January 11, 2019

Statutory (SBA) vs. GAAP Accounting Differences

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The Small Business Investment Act of 1958 established the framework for the Small Business Investment Company (“SBIC”) system. Under the SBIC system, private investment companies provide debt and equity financing to small businesses with the benefit of additional funding from the Small Business Administration (“SBA”). In order to qualify for funding from the SBA, SBICs must be both licensed by the SBA and adhere to strict statutory guidelines established by SBA regulations. These guidelines include rules related to both the operations of SBICs and the accounting requirements for these companies. SBICs are required to file financial reports with the SBA annually by submitting SBA Form 468 which must be completed according to the SBA’s accounting standards and audited by an independent public accounting firm.Similar to other statutory bases of accounting, the accounting framework prescribed by the SBA differs from accounting principles generally accepted in the United States of America (“GAAP”) in several key respects. Some of these differences include the treatment of unrealized gains and losses and the presentation of the financial statements and financial highlights. However, the most significant difference between the reporting requirements prescribed by the SBA and GAAP relates to the valuation of the investments held by companies. Under GAAP, investments held at the end of the reporting period are presented on the statement of financial position at fair value. Fair value is defined by ASC 820 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” On the other hand, investments reported by SBICs on Form 468 must be valued using the valuation guidelines issued by the SBA.The SBA valuation framework differs from GAAP in several key respects. The most notable being that investments are not necessarily reported at fair value. The guidelines prescribed for SBICs note that the initial valuation of an investment takes place when the SBIC enters into the investment of a portfolio company and negotiates the terms of the investment. Once this cost basis is established, the investment is held at this initial valuation until the SBIC’s management determines that there is a basis to increase or decrease the valuation. The guidelines further establish very specific criteria which must be met in order to justify changes in the valuation of an investment.The first of several criteria listed in the guidelines are related to debt securities or loans which may be issued by an SBIC. Under the SBA guidelines, a loan can never be valued at an amount greater than cost, and unrealized depreciation on the loan must be recognized if the value is impaired. Additionally, the management of the SBIC must consider the financial condition of the portfolio company and its ability to repay the loan. The guidelines also establish criteria for valuing loans based on the assets secured by the loan. If this approach is taken, the SBIC must evaluate the value of the collateral, and the value of the loan cannot be increased above cost basis regardless of the collateral value. Also, the value of loans cannot be adjusted for changes in interest rates. This approach differs from GAAP primarily in its constraints related to increasing the carrying value of the investment over cost and adjusting carrying value based on changes in interest rates. Under GAAP, debt securities are valued at fair value.More differences are notable when reviewing the SBA guidelines for investments in equity securities. Similar to the guidelines for debt securities, investments in private companies are valued at investment cost unless it is determined that the valuation should be written up or down. The first requirement under SBA guidelines states that the valuation should be reduced if a portfolio company’s financial performance has significantly deteriorated. Additionally, subsequent equity financing of a portfolio company must be considered in reporting unrealized depreciation on the investment. If a significant amount of financing by a new investor indicates that the price of the securities has decreased below the original cost, then the value of the investment should be reduced. The SBA guidelines also allow for increasing the valuation of investments in private companies if subsequent equity financing by a new investor indicates an appreciated valuation or if the company has been self-financing and had positive operating cash flow for at least the past two fiscal years. In this case, the value of the investment may be increased based on financial measures such as cash flow multiples or price to earnings ratios. This approach is very different from GAAP reporting which requires companies to determine the fair market value of portfolio companies at the end of each reporting period using either a market price or a valuation model in instances where a market price cannot be readily determined.The requirements for valuing publicly traded securities are much more similar between the SBA guidelines and GAAP than for debt or private equity investments as both frameworks rely on recently quoted market prices to determine the valuation. Under SBA guidelines, securities listed on stock exchanges are valued using the average of the closing price on the valuation date and the two previous days. For securities that are infrequently traded, the regulations require management to determine the value with an appropriate discount applied if there are restrictions on the stock or if the SBIC owns a significant amount of the stock being valued. GAAP takes a similar approach in that the securities are generally valued using the market price of the security on the valuation date. Under GAAP, management must also consider the frequency with which a security trades in determining fair value, and thinly traded securities may need to be evaluated for change in value especially if substantial time has passed between the last time the security was traded and the valuation date.Another significant difference between GAAP and the SBA regulations relates to the presentation in the company’s financial statements of unrealized appreciation and depreciation in the valuation of investments. Under the SBA guidelines, SBICs report changes in unrealized appreciation and depreciation directly to the capital/equity on the statement of financial condition. GAAP, on the other hand, requires the net changes in unrealized appreciation and depreciation on investments to be reported as a component of net income. The SBA notes in the regulations that the purpose of this difference is to prevent the net income of SBICs from being influenced by the investment valuations which can be highly subjective in many circumstances.Overall, other than the differences related to the valuation of investments and the treatment of unrealized gains and losses, the reporting requirements under the SBA framework and GAAP are very similar. In fact, the SBA regulations point out that unless otherwise noted, SBICs are required to follow GAAP as a general rule. The SBA rules related to the valuation of investments and recognition of unrealized gains and losses are designed to take a more conservative approach to valuing the investments for statutory reporting purposes. However, many SBICs are required to produce GAAP financial statements in addition to the required SBA Form 468. Therefore, it is essential for SBIC operators to be knowledgeable of the valuation and reporting requirements under both frameworks to satisfy the needs of any potential users of their financial statements.

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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.

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