company accounting alternatives does not result in the need to justify the change in accounting principles upon initial adoption of the accounting alternatives in that the alternatives were developed with the intent of enhancing the private company reporting process.
Election of One or More Accounting Alternatives
As mentioned earlier, use of the private company accounting alternatives should be considered policy elections in much the same manner as other policy choices are available within U.S. GAAP. As such, with the two current alternatives, an election could be made to use the alternative associated with amortizing goodwill while not electing to use the simplified hedge accounting alternative. Essentially, electing to use one or more of the private company accounting alternatives does not result in the requirement to use all of the available alternatives.
FASB ASC 235, Notes to Financial Statements, provides guidance about policy note disclosures. In FASB ASC 235-10-05-4, it is clear that the usefulness of financial statements for purposes of making economic decisions depends significantly on the ability of users to understand the accounting policies followed by reporting entities. Using the private company accounting alternatives in preparing financial statements easily could result in significant differences in the financial statements when compared to not using the alternatives. To that end, policy note disclosures need to be clear as to the accounting approach used in preparing the financial statements when alternative accounting treatments are available.
Practice Note: When consolidated financial statements are being prepared, an accounting policy decision on whether to adopt the private company accounting alternatives is needed at the consolidated entity level. So, for example, if a subsidiary entity has financial statements prepared using one or more of the accounting alternatives, and the parent company does not elect to use the accounting alternatives, the subsidiary entity financial statements would need to be recast in that election of the goodwill accounting alternative is an all or nothing proposition.
Reporting and EOM Paragraphs
When the private company accounting alternatives are used in preparing financial statements, questions have arisen as to whether practitioners would need to emphasize this matter in their compilation, review, and audit reports. The Statements on Standards for Accounting and Review Services [SSARSs] requirements for compilation and review engagements differ from requirements in the Statements on Auditing Standards [SASs] that need to be followed in audit engagements.
Audit Engagements. When auditing financial statements where the election is made to use the private company accounting alternatives in preparing reporting entity financial statements, the auditing technical literature that needs to be followed in addressing a change in accounting principle is in paragraphs .07 through .12 of AU-C section 708, Consistency of Financial Statements. There, in addition to performance requirements that need to be followed, the key reporting issue that needs to be addressed is whether an emphasis-of-matter [EOM] needs to be added to audit reports. The key issue in making that decision is whether the change in accounting principle has a material effect on the financial statements.
Practice Note: Using the requirements in AU-C section 708, auditors need to evaluate changes in principle to determine whether the newly-adopted principle is in accordance with the applicable financial reporting framework, the method of accounting for effect of the change is in accordance with the applicable financial reporting framework, the disclosures related to the accounting change are appropriate and adequate, and the reporting entity has justified that the alternative accounting principle is preferable. On the last point, as noted from an accounting perspective earlier, initial adoption of the new private company accounting alternatives should present no challenges from an audit perspective.
As an example, assume the election has been made for a private company to use the alternative accounting for goodwill. The election has been made to use the accounting alternative assuming that the calendar-year 2013 financial statements have not yet been made available for issuance by the reporting entity and, therefore, early adoption is permitted. An example EOM paragraph that would need to be added to audit reports to address this situation, assuming the change is material to the financial statements, is as follows:
As discussed in Note X to the financial statements, in 2013, the Company changed its method of accounting for goodwill. Our opinion is not modified with respect to this matter.
Practice Note: Without the required disclosures in the financial statements related to significant accounting policies as well as other required disclosures, there would be a departure from U.S. GAAP that could not be addressed simply through an EOM paragraph. When required disclosures are omitted from financial statements, auditors work with their clients to ensure that appropriate disclosures are added to the statements. In rare situations where required disclosures ultimately are not added to the financial statements, there would be a departure from U.S. GAAP that would need to be addressed in audit reports using the requirements in AU-C section 705, Modifications to the Opinion in the Independent Auditor’s Report.
