By Lakshmi Prasanna Narayanam
The Financial Accounting Standards Board (FASB) has recognized over the years that there are different levels of reliance of the users of financial statements between the private and public sectors. And given the limited resources available for some privately held entities, the FASB has provided some relief in the form of GAAP alternatives.
Where financial reporting differs between private and public companies
The FASB formed the Private Company Council (PCC) in 2012 for developing private company alternatives within U.S. GAAP that are intended to meet the needs of both private companies and their stakeholders.
The FASB and the PCC issued A Guide for Evaluating Financial Accounting and Reporting for Private Companies. The guide is used as a tool to help the FASB and the PCC identify opportunities to reduce the complexity and costs of preparing financial statements in accordance with U.S. GAAP for private entities.
To be more precise, the guide encompasses five significant factors that differentiate the financial reporting considerations of private companies vs. public companies:
- Number of primary financial statement users and their access to company management
- Investment strategies of primary users
- Ownership and capital structures
- Accounting resources
- The manner in which preparers learn about new financial reporting guidance
The guide also sets forth five areas where financial accounting and reporting guidance might differ for private and public companies:
- Recognition and measurement
- Financial statement display (i.e., presentation)
- Effective dates of new guidance
- Transition methods
8 GAAP simplifications available to private companies
Below are the eight GAAP simplifications available to private companies as of December 31, 2021:
- ASU 2014-02: Accounting for Goodwill
- ASU 2014-03: Simplified Hedge Accounting in an Interest Rate Swap
- ASU 2014-18: Subsuming Certain Intangibles into Goodwill
- ASU 2018-07: Exclusion from Applying VIE Guidance in Common Control Situations (supersedes 2014-07)
- ASU 2021-02: Franchisor Accounting
- ASU 2021-03: Performing Goodwill Impairment At the end of a Reporting Period
- ASU 2021-07: Estimating Share Price to Determine Fair Value of Share-Option Awards
- ASU 2021-09: Using a Risk-Free Rate to Determine Present Value of Lease Payments
Let’s dive a little deeper into each of the ASUs listed and understand the alternatives provided from accounting point of view in a summary:
1. ASU 2014-02: Accounting for Goodwill
The FASB issued ASU No. 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill, which established an accounting alternative under which private companies are allowed to:
- Amortize goodwill on a straight-line basis over the useful life of the primary asset acquired in a business combination, not to exceed 10 years, and
- Test goodwill for impairment either at the entity-wide level or at the reporting unit level only when a triggering event occurs indicating that the fair value of an entity or reporting unit may be below its carrying amount.
Under the accounting alternative, private companies are permitted to make an accounting policy election regarding subsequent accounting for goodwill 1) recognized in a business combination, or 2) in applying the equity method of accounting. The accounting alternative also applies to the excess reorganization value recognized when fresh-start reporting is adopted. Note that once the accounting alternative is elected, it must be applied to existing goodwill and to all new goodwill generated in future business combinations.
In applying the accounting alternative:
- SLM basis over its useful life, not to exceed 10 years.
- If the useful life of goodwill is revised under any circumstances, the remaining carrying amount should be amortized prospectively on a SLM basis over the new remaining useful life, but the cumulative amortization period for any amortizable unit of goodwill cannot exceed 10 years.
- An accounting policy election must be made to test goodwill for impairment either at the entity level or at the reporting unit level.
- Goodwill must be tested for impairment when an event occurs or circumstances change indicating that the fair value of the entity or the reporting unit may be below its carrying amount (i.e., a triggering event). If no triggering event occurs, further impairment testing is not necessary.
- Regarding equity method investments, goodwill should be reviewed for impairment in accordance with applicable provisions of FASB ASC Section 323-30-35.
2. ASU 2014-03: Simplified Hedge Accounting in an Interest Rate Swap
Under the current accounting rules, it’s complicated and costly to qualify for hedge accounting treatment; one of the many requirements includes an annual ineffective test. This alternative allows for hedge accounting for these type of swap arrangements and enables the volatility of the hedge instrument to remain out of I/S and recorded through OCI without having to comply the rigorous rules/tests and disclosures of the original standard.
