By Jake Vossen

Part 1 of 2
Click here to read part 2.

An alternate financial reporting tool is available for small- and medium-sized entities

Recently the American Institute of CPAs released a new financial reporting framework for private companies. In some circumstances it may be a useful, easy to use, comprehensive tool to provide owners and lenders financial statements on a consistent basis. The new framework is called the “Financial Reporting Framework for Small- and Medium-Sized Entities,” or “FRF for SMEs” for short.

The accounting rules in the Framework are not Generally Accepted Accounting Principles (or U.S. GAAP), but they were developed after a rigorous process and are comprehensive. Thus financial statements prepared in accordance with the Framework are technically prepared using an “Other Comprehensive Basis of Accounting” or “OCBOA.” Other forms of OCBOA statements use the income tax basis of accounting or the cash basis of accounting. Whether both smaller private companies and banks will accept the Framework or not is now being put to the test. There remains a great deal of interest in this form of reporting, but also a great deal of uncertainty, because on the one hand, it is comprehensive and easy to use, leading to somewhat simpler and less expensive statements. On the other hand, it is not GAAP. We are giving presentations on the Framework to sold-out audiences on this subject, so we thought we would further discuss the matter here. In the first article of this series we will explain the concepts of the new non-GAAP Framework and in the second we will dig further into the differences between the Framework and GAAP.

GAAP is the U.S.’s highest standard of accounting rules. GAAP rules are generally set by the Financial Accounting Standards Board. Since the creation of the FASB in the early 70’s, the AICPA is mostly looked to for audit standards. The main problem the AICPA was trying to solve in releasing the Framework is that small and closely held companies often don’t need the types of standards that large and public companies need. Smaller or more entrepreneurial companies mainly deal with bankers, not outside investors and bondholders, for their financial needs. Many smaller companies believe that GAAP is overly complex and too difficult and expensive to implement. Prior to the Framework being released, companies who did not want to adopt GAAP had limited options to present their financial statements in a meaningful comprehensive way.

One example of the complexity of GAAP is the fair value accounting rules. GAAP often requires an asset or liability of the company to be revalued to its current fair value. The offset of this adjustment is a non-cash gain or loss in the income statement. Estimating fair value is often highly subjective and complex.

In practice, users often add back such non-cash charges to attempt to calculate “cash” earnings. Not only are fair value assessments expensive and complex; they often require private companies to hire an outside valuation expert, who may produce a valuation that the owner and other users may or may not agree with.

The Concept behind the New FRF for SMEs

The FRF for SMEs condenses down all of the accounting for every type of transaction into a 188-page framework, which by its nature makes the Framework simpler but leaves significant room for the reporting company and auditor judgment in how to apply the framework.

The framework has the advantage of other OCBOAs because it is more consistent. It can be compiled, reviewed or audited by external accountants and is responsive to the issues and concerns surrounding U.S. GAAP among small and medium-sized entities. Also, because the AICPA realizes that the ever-changing nature of U.S. GAAP is part of the reason it is complex, it is anticipated that the Framework will be rarely changed. User of the Framework should expect years in between changes instead of the near constant changes by FASB.

The main users of the Framework will not be in an industry with highly specialized accounting or be engaged in overly complicated transactions. Most won’t have significant foreign operations and have little interest in going public. The users, who have direct access to management, are more interested in cash flows, liquidity, financial strength and interest coverage than in a GAAP net income number.

Both owners and financiers need to understand the Framework better.

In our discussions with both owners and bankers, we have observed a lack of knowledge about what the Framework is. This is understandable as the Framework is so new. Although some lenders won’t be comfortable lending to users of non-GAAP financial statements, others may decide that allowing the use of FRF for SMEs for companies in their portfolios will be a strategic advantage. Banks may also agree to statements prepared under the Framework if there is ample collateral behind a loan. Ultimately, we believe the banks are the key to the Framework being widely accepted, and we encourage private companies who are considering adopting the Framework to begin discussions with both your auditor and banker soon.

In the next article: we will compare GAAP and the Framework on critical issues.

About the author

Jake VossenJake Vossen - Hein CPA - Denver CPA Firm, CPA, is National Director of Audit and Accounting for Hein & Associates LLP,a fullservice public accounting and advisory firm with additional offices in Houston, Dallas and Orange County. Vossen specializes in  financial reporting services and assists companies with due diligence and other services for complex transactions,  including IPOs, private offerings and mergers and acquisitions. He can be reached at jvossen@heincpa.com.

This article was originally published on Accounting Today.