Compilation and Review Engagements. When compiling or reviewing financial statements where the election is made to use the private company accounting alternatives in preparing reporting entity financial statements, the current compilation and review technical literature differs significantly from the auditing technical literature. The applicable compilation engagement literature related to EOM paragraphs is in paragraphs .25 through .26 of AR section 80, Compilation of Financial Statements. The applicable review engagement literature related to EOM paragraphs is in paragraph .33 of AR section 90, Review of Financial Statements. Neither the compilation nor the review engagement technical literature includes the requirement for practitioners to add EOM paragraphs to their reports in any circumstances; rather, EOM paragraphs may be added to compilation or review reports using practitioner discretion.
Practice Note: Unlike the auditing technical literature, the compilation and review technical literature does not contain requirements for practitioners to modify their reports for changes in accounting principles or to address material uncertainties. Somewhat similar to the requirements in the auditing technical literature, if compiled or reviewed financial statements do not contain required disclosures, there is the requirement to modify compilation or review reports to address the known departure from the applicable financial reporting framework.
Prior Year U.S. GAAP Departures
In some cases, financial statements of private companies are not prepared to comply with all U.S. GAAP requirements in that following that guidance is not deemed to be cost effective. When the U.S. GAAP departures are material to the financial statements, the result has been that auditors have needed to qualify their audit opinions on the financial statements and practitioners who have been compiling or reviewing the financial statements have had to modify their compilation or review reports to address the known GAAP departures.
Practice Note: When auditing financial statements, departures from the applicable financial reporting framework actually are addressed in audit reports through considering whether qualified or adverse opinions are needed. As a practical matter, qualified opinions are included in audit reports to address these type departures in that preparers would not elect to have the departures if the result would be receiving adverse opinions on the financial statements.
Before electing to utilize the private company accounting alternatives, preparers of financial statements of reporting entities need to carefully consider the feasibility of using the alternatives. For example, if a reporting entity has been taking a U.S. GAAP departure in the past on goodwill accounting through amortizing goodwill, electing the private company accounting alternative to amortize goodwill could be problematic. One of the challenges might be that the FASB ASC 350 guidance before the private company alternatives were incorporated includes the requirement for reporting entities to assess goodwill for impairment on at least an annual basis. If the impairment assessments were not made appropriately, it could be problematic, and perhaps not possible, to look back to previous reporting periods in efforts to make those assessments.
Private Companies Becoming PBEs
Care needs to be exercised in reaching conclusions associated with use of the private company accounting alternatives when reporting entities could become PBEs, where use of the alternative accounting treatments would not be allowed. Without any additional guidance from the FASB, changes between using the private company accounting alternatives and not using the alternatives would need to be accounted for using the guidance in FASB ASC 250 where that guidance requires retrospective application of the change in accounting principles unless retrospective application is considered impracticable. While changing from use of the private company accounting alternatives to not using those alternatives could prove to be challenging, in most situations the result would be that the changes would not rise to the level of being impracticable.
Practice Note: Having to recast financial statements so that they are prepared not using the private company accounting alternatives after the statements have been prepared using the private company alternatives easily could reverse any time and cost savings that were present through use of the alternatives.
Acceptance by Users of the Financial Statements
Even when private companies are not considered to be PBEs and when there are no plans associated with becoming PBEs, care needs to be exercised to ensure that users of private company financial statements would accept statements using the private company accounting alternatives before even attempting to use the accounting alternative treatments. Accounting issues paralleling those discussed previously when private companies become PBEs could be encountered in this situation as well in that, if financial statements are prepared using the accounting alternatives, and the users of the financial statements will not accept the statements using the alternatives, the statements would have to be recast so that they are prepared without using the alternatives.
Practice Note: Reporting entities with debt covenants or other requirements to provide financial statements to banks or other lending institutions may want to contact those third parties before electing the private company accounting alternatives to ensure they would be acceptable for those third party users. When lending institutions only require that financial statements be prepared using U.S. GAAP, use of the private company alternatives within U.S. GAAP still would result in financial statements being prepared in accordance with U.S. GAAP in that the alternatives are incorporated within U.S. GAAP.