The first two generally accepted accounting principle (GAAP) alternatives created by the Private Company Council (PCC) were released by the Financial Accounting Standards Board (FASB) on January 16, 2014, giving private companies new options for possible cost savings in their financial reporting.
The FASB issued two Accounting Standards Updates (ASUs) describing the alternatives. They are:
- An election for private companies to amortize goodwill and forego the annual impairment testing for goodwill subsequent to a business combination.
- A simplified hedge accounting approach for certain interest-rate swaps that private companies other than financial institutions enter to convert variable-rate debt to fixed-rate debt.
In addition, the FASB recently approved a new definition for what constitutes a “public business entity,” and finalized criteria for when differences in accounting standards might be warranted for entities that are not public.
Accounting for Goodwill
Under the goodwill alternative, a private company may elect to amortize goodwill on a straight-line basis over a period of ten years or over a shorter period if the company demonstrates that another useful life is more appropriate. In addition, goodwill would be subject to impairment testing only upon the occurrence of a triggering event.
A company that elects this accounting alternative is required to make an accounting policy decision to test goodwill for impairment at either the company level or the reporting unit level. Goodwill would be tested for impairment when a triggering event occurs that indicates that the fair value of an entity (or a reporting unit) may be below its carrying amount. If a quantitative impairment test is required, a one-step impairment test would be performed. The amount of the impairment would be measured by calculating the difference between the carrying amount of the entity (or reporting unit, as applicable) and its fair value. A hypothetical purchase price allocation to isolate the change in goodwill (i.e., step two) would no longer be required.
If a private company elects to apply the alternative, it will be required to apply all aspects of the alternative (i.e., both amortization and the simplified impairment test).
“Plain-Vanilla” Interest Rate Swaps
It’s often difficult for private companies to receive a fixed-rate loan from a bank. Instead, they are required to take out a variable-rate loan with a separate interest-rate swap to receive the fixed rate (i.e., “receive-variable, pay-fixed” or “plain-vanilla” interest rate swap). Understanding and applying traditional hedge accounting to these swaps can be difficult for private companies.
Under the simplified hedge accounting approach, a private company that is not a financial institution would be able to apply hedge accounting to its receive-variable, pay-fixed interest rate swaps as long as the terms of the swap and the related debt are aligned. Under this approach, the income statement charge for interest expense will be similar to the amount that would result if the company had directly entered into a fixed-rate borrowing instead of a variable-rate borrowing and an interest rate swap. This exception could be particularly advantageous for private companies that entered into swaps in the past, but did not initially choose hedge accounting, because the exception is allowed for existing swaps as well as new swaps.
Private companies also can wait until their financial statements are issued to have the documentation in place and elect to apply the simplified hedge accounting approach. Furthermore, the simplified hedge accounting approach allows the swap to be measured at its settlement value, which measures the swap without non-performance risk, instead of fair value.
To Elect or Not Elect? That is the Question
Each of the alternatives has the potential to bring significant cost savings to private companies that can use them. The combination of the amortization method and the relief from the requirement to test goodwill for impairment at least annually is expected to result in significant cost savings for many private companies that carry goodwill on their balance sheets. The simplified hedge accounting approach, which allows the interest rate swap to be measured at its settlement value instead of fair value, should also provide cost savings.
Under the goodwill alternative, amortization should reduce the likelihood of impairments, and private companies generally will test goodwill for impairment less frequently. In addition, even when impairment testing is required, it should be simpler than in the past. Private companies often have struggled to comply with current guidance requiring testing at the reporting unit level because it is difficult for them to identify their reporting units. The alternative will give them the opportunity to test for impairment at the entity level rather than the reporting unit level. In cases where impairment is identified, it will be recorded simply as the amount by which the book value exceeds the fair value. This can be a cost savings because traditional guidance in this situation calls for hypothetical business combination accounting that can require identification and valuation of intangible assets.
Under the interest rate swap alternative, because settlement value is generally easier to determine in comparison to fair value, this will alleviate some of the cost and complexity concerns that have been raised by some private companies with regard to estimating fair value. In addition, private companies whose only derivatives are such swaps also will be relieved of certain fair value disclosures.
