Tuesday, July 21, 2009

U.S. Private Companies Now Have Additional Accounting Alternatives

Although there has often been a call for simplified accounting principles for smaller or non-public enterprises, U.S. generally accepted accounting principles (GAAP) do not have a separate financial reporting standard for smaller companies. This changed last week, when the International Accounting Standards Board (IASB) approved a new and simplified set of accounting rules for small and medium sized businesses (SME). The rules are a shorter version of International Financial Reporting Standards (IFRS). U.S. private companies can adopt IFRS and have their financial statements be in full compliance with generally accepted accounting principles in the U.S.

The IASB described the new standards as follows:

"The IFRS for SMEs is a self-contained standard of about 230 pages tailored for the needs and capabilities of smaller businesses. Many of the principles in full IFRSs for recognizing and measuring assets, liabilities, income and expenses have been simplified, topics not relevant to SMEs have been omitted, and the number of required disclosures has been significantly reduced. To further reduce the reporting burden for SMEs, revisions to the IFRS will be limited to once every three years."

Portions of this description deserve emphasis, since it is so different than the status quo. Specifically:

1. At 230 pages, IFRS for SMEs is about 10-15% of the length of the full set of IFRS, commonly described as containing approximately 2,500 pages. But, the size difference is even more dramatic when compared to U.S. GAAP. Even after the Financial Accounting Standards Board's recent "simplified" Accounting Standards Codification, IFRS for SMEs is approximately only 1% the length of U.S. GAAP.

When compared to full IFRS, IFRS for SME eliminates over three-quarters of the disclosures, omits topics that are not likely to be relevant to smaller enterprises, provides fewer choices (although the more complex options can still be elected), and are written in "plain English".

2. Pledging to not change these rules but once every three years is dramatically different that what has occurred under the U.S. accounting rule makers. Since all of the IFRS is principles-based, rather than rule-based, there should not be a need to create a new rule whenever some creative accountant comes up with a cleaver way of skirting existing U.S.-based detailed rules.

But, with fewer rules, more judgment is needed with IFRS. IFRS provides less implementation guidance and practically no industry-specific guidance. Because of this, critics contend that IFRS provides less comparability between financial statements of different companies. IFRS supporters counter that comparability is improved to the extent that IFRS prevents improper accounting by preventing abuse of rules that are too specific. This possible abuse occurs under a rule-based approach when financial engineering of transactions is allowed using accounting applications that, although technically compliant, do not reflect the economic substance of the transaction. See principles-based accounting for more information.

3. Interestingly, the definition of "small and medium sized" has nothing to do with size at all, but instead involves the lack of public accountability. The vast majority of U.S. private companies fit that definition regardless of how large they are. The definition of an SME from the standards follows:

1.2 Small and medium-sized entities are entities that:

a. do not have public accountability, and

b. publish general purpose financial statements for external users. Examples of external users include owners who are not involved in managing the business, existing and potential creditors, and credit rating agencies.

1.3 An entity has public accountability if:

a. its debt or equity instruments are traded in a public market or it is in the process of issuing such instruments for trading in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets), or

b. it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. This is typically the case for banks, credit unions, insurance companies, securities brokers/dealers, mutual funds and investment banks.

U.S. GAAP is fading away

Given that the IFRS is effectively replacing the AICPA as an accounting standards setter, the AICPA is surprisingly supportive of the new standard. According to the AICPA:

"AICPA members [have] the option to use IFRS as an alternative to U.S. GAAP. As such, any professional barrier to using IFRS and therefore IFRS for SMEs has been removed. … The AICPA's governing Council recognizes the IASB as an accounting body for purposes of establishing international financial accounting and reporting principles. Full IFRS and IFRS for SMEs are not an other comprehensive basis of accounting. Rather, they are generally accepted accounting principles".

The AICPA continues by acknowledging possible superiority of the new rules, as follows:

"Some U.S. private companies may find the simplified IFRS for SMEs an attractive alternative to the more complicated and voluminous U.S. GAAP. Those private companies may find IFRS for SMEs to be a more relevant and less costly financial accounting and reporting standard than U.S. GAAP."

Other major accounting organizations, including the Institute of Management Accountants and Financial Executives International, have also suggested that companies should consider switching to the simplified standard.

Similar (but slower) changes are occurring for larger companies that are SEC registrants. In late, 2007, the SEC announced it would allow foreign public companies to issue financial statements in the U.S. under IFRS. Related Rule 33-8879 permits no reconciliation between IFRS and U.S. GAAP results. In August 2008, the SEC announced a roadmap to begin to permit registrants to file statements under IFRS.

Comparison to U.S. GAAP

Some of the key differences between IFRS for SMEs and U.S. GAAP are:

1. Disclosures are simplified in a number of areas, including pensions, leases, and financial instruments.

2. LIFO is prohibited.

3. Goodwill and indefinite life intangible assets are amortized over a period of 10 years or less.

4. Depreciation is based on a components approach.

5. Revenue recognition is based on broad principles with little or no industry-based guidance.

6. There are no bright line tests for capitalization of leases.

7. There's a simplified temporary difference approach to income tax accounting.

8. Reversal of impairment charges are allowed if certain criteria are met.

9. Accounting for financial assets and liabilities makes greater use of cost.

See Comparison of U.S. GAAP to IFRS for a table that explains additional differences.

Fulcrum Inquiry is a licensed CPA firm that performs financial investigations and forensic accounting.