The Financial Accounting Standards Board (FASB) has issued its long-awaited update revising the proper treatment of leases under U.S. Generally Accepted Accounting Principles (GAAP). Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), will affect entities that lease real estate, vehicles, equipment, and other assets. The standard requires these entities to recognize most leases on their balance sheets, potentially inflating their reported assets and liabilities.
According to the FASB, most lease obligations today aren’t recognized on the balance sheet, and transactions often are structured to achieve off-balance-sheet treatment. A 2005 U.S. Securities and Exchange Commission (SEC) report estimated that SEC registrant companies held approximately $1.25 trillion in off-balance-sheet lease obligations. As a result of these obligations being left off balance sheets, users of financial statements can’t easily compare companies that own their productive assets with those that lease their productive assets.
To address this issue, the FASB launched a joint lease accounting project with the International Accounting Standards Board (IASB) in 2006. The joint project was unsuccessful, however. The boards couldn’t agree on how to report leases on the income statement and decided to issue separate standards. The IASB issued its standard (International Financial Reporting Standards 16) in January, and now the FASB has released its own standard.
Impacts on lessees
Currently, entities that lease assets (lessees) account for a lease based on its classification as either a capital (or finance) lease or an operating lease. Lessees recognize capital leases (for example, a lease of equipment for nearly all of its useful life) as assets and liabilities on their balance sheets. But they don’t recognize operating leases (for example, a lease of office or retail space for 10 years) on the balance sheet. Such leases appear in financial statements only as a rent expense and disclosure item.
The new standard will require lessees to recognize on their balance sheets assets and liabilities for all leases with terms of more than 12 months, regardless of their classification. Lessees will report a right-to-use asset and a corresponding liability for the obligation to pay rent, discounted to its present value. The discount rate is the rate implicit in the lease or the lessee’s incremental borrowing rate.
The recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee will continue to depend primarily on its classification as a capital or operating lease:
For capital leases, lessees will amortize right-to-use assets separately from interest on the lease liability on the statement of comprehensive income. They will classify repayments of the principal portion of the lease liability within financing activities, and payments of interest on the lease liability and variable lease payments within operating activities, in the statement of cash flows.
For operating leases, lessees will recognize a single total lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis. They’ll classify all cash payments within operating activities in the statement of cash flows.
The standard requires additional disclosures to help users of financial statements better understand the amount, timing and uncertainty of cash flows related to leases. Lessees will disclose qualitative and quantitative requirements, including information about variable lease payments and options to renew and terminate leases.
These changes may have additional repercussions for lessees. Entities with significant leases may incur costs to educate their employees on the proper application of the new requirements and financial statement users on the impact of the requirements. They’ll need to develop supplemental processes and controls to collect the necessary lease information.
The reporting changes could affect financial ratios and, in turn, have implications for debt covenants. They might also lead to higher borrowing costs for lessees whose balance sheets look weaker with their operating leases included. Entities could consider buying instead of leasing, because they’ll end up with similar leverage on their balance sheets from either transaction.
Impacts on lessors
Entities that own leased assets (lessors) will see little change to their accounting from current GAAP. The new standard does, however, include some “targeted improvements” intended to align lessor accounting with both the lessee accounting model and the updated revenue recognition guidance published in 2014 (ASU No. 2014-09, Revenue from Contracts with Customers).
For example, lessors may be required to recognize some lease payments received as liabilities in cases where the collectability of the lease payments is uncertain. Users of financial statements will have more information about lessors’ leasing activities and exposure to credit and asset risk related to leasing.
Lessors also could see the changes to lease accounting play out in lease negotiations. Existing lessees may seek to modify their leases to reduce the impact of the new standard on their balance sheets by, for example, securing lease terms of one year or less.
Contracts sometimes include both lease and service contract components (for example, maintenance services). ASU 2016-02 continues the requirement that entities separate the lease components from the nonlease components, and it provides additional guidance on how to do so.