Each alternative may be adopted for 2013 financial statements as long as the private company hasn’t already made those financial statements available for issuance. However, before electing the alternatives, private companies should consider:
- Will the users of the company’s financial statements accept financial statements in which a private-company accounting alternative has been elected? Companies should discuss with their financial statement users (e.g., lenders, other creditors, investors and regulators) whether it is acceptable to utilize a private-company accounting alternative in their financial statements. For example, if a private company has debt, it would be a good idea to discuss the alternatives with the bank and make sure that they’re comfortable with them.
- Does the company plan to ever go public—or be acquired by a public company? In either case, using GAAP alternatives for private companies could create difficulties in the future. If a private company is acquired by a public company or a public business entity, the private company may have to undo the election of the alternatives. There are significant consequences associated with retrospectively adjusting financial statements to: (a) eliminate the effects of applying a private-company accounting alternative and (b) reflect the application of guidance applicable to public business entities.
- Will the terms of the swap or the debt change or get out of sync? The prerequisites for taking the simplified hedge accounting exception include having variable rates of the swap and debt based on the same index, with the same terms of maturity. If there’s a chance that is not going to hold through for the term of the swap, it would not be a good idea to elect this approach.
Who’s Eligible for the Alternatives?
In conjunction with the work of the PCC, the FASB, in December, issued an update to its Accounting Standards Codification (ASC) to define a “public business entity” in its master glossary and issued its final Private Company Decision-Making Framework. The framework is a guide for evaluating accounting and reporting issues for private companies to help determine when differences might be appropriate. The FASB is defining a public business entity to prevent confusion over which entities can apply the private company alternatives, such as those discussed above.
Elliott Davis Observation: The new definition of a public business entity will be used by the FASB to specify the scope of future accounting and reporting guidance. In other words, the new definition does not affect the definitions of other related pre-existing terms in the ASC (e.g., public entity, publicly traded company) or the situations in which those definitions are used.
An organization is considered a public business entity if it meets any of the following criteria:
- It files or furnishes—or is required to file or furnish—financial statements with the Securities and Exchange Commission (SEC). This includes other entities whose financial statements or financial information are required to be or are included in a filing.
- It is required to file or furnish financial statements with a regulatory agency by the Securities Exchange Act of 1934, as amended, or rules or regulations promulgated under the Act.
- It is required to file or furnish financial statements with a regulatory agency in preparation for the sale of securities or for the purposes of issuing securities.
- It has (or is a conduit bond obligor for) unrestricted securities that are traded or can be traded on an exchange or an over-the-counter (OTC) market.
Elliott Davis Observation: The FASB has stated that an OTC market includes an interdealer quotation or trading system for securities that are not listed on an exchange (for example, OTC Markets Group Inc., including the OTC Pink Markets, or the OTC Bulletin Board).
- It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including footnotes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
Elliott Davis Observation: An entity has to provide a full set of U.S. GAAP financial statements (including footnotes) to meet criterion 5. Call reports that are required to be filed by all federally insured depository institutions (which include financial information prepared in accordance with U.S. GAAP, but not a full set of financial statements) would not meet this criterion. However, a bank with over $500 million in assets required to file annual audited financial statements with the FDIC and whose financial statements are available upon request would meet criterion 5. If it has one or more securities not subject to contractual restrictions on transfer. These restrictions may be contained in buy-sell, shareholder, or other agreements.
As a result, the following types of entities will not be able to apply any private-company accounting alternatives: (a) public business entities as defined above, (b) not-for-profit entities and (c) employee benefit plans. Whether accounting alternatives should be provided to not-for-profit entities and/or employee benefit plans will be separately considered by the FASB.
When Can These Alternatives Be Used?
Although the alternatives are effective for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015, early adoption is permitted. This means that an eligible private company could elect to apply one or both of the alternatives in its 2013 financial statements, as long as those financial statements have not been made available for issuance prior to the release of the final standards.
The goodwill alternative would be applied on a prospective basis with amortization of existing goodwill commencing at the beginning of the period of adoption. The simplified hedge accounting approach will be applied on either a modified retrospective basis or a full retrospective basis, with such election to be made on a swap-by-swap basis.
The FASB has separately added a project to its technical agenda to address the accounting for goodwill for public business entities and not-for-profit entities. Deliberations on this project are expected to commence in 2014.