The American Institute of Certified Public Accountants (AICPA) has announced a new option for small business financial reporting. The “Financial Reporting Framework for Small- and Medium-Sized Entities” (SME framework) is intended to ease reporting for smaller, privately held, owner-managed businesses that aren’t required to abide by Generally Accepted Accounting Principles (GAAP). The framework is intended to help these businesses clearly and concisely report what they own, what they owe and their cash flow.
The SME framework draws on a blend of traditional methods of accounting and some accrual income tax methods to address the issues and concerns stakeholders currently encounter when preparing financial statements for SMEs. The AICPA believes the SME framework to be a cost-efficient solution for management, owners and others who require financial statements that are prepared in a consistent and reliable manner in accordance with a non-GAAP framework that has undergone public comment and professional scrutiny. The most frequently used special purpose frameworks — the cash basis and tax basis of accounting — haven’t undergone such public exposure and professional scrutiny.
Still, the SME framework has no official or authoritative status. In addition, the AICPA has made it clear that the SME framework isn’t meant to replace GAAP — it’s for those entities that don’t require GAAP reporting.
The framework’s advantages
According to the AICPA, the SME framework provides efficient, meaningful financial statements without needless complexity or cost. In contrast to GAAP’s prescriptive, detailed standards and voluminous disclosure requirements, the new option is a streamlined framework providing the financial information that’s relevant to owner-managed SMEs and their external stakeholders (including lenders), focused on the performance of the SME and its assets, liabilities and cash flows. Key measures of a business and its creditworthiness that will be reported include profitability, cash available and assets to cover expenses.
The framework is constructed of accounting principles that are particularly suited for a typical SME. To this end, among other things, it:
• Uses historical cost as its measurement basis, allowing SMEs to avoid complicated fair value measurements,
• Reduces book-to-tax differences,
• Doesn’t require complicated accounting for derivatives, hedging activities or stock compensation, and
• Targets its disclosure requirements to provide users of financial statements with the relevant information they need while recognizing that those users can obtain additional information from management if they desire.
It also provides a degree of flexibility to allow SMEs to appropriately communicate their situations to financial statement users with those users’ specific needs in mind.
Who should use the framework?
Although the framework doesn’t specifically define “SME” or provide quantified size criteria, the AICPA has identified several characteristics of typical entities that could use the SME framework. Such an entity:
• Isn’t subject to regulatory reporting requirements that essentially require it to use GAAP-based financial statements,
• Doesn’t intend to go public,
• Is for-profit,
• May be owner-managed, meaning a closely held company where the individuals with a controlling ownership interest are substantially the same people who run the company (as opposed to public companies where the ownership and the management are clearly separated),
• Has owners and managers who rely on a set of financial statements to confirm their assessments of performance, cash flows, what they own and what they owe,
• Doesn’t operate in an industry where it’s involved in transactions that require highly specialized accounting guidance (for example, financial institutions or governmental entities),
• Doesn’t engage in overly complicated transactions, and
• Doesn’t have significant foreign operations.
The AICPA’s cited characteristics also consider the users of the entity’s financial statements. It indicated the framework could be appropriate if key users have direct access to the entity’s management and users are primarily interested in cash flows, liquidity, statement of financial position strength and interest coverage. It could also be appropriate if the entity’s banker doesn’t base lending decisions solely on financial statements, but also on available collateral or other evaluation mechanisms not directly related to the financial statements.
The framework is appropriate for entities in most industry groups and both unincorporated and incorporated entities. Moreover, the AICPA has stated that it doesn’t intend to exclude entities that aren’t owner-managed from using the framework. Indeed, entities that have nonowner operational management may find the framework to be a wise choice for their financial reporting needs.
Additional GAAP options for private companies
On the same day the AICPA’s SME framework was released, the Financial Accounting Standards Board (FASB) endorsed three proposals from the Private Company Council (PCC) that would ease accounting requirements for privately held companies. The PCC is focused on modifications to GAAP for private companies that need or are required to have financial statements prepared in accordance with GAAP.
Both FASB and the PCC operate under the auspices of the Financial Accounting Foundation. They’re working together to identify opportunities to enhance the relevance to users and reduce the cost and complexity of preparing private company financial statements under GAAP.
The endorsed proposals would:
• Provide relief from requirements that certain intangible assets acquired in a business combination, such as a merger, be separately recognized,
• Allow the amortization of goodwill and a simplified goodwill impairment model, and
• Allow two simpler approaches to accounting for certain types of interest rate swaps when a private company intends to economically convert the interest rate on its debt from variable to fixed.
The AICPA has stated that its framework complements the PCC’s efforts to modify GAAP for private companies.
Because use of the SME framework is optional, there’s no effective date for its implementation. Businesses, however, will need to carefully consider which alternative is best for their circumstances before making any changes. We’d be pleased to help you chart the best course for your financial reporting.
For more information contact David Holmes at [email protected] David is a Shareholder with Clark Schaefer Hackett and Chairs the firm’s Assurance Services Group.