The consideration in the contract is allocated to the lease and nonlease components on a relative standalone basis for lessees. For lessors, it’s done according to the allocation guidance in the revenue recognition standard. Consideration attributed to nonlease components isn’t a lease payment and, therefore, is excluded from the measurement of lease assets or liabilities.
Interplay with international standards
Many aspects of ASU 2016-02 are converged with IFRS 16, including the definition of a lease and initial measurement of lease liabilities. But there are some significant differences.
For example, the IASB opted for a single-classification model that requires lessees to account for all leases as capital leases. That means leases classified as operating leases will be accounted for differently under GAAP vs. IFRS, with different effects on the statement of comprehensive income and the statement of cash flows.
Effective dates and transition
Public companies are required to adopt the new standard for interim and annual periods beginning after December 15, 2018. Nonpublic entities following GAAP will need to comply for annual periods beginning after December 15, 2019, and for interim periods beginning a year later. Early adoption is permitted.
The standard requires entities to take a “modified retrospective transition approach,” which includes several optional “practical expedients” entities can apply. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that begin before the effective date in accordance with previous GAAP unless the lease is modified.
The exception is that lessees are required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.
Act soon if you have extensive lease portfolios
Because of this standard’s long gestation period, many entities have taken a wait-and-see approach to tackling the lease accounting changes. But now that the new standard has been released, entities would be wise to begin their preparations if they have extensive lease portfolios.
FASB provides alternatives for private companies on accounting for goodwill, interest rate swaps
The Financial Accounting Standards Board (FASB) has issued two updates to Generally Accepted Accounting Principles (GAAP) that are intended to reduce the cost and complexity of preparing financial statements for private companies. As outlined in Accounting Standards Update (ASU) 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill, and ASU 2014-03, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps—Simplified Hedge Accounting Approach, the alternative standards streamline the method for goodwill impairment and make it easier for certain interest rate swaps to qualify for hedge accounting.
Move toward private company alternatives to GAAP
The updates grew out of proposals from the Private Company Council (PCC) and were endorsed by FASB last year. The Financial Accounting Foundation, FASB’s parent organization, formed the PCC in May 2012 to improve the process of setting accounting standards for private companies that need or are required to have financial statements prepared in accordance with GAAP.
In December 2013, FASB and the PCC released new guidance, Private Company Decision-Making Framework: A Guide for Evaluating Financial Accounting and Reporting for Private Companies (the Guide), to be used to determine whether private companies should be allowed to use alternative standards in the areas of recognition and measurement, disclosures, display/presentation, effective date and transition method. For each of these areas, the Guide describes criteria FASB and the PCC will use to evaluate whether to permit alternative guidance. ASU 2014-02 and ASU 2014-03 contain the first of the alternative guidance.
Existing GAAP for goodwill
The term “goodwill” refers to the residual asset recognized in a business combination, such as a merger, after recognizing all other identifiable assets acquired and liabilities assumed. Under GAAP, goodwill is carried on the books at its initial value less any impairment. It isn’t subject to amortization.
Goodwill is considered impaired when the implied fair value of goodwill in a company’s reporting unit — basically, an operating unit that has its own discrete financial information, separate from the overall company — falls to an amount that’s less than its carrying amount, or book value, including any deferred income taxes. Under GAAP, companies must test for impairment at least annually, and more frequently if certain conditions exist.
GAAP allows a company to choose initially to perform a qualitative evaluation to determine whether it’s more likely than not (that is, a likelihood of more than 50%) that a reporting unit’s fair value is less than its carrying amount. If the company determines it’s not more likely than not that fair value is less than the carrying amount, it need not perform a quantitative two-step impairment test. If it is more likely than not, the company must proceed to the two-step impairment test.
