Question: Should you let borrowers use the AICPA’s small business reporting framework? The short answer to this question is, “It depends.”
The AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) — published last year and now being picked up by some businesses — has the potential to benefit borrowers and lenders alike. But it’s important for lenders to analyze clients on a case-by-case basis to see whether it’s appropriate to accept financial statements prepared in accordance with the FRF for SMEs.
What is it?
The AICPA designed the FRF for SMEs as an alternative to Generally Accepted Accounting Principles (GAAP) that’s more robust and reliable than existing options, such as the income tax and cash bases of accounting. The goal was to provide banks and other financial statement users with information about what a borrower owns, what it owes and its cash flow, without the complexity of GAAP financial statements.
This complexity can substantially increase a borrower’s financial reporting costs. And it can result in financial statements that contain unnecessary “noise,” making it more difficult for a lender to pinpoint the information it cares about. So, under the right circumstances, the FRF for SMEs can benefit both the borrower and the lender.
What’s an SME?
The AICPA declined to provide a quantifiable definition of “SME.” Instead, it identified certain common characteristics, including:
- The entity is closely held and owner-managed,
- The entity isn’t required to use GAAP financial statements for regulatory purposes,
- The entity is for-profit,
- A majority of the owners and management don’t intend to take the entity public,
- The entity doesn’t engage in overly complicated transactions or have significant foreign operations,
- Key financial statement users have direct access to management and are most interested in cash flows, liquidity, interest coverage and statement of financial position strength, and
- The entity’s financial statements aren’t the sole basis for a bank’s lending decision — the decision is also made based, for example, on collateral strength.
These and other listed characteristics are intended only as guidelines. Just because an entity lacks one or more of them doesn’t necessarily mean that it’s inappropriate for it to use the FRF for SMEs.
How does it differ from GAAP?
The FRF for SMEs is a blend of traditional accounting principles and certain accrual-based income tax methods. It’s designed to produce streamlined financial statements that highlight relevant information when GAAP-compliant statements aren’t necessary. Here are some key ways in which the FRF for SMEs differs from GAAP:
- Measurement focuses on historical cost, avoiding the complexity of GAAP’s fair value measurements and costly impairment tests.
- It doesn’t require the consolidation of variable interest entities and allows parent-only financial statements.
- It doesn’t require an entity to recognize the cost of stock-based compensation.
- It gives entities the flexibility to choose among optional accounting policies in areas such as income tax accounting, subsidiary accounting and treatment of long-term and service contracts.
One advantage of the FRF for SMEs is that it has fewer book-to-tax adjustments than does GAAP. So, an entity’s financial statements are more closely aligned with its income tax returns.
Should you allow it?
To decide whether the FRF for SMEs is appropriate for a particular borrower, determine whether the differences between the FRF for SMEs and GAAP will adversely affect your ability to evaluate the client’s financial condition over the course of the loan. For example, if the borrower’s assets and liabilities are generally stable, measurement based on historical cost may be sufficient. And requiring the client to report current fair values may not be necessary.
Also consider whether your relationship with management gives you access to additional financial information and the ability to tailor financial statements — in particular, optional accounting policies — to meet your needs.