The FASB issued ASU No. 2014-03, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps—Simplified Hedge Accounting Approach, which provided a simplified approach for private companies (excluding financial institutions) that are not PBEs to elect to apply to accounting for swaps entered into for the purposes of converting a variable-rate borrowing to a fixed-rate one. The simplified approach may be applied to a qualifying cashflow hedge of a variable-rate borrowing with a receive-variable, pay-fixed interest rate swap under the certain circumstances as detailed in the ASU.
Under the simplified approach:
- A receive-variable, pay-fixed interest rate swap may be measured subsequently at settlement value instead of fair value. Thus, settlement value may be estimated by applying a PV calculation of the swap's remaining estimated cash flows using a valuation technique that is not adjusted for non-performance risk.
- No hedge ineffectiveness may be assumed in a covered cash flow hedging relationship.
- Required documentation to qualify for hedge accounting must be completed by the date on which the first annual financial statements are available to be issued after hedge inception, rather than concurrently at inception of the hedge.
- If any of the qualifying conditions for applying the simplified hedge accounting approach subsequently cease to be met or the relationship otherwise ceases to qualify for hedge accounting, the applicable provisions of hedge accounting in general must be applied prospectively.
3. ASU 2014-18: Subsuming Certain Intangibles into Goodwill
The FASB issued ASU No. 2014-18, which established an accounting alternative that allows private companies not to recognize, or otherwise consider the FV of intangible assets resulting from a qualifying transaction, separately from goodwill for certain intangible assets.
The accounting alternative permits, but does not require, private companies not to recognize separately from goodwill 1) customer-related intangible assets, unless they are capable of being sold or licensed independently from other assets of a business, and 2) non-competition agreements.
The accounting alternative may be elected in any of the following qualifying transactions:
- Applying the acquisition method to a business combination
- Assessing the nature of the difference between the carrying amount of an investment and the amount of underlying equity in net assets of an investee in applying the equity method of accounting
Required Adoption of ASU No. 2014-02: To apply the accounting alternative, a private company must also have adopted the accounting alternative for amortizing goodwill introduced in ASU No. 2014-02 and, accordingly, must amortize goodwill on the straight- line basis over 10 years, or less than 10 years if it can be demonstrated that another useful life is more appropriate. If the accounting alternative for amortizing goodwill was not adopted previously, it should be adopted on a prospective basis as of the adoption of the accounting alternative in ASU No. 2014-18.
4. ASU 2018-07: Exclusion from Applying VIE Guidance in Common Control Situations (supersedes 2014-07)
The FASB issued ASU No. 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities, which provided an accounting alternative under which a private company could elect not to apply the guidance for variable interest entities (i.e., VIE guidance) to arrangements between legal entities under common control (including common control leasing arrangements) if both the parent and the legal entity being evaluated for consolidation were not public business entities (PBEs).
Under the optional accounting alternative, which is made as an accounting policy election, the private company is not required to apply VIE guidance to evaluate arrangements with a legal entity if all of the following criteria are met:
- The reporting entity and the legal entity are under common control
- The reporting entity and the legal entity are not under common control of a PBE
- The legal entity under common control is, itself, not a PBE
- The reporting entity does not otherwise directly or indirectly have a controlling financial interest in the legal entity
The accounting policy election must be applied to all current and future legal entities under common control that meet the criteria for applying the alternative.
Read more: What is a VIE, and do you have one?
5. ASU 2021-02: Franchisor Accounting
The FASB issued ASU No. 2021-02, Franchisors—Revenue from Contracts with Customers (Subtopic 952-606): Practical Expedient, which provided an optional practical expedient to simplify application of the guidance on identifying performance obligations for certain franchisors.
Specifically, permits franchisors that are not PBEs to account for pre-opening services provided to franchisees as distinct from the franchise license itself, if such services are of the type that are consistent with those included in a pre-defined list and this alternative also helps with concerns by constituents about the cost, complexity, and effort involved in identifying and evaluating performance obligations relating to pre-opening services.