In the first step, the company calculates the fair value of the reporting unit and compares that amount with the reporting unit’s carrying amount, including goodwill. If the carrying amount exceeds the fair value, the company performs the second step — measuring the amount of the goodwill impairment loss, if any, by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. This requires performing a hypothetical application of the acquisition method to determine the implied fair value of goodwill after measuring the reporting unit’s identifiable assets and liabilities.
Private company goodwill alternative
Preparers and auditors of private company financial statements have complained about the cost and complexity involved in carrying out the existing GAAP goodwill standards. Moreover, users of these financial statements have indicated that the requirements provide limited benefits to them because they often disregard goodwill and impairment losses when analyzing a company’s financial condition and operating performance.
The alternative standards in ASU 2014-02 are designed to address these concerns. They allow a private company to amortize goodwill after its acquisition (and initial recognition and measurement) on a straight-line basis during a period of 10 years, or less if the company demonstrates that another useful life is more appropriate. The company can revise the remaining useful life of goodwill in response to events and changes in circumstances that warrant a revision, but the cumulative amortization period can’t exceed 10 years.
A company that elects this alternative must make an accounting policy decision to test goodwill for impairment at either the company level or the reporting unit level. But goodwill needs to be tested for impairment only when a triggering event — such as a significant adverse change in business climate, legal issues or loss of key personnel — occurs that indicates the fair value of a company or a reporting unit may be below its carrying amount.
The alternative standard also drops the second step of the existing impairment test: the costly and complicated hypothetical application of the acquisition method. Instead, the amount of the impairment equals the amount by which the carrying amount of the company or reporting unit exceeds its fair value. The goodwill impairment loss can’t exceed the company’s or reporting unit’s carrying amount of goodwill.
The aggregate amount of goodwill net of accumulated amortization and impairment will appear as a separate line item in the company’s statement of financial position. The amortization and aggregate amount of goodwill impairment will be presented in income statement line items within continuing operations unless the amortization or impairment is associated with a discontinued operation. Such amortization and impairment must be included on a net-of-tax basis within the results of discontinued operations.
The disclosures required under this alternative are similar to existing GAAP. A company that elects the alternative, however, isn’t required to present changes in goodwill in a tabular reconciliation.
Benefits of the goodwill alternative
Private companies that opt for the goodwill alternative may experience significant cost savings because of the combination of the amortization method and the elimination of the requirement to test goodwill for impairment at least annually. Amortization should reduce the likelihood of impairments, and testing may occur less frequently. When impairment testing is required, the removal of the second step and the ability to test at the company level (as opposed to the reporting unit level) should cut the test’s cost.
Once elected, the goodwill alternative will apply prospectively. A company will amortize existing goodwill starting at the beginning of the period of adoption in which the alternative is elected, as well as new goodwill recognized after the beginning of the annual period of adoption.
Interest swap alternative
Private companies can find it difficult to obtain fixed-rate loans. They often must enter into an interest rate swap (a derivative instrument) to economically convert their variable-rate loans to fixed-rate loans. Existing GAAP guidance requires a company to recognize all of its derivative instruments in its balance sheet as either assets or liabilities and measure them at fair value.
A company may elect cash flow hedge accounting to mitigate income statement volatility if certain requirements are met. But many private companies lack the resources and expertise to comply with the requirements and, therefore, remain vulnerable to volatility.
The alternative standards in ASU 2014-03 will allow nonfinancial institution private companies to apply a simplified hedge accounting approach to their receive-variable, pay-fixed interest rate swaps as long as the terms of the swap and the related debt are aligned. Using this hedge accounting results in presenting interest expense in the income statement as if the company had directly entered a fixed-rate loan, instead of a variable-rate loan and an interest rate swap. Companies applying the alternative will have until the issuance of their financial statements to complete the required hedging documentation.
The alternative standard also allows a private company to recognize the swap at its settlement value, which measures the swap without consideration of nonperformance risk, rather than at fair value. Private companies that apply this alternative may enjoy cost savings, because settlement value is generally easier to determine than fair value. The variability of the fair value or settlement amount will be recorded as accumulated other comprehensive income (part of equity).
