The recent efforts by the accounting profession to improve private company financial reporting revealed a clear and strong demand by small and medium-size entities, the CPAs who serve them, and those who use their financial statements for a more robust and reliable financial reporting framework when GAAP is not required.
In response to that marketplace demand, the AICPA staff and a task force are developing a Financial Reporting Framework for Small- and Medium-Sized Entities. The framework is intended for entities that are not required to prepare financial statements in accordance with GAAP.
The proposed special-purpose framework is geared for simplicity. It emphasizes historical cost over fair value. It calls for reporting of costs when they are incurred and revenue when performance is achieved with reasonable assurance that collection will occur.
Traditional accounting methods and accrual income tax methods are blended into the proposed framework. Preparers who follow the proposed framework will find that it reduces the number of Schedule M differences that a business would have to report on its tax returns to reconcile its financial statements to its taxable income.
As proposed, the framework is designed to facilitate the creation of financial statements that provide users, especially banks, the information they need without unnecessary disclosures that increase the time and expense of preparation.
SMEs run by owner-managers are expected to find the proposed framework especially useful, as the financial statements prepared under the framework will confirm their assessments of performance, describe what they owe and own, and help users understand cash flows. The proposed framework is intended for SMEs whose financial statement users have direct access to management, and is intended for companies that have no intention of going public.
No concept of variable-interest entities is included in the proposed framework, and preparers have the option of presenting parent-only financial statements. In addition, the proposed framework will not include a concept of other comprehensive income, and it will not require complicated accounting for derivatives such as interest rate swaps. Derivatives will be handled largely through disclosure, eliminating complicated issues.
An exposure draft of the framework was released Nov. 1 at aicpa.org/FRF-SMEs, with comments due Jan. 30. The completed framework is scheduled to be released in the second quarter of 2013.
To provide more information on the framework, the JofA organized a round table with AICPA Vice President—Professional Standards & Services Chuck Landes and two members of the project task force, Pat Piteo and Tom Ratcliffe.
Chuck Landes is vice president–Professional Standards & Services for the AICPA and has led the staff effort to develop the Financial Reporting Framework for Small- and Medium-Sized Entities (FRF-SME).
Pat Piteo is an audit partner for Cohen & Co. Ltd. in Akron, Ohio, who provides compilations and reviews as well as audit and attest services for clients. She is a member of the task force that is developing the FRF-SME.
Tom Ratcliffe serves on the FRF-SME task force and is a senior accounting and auditing technical adviser for Warren Averett LLC in Montgomery, Ala.
Here are excerpts from that conversation:
Tysiac: How will this framework change private company financial reporting?
Landes: The framework focuses on historical cost because what we have heard for several years now is that most users of small business financial statements are interested in the cash flow. Fair value accounting doesn’t impact cash flow, and it’s more expensive to use. For example, a banker wants to know that an entity has the cash flow necessary to pay its loan. An insurance company wants to know that a small business, if they’re giving a bond on performance, has sufficient cash flow out of their construction operations to complete the project. And so what we’ve been hearing over probably the last five years is that a lot of the new accounting standards simply are not relevant to the needs of users of small businesses. So … the No. 1 difference [between the Framework for SMEs and U.S. GAAP] will be that this framework really does not use fair value except in a few areas. It’s based on historical costs.
The second major difference is that there are more options built into the framework that will allow a practitioner working with his or her client to tailor the presentation to the needs of a user. Let me just give you a quick example. Many bankers [work with] small businesses that might have their real estate in a separate partnership or a separate company. Under generally accepted accounting principles, [the businesses] have to consolidate that real estate in with their operations. And the banker may say to the small business owner, “I know all about your real estate operation because I hold the mortgage on that. What I want to see is just a picture of your operations.”
And today the small business owner has to say, “Well, under GAAP, I have to consolidate that.” And it’s very frustrating to both the owner and the user, not to mention the CPA who is trying to serve this client, not to be able to provide something to the user that is relevant and cost-effective. So that’s going to be another change that folks will see, there is some optionality built in here for the CPA working with a small business client to tailor some of the disclosures, to tailor some of the accounting to meet the needs of the users.
So the two major changes are almost no fair value, and secondly, more optionality introduced, which, as a result, will really make the financial statement preparation more cost-beneficial and more relevant to the end user.
Tysiac: What niche will this fill in the marketplace? Why is there such a great need for this framework?
Landes: I’d say the need really comes about as a result of the frustrations around some of the more costly accounting standards that small businesses have to comply with if they follow GAAP. We’ve been hearing some of these complaints [for years] … So what we’re trying to do is serve a marketplace where GAAP financial statements are not necessary. The user, however, wants a good, solid accounting framework, one that’s been through due process, that they know the CPA professional has been involved with, and one that will provide more relevant financial information.
Tysiac: Is it important to be clear that the framework is not in competition with GAAP, that it’s intended for businesses that are not required to file financial statements that are prepared in accordance with GAAP?
Ratcliffe: That is unquestionably the truth. In fact, this framework we are developing is a special-purpose framework that is by definition not U.S. GAAP, or GAAP at all under any meaning of GAAP under the AICPA Code of Professional Conduct. So it is not a GAAP framework, but it is self-contained, it is robust, and it is a framework that can be used by a variety of different entities. [The framework is] a little more than 200 pages with a companion volume that will be [released along with the final framework] to help folks in some implementation issues.