A franchisor that elects the practical expedient is required to apply the guidance in FASB ASC 606 to determine whether the pre-opening services are distinct from one another, unless the franchisor has made an accounting policy election to account for the pre-opening services as a single performance obligation.
The practical expedient applies only to identifying performance obligations and should be applied consistently to contracts with similar characteristics and in similar circumstances. The remaining guidance in FASB ASC 606, including allocation of the transaction price and the recognition of revenue, must still be applied. If the entity has not elected to apply the practical expedient or the pre-opening services performed are different from those on the foregoing list, FASB ASC 606 should also be applied to identify performance obligations.
6. ASU 2021-03: Performing Goodwill Impairment At the end of a Reporting Period
The FASB issued ASU No. 2021-03, Intangibles—Goodwill and Other (Topic 350): Accounting Alternative for Evaluating Triggering Events, which provided private companies and nonprofit entities with an option to perform the identification and evaluation of a triggering event for goodwill impairment only as of the end of an interim or annual reporting period. Thus, upon election of the option, goodwill impairment triggering events are required to be monitored only as of the end of each reporting period, rather than when a triggering event occurs.
Note that the accounting alternative does not change the following: 1) the requirement to assess other assets for impairment (e.g., long-lived assets and indefinite-lived intangibles) under existing guidance, 2) the timing of when to test goodwill for impairment as part of a disposal group classified as held for sale and 3) the requirements to test the remaining goodwill for impairment if only a portion of goodwill is allocated to a business or nonprofit activity to be disposed of.
7. ASU 2021-07: Estimating Share Price to Determine Fair Value of Share-Option Awards
The FASB issued ASU No. 2021-07, Compensation—Stock Compensation (Topic 718): Determining the Current Price of an Underlying Share for Equity-Classified Share-Option Awards, to permit (but, not require) nonpublic entities to apply a practical expedient to estimate the current price of their underlying shares for purposes of determining the fair value of share options at the grant date or upon a modification to the award.
The practical expedient requires the “reasonable application of a reasonable valuation method,” which must include the following characteristics: 1) the date on which the reasonableness of a valuation is made, 2) the factors and scope of information that a reasonable valuation should consider and 3) the criteria that should be met for the use of a previously calculated value to be considered reasonable at a later date.
The practical expedient allows a nonpublic entity to use a value determined by the reasonable application of a reasonable valuation method as the current price of its underlying shares for purposes of determining the fair value of an equity-classified award at the date of grant or upon a modification to the award. Note that the practical expedient 1) may not be applied to awards classified as liabilities and 2) must be applied to all eligible share-based awards having the same underlying shares and measurement date.
8. ASU 2021-09: Using a Risk-Free Rate to Determine Present Value of Lease Payments
ASU No. 2016-02, Leases (Topic 842), issued in February 2016, included a practical expedient allowing non-PBE lessees to make an accounting policy election to use a risk-free rate (i.e., rather than the incremental borrowing rate) as the discount rate to arrive at the PV of lease payments for all leases.
The practical expedient was included in ASU No. 2016-02 to provide relief for private company lessees from having to calculate an incremental borrowing rate. Subsequently, some private companies have been reluctant to apply the risk-free rate election for all leases, noting that in the current economic environment, a risk-free rate (e.g., a U.S. Treasury rate) is low compared with expected average incremental borrowing rates and, thus, applying the risk-free rate election could increase an entity's lease liabilities and corresponding right-of-use assets.
In response to comments by constituents, the FASB issued ASU No. 2021-09, Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities, which amends the practical expedient in FASB ASC Topic 842, Leases, allowing the use of a risk-free discount rate by lessees as an accounting policy election (i.e., the risk-free rate election) for entities that are not PBEs to permit such entities to make the risk-free rate election by class of underlying asset, rather than at the entity-wide level. Note that when the rate implicit in a lease is readily determinable, that rate would have to be used.
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