The standard can be applied to both existing and new qualifying swaps because the election of hedge accounting can be made on a swap-by-swap basis. This is good news for private companies that chose not to elect hedge accounting in the past because of the difficulty involved in complying with the requirements.
Availability of the alternatives
Users of financial statements, including regulators, lenders or other creditors, may require a private company to continue to apply traditional GAAP accounting standards, even if the company is otherwise eligible for the alternatives. Further, FASB is working on a project that addresses the subsequent accounting for goodwill for public companies and not-for-profit organizations, which could result in a future change to the subsequent accounting for goodwill for all entities, including private companies.
And a company that elects an accounting alternative could subsequently become subject to public company reporting and, therefore, need to recast prior periods as if it hadn’t elected the alternative.
Both of the new alternatives will be effective for annual periods beginning after Dec. 15, 2014, and interim periods beginning after Dec. 15, 2015. Early adoption is permitted, so an eligible private company could elect to apply the alternatives on its 2013 financial statements, as long as the financial statements weren’t made available for issuance before the ASUs were released.
If you have questions regarding how the updates affect how you prepare your financial statements, please give us a call. We’d be happy to answer your questions.
SKR+Co Alert: The creation of"Little GAAP" has been approved for private companies!
June 8, 2012
After considering numerous public comments, the Financial Accounting Board (FAF) — the parent organization to the Financial Accounting Standards Board (FASB) — has approved the creation of the Private Company Council (PCC). The PCC will identify and vote on exceptions and modifications to U.S. GAAP that respond to the needs of private companies and their financial statement users. This article details PCC’s role and discusses the AICPA’s plan to develop “little GAAP.”
To read the full article, click here.
If you own a private company, it’s a good idea to monitor the activities of the PCC and the AICPA, which will likely have a big effect on how you prepare your financial statements. For more information on the PCC, please give us a call. We’d be happy to answer your questions.
Contact us with any questions or concerns at (719) 630-1186 or through our Secure Email.
Private companies and GAAP
September 22, 2011
There have been discussions about separate private company accounting standards for years. Now standard-setters may actually do something about it. The Financial Accounting Foundation (FAF) — parent organization to the Financial Accounting Standards Board (FASB) — will soon decide whether to adopt recommendations made earlier this year by a blue-ribbon panel on standard setting for private companies.
The panel recommended that the FAF establish a separate, private company standards board to develop appropriate exceptions and modifications to U.S. Generally Accepted Accounting Principles (GAAP) that would “better respond to the needs of the private company sector.” The new board would work closely with FASB, and its standards would be incorporated into FASB’s Accounting Standards Codification (ASC).
However, the board would have final authority over all exceptions and modifications. The panel also recommended the creation of a “differential framework” to guide the new board’s standard-setting activities.
Public vs. private
In the United States, public and private companies, for the most part, are subject to the same set of accounting standards — GAAP. Public companies are required under SEC rules to prepare audited, GAAP-compliant financial statements. Generally, private companies aren’t legally obligated to follow GAAP, but they may need to do so to satisfy lenders, sureties, venture capitalists or other stakeholders.
Preparing GAAP financial statements can be a challenge for private companies, particularly in the current environment. During the last several years, FASB has been shifting toward a fair-value-based accounting approach. In other words, GAAP increasingly requires companies to report assets and liabilities at fair value rather than historical cost. This trend is increasing the complexity and cost of complying with GAAP, which now demands periodic valuations and impairment testing for many financial statement items.
This type of information is valuable to public company investors, who use it to evaluate the price of securities traded in the stock exchanges or other public markets. But lenders and other users of private company financial statements tend to be less interested in fair value and more interested in free cash flow and a company’s ability to pay its debts. In some cases, GAAP can make it more difficult for these users to get the information they need.