Tysiac: Are CPAs themselves going to have to play key roles in the marketing of the framework, spreading the word? How do they pitch it to their clients?
Piteo: CPAs are going to have to have a real role in marketing this. I don’t think that this will be a tough sell to our clients at all. We’re on the front lines. We’re hearing a lot of complaints about the excess disclosures and requirements. I think the real sell has to be to the external user for these clients. We as CPAs have to educate the bankers so that they’re comfortable requesting these financial statements under this framework. Again, I don’t think that will be a tough sell.
Tysiac: I’ve heard the framework described as “principles based” rather than “rules based.” Is this the case, and why does this make sense for this kind of company?
Landes: I suspect the reason you’re hearing that is that what we’re trying to do with the framework is not to create pages and pages and pages of guidance and interpretations. The term “principles based” versus “rules based” gets confused oftentimes. Even most rules are based on good principles. The difference is the quantity of material that one has to look at and the number of bright lines presented.
What we’re doing here is essentially creating a framework where everything is going to be in one document, a little more than 200 pages. So if you want to research something on how to account for a certain transaction, it’s going to be easy to find.
The flip side, and this goes to your question of principles based versus rules based, is that we won’t have tons and tons of bright lines. So practitioners will have to say, “OK, I understand the idea here. Now I’m going to have to apply my own professional judgment in looking at the actual facts and circumstances of my client and advise them on the right way to do that.” It’s a good thing in that I think it does allow practitioners to use their professional judgment.
Tysiac: The AICPA has proposed changes to auditing standards that would pave the way for audits of the Framework for SMEs. Will the framework have any benefits from an auditing perspective?
Piteo: I think in eliminating some or all of the fair value requirements and disclosures, that’s going to reduce the audit work we have to do in that case. Especially in smaller companies, getting valuations of things like goodwill makes the audit very difficult and much more expensive than it needs to be for the benefit of that information. The use in [compilations] and reviews is where you’re going to see the beginning of it, but I definitely see it having a good aspect in audits, too, for our smaller clients who just have requirements from their bank.
Tysiac: Would there be a post-implementation review of the framework, and when would that take place?
Landes: What we think we’ll have is a very stable platform, if I can use a computer analogy. And therefore let’s not tinker with it. Let’s not come back and keep telling practitioners, “This is changing. That is changing.” Let’s just set it out there for three, four years—I can’t tell you exactly what that time frame will be—and then we’ll come back and visit it.
Tysiac: What will success look like for this framework five years from now?
Ratcliffe: I would say success would be that you will see more and more financial statements prepared using this framework. I think we have a real potential of achieving that goal … It will be a success for all stakeholders who for years have been saying that something like this needed to be developed, and I think that probably will be within that five-year threshold.
Piteo: I just look at success as being defined as acceptance, that this is out there and accepted by banks and used by our clients so that they can get the benefits of this. So in five years, I hope all my clients that are smaller than a certain amount are using this and having the banks accept it.
Separate initiatives for private companies
Two major developments in private company accounting and financial reporting over the past year have separate constituents. Here is a brief summary about each private company initiative:
Framework for SMEs:
- Developed by AICPA
- For use by non-GAAP filers
- Comments on ED due Jan. 30
- Final version expected 2Q 2013
Private Company Council:
- Formed by Financial Accounting Foundation
- Creating exceptions for filers that use U.S. GAAP
- Meets for first time Dec. 6
- Timetable for exceptions uncertain
The new Financial Reporting Framework for Small- and Medium-Sized Entities that is being developed by the AICPA will focus on historical cost and provide CPA practitioners who are working with small business clients more options to tailor financial statements to the needs of users.
SMEs that are not required to prepare financial statements in accordance with GAAP will be able to use the framework to produce financial reporting that is relevant to users at a reasonable cost.
When completed, the project is expected to produce a framework of a little more than 200 pages along with a companion volume to aid implementation.
The framework will be designed to be a relatively stable document because preparers of small business financial reports often complain that frequent changes to accounting standards create unnecessary complexity. After the framework is completed, it may take three or four years before it is reviewed and updated.
CPAs will need to educate the bankers who are the primary users of financial statements prepared for their small business clients on the benefits of using statements prepared under the framework.
The proposed framework can be viewed at aicpa.org/FRF-SMEs. Comments are due on Jan. 30.
Ken Tysiac is a JofA senior editor. To comment on this article or to suggest an idea for another article, contact him at email@example.com or 919-402-2112.
- “Back to Basics: Proposed Framework for SMEs Geared for Reliability and Simplicity,” Nov. 2012, page 32
- “Small Businesses, Big Risk,” Aug. 2012, page 38
- “Gaining (From) Your Clients’ Trust,” May 2012, page 38
- “Pricing, Billing and Collecting Fees,” Feb. 2012, page 24
- “One Size Does Not Fit All,” Jan. 2012, page 46
- Adviser’s Guide to Retirement Plans for Small Businesses (#017260PDF, on-demand)
- Quick and Easy Business Continuity Plan for Your Small Business: Step-by-Step Template With Sample Plans on CD (#991011, CD-ROM)
Innovative Tax Planning for Small Businesses: Corporations, Partnerships & LLCs (#745524)
For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.
To access the ED, CPE and learning opportunities, an educational toolkit, and more, visit the FRF-SME website at aicpa.org/FRF-SMEs.