Consider, for example, employee stock options. Historically, these options were reported at their “intrinsic value” — that is, the amount (usually zero) by which the underlying stock’s market value on the grant date exceeded the option exercise price. Several years ago, however, FASB modified its standards to require companies to expense employee stock options based on their grant-date fair value, using one of several option-pricing models.
Valuing options can be complex — especially for private companies with limited trading data. Plus, many lenders view stock options as a noncash expense that has little effect on a company’s ability to pay its debts. So, from their perspective, reporting options at grant-date fair value actually distorts the company’s income. For that reason, they add the expense back into net income when evaluating a company’s financial statements.
Proponents of separate private company accounting standards point to fair value reporting as well as other GAAP provisions that may be irrelevant at best and counterproductive at worst in a nonpublic setting. They include:
Reporting of uncertain tax positions
Consolidation of variable interest entities, and
Accounting for derivatives.
As a result, many private companies prepare non-GAAP financial statements — on a cash or income tax basis, for example — while others opt to receive “qualified” opinions from their auditors. Many lenders accept these financial statements or waive certain GAAP requirements because they recognize that compliance can be burdensome and that many GAAP standards lack relevance for private companies.
The concept of separate standards for private companies isn’t without its critics, however. Some opponents argue that financial statements are either correct or they aren’t, and that separate standards will lead to inconsistency and lack of comparability.
They advocate a single set of standards that can be modified, if appropriate, on a case-by-case basis by agreement between a company and its financial statement users. They also contend that, if GAAP standards are overly complex or burdensome, they should be simplified for all companies, both public and private.
The panel’s recommendations
The blue-ribbon panel considered several models for addressing the needs of private companies, including a standalone GAAP built from the ground up and several versions of International Financial Reporting Standards (IFRS), including IFRS for Small and Medium Entities.
In settling on U.S. GAAP with exceptions and modifications for private companies, the panel explained that a standalone set of standards could take a significant amount of time to create and could be significantly different from current U.S. GAAP. It also rejected the various IFRS options, noting that “U.S. private companies should not be leading the charge, en masse, to an IFRS-based set of standards before the SEC makes a decision on U.S. public companies…”
The panel concluded that a new board with standard-setting power would be the most effective approach. In the panel’s view, FASB is too focused on public company financial reporting to address the needs of private companies.
The panel noted that FASB’s Private Company Financial Reporting Committee (PCFRC) has submitted approximately 40 recommendation letters since it was formed in 2007. Although FASB has modified some standards, generally by changing effective dates or disclosure requirements for private companies, the panel concluded that many private company stakeholders view the PCFRC’s work as “not being wholly successful because the FASB has not also shown a willingness to consider carefully and approve, where appropriate, the possibility of measurement, recognition, or presentation differences.”
It’s not yet certain how the FAF will respond to the blue-ribbon panel’s recommendations. But there’s widespread support for the panel’s approach among accountants and finance executives, as reflected in the vast majority of nearly 2,000 letters the FAF has received. Keep in mind that the FAF’s decision and ultimate approach may be affected by the SEC’s decision, expected later this year, on whether to adopt IFRS for U.S. companies.
If you own a private company and have questions about how the blue-ribbon panel’s proposed recommendations might affect how you prepare your financial statements, please give us a call. We would be happy to answer your questions.
By Mike Rowe, Audit Partner
January 25, 2011
Generally Accepted Accounting Principles (GAAP) have become increasingly complex over the past decade. Many of the new accounting standards are issued primarily to address the needs of the users of public company financial statements. Private companies have been saying for years that their financial reporting needs are different from those of large public companies, as the users of their financial statements are different. As a result, consideration is being given to creating separate accounting rules for private companies.
The following are arguments both for and against private company GAAP.
Those in favor of creating a private company GAAP raise the following issues about the existing rules:
• Excessive Complexity
• Lack of Relevance
Opponents of a private company GAAP raise the following issues with private company GAAP:
• Costs to Create and Implement
• Lack of Consistency and Comparability
To read more about it, please click here.
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