Reconsidering Private Company GAAP
Adopting private company GAAP alternatives could yield significant time and cost savings.
By MARK RILEY, PH.D., AND PAMELA A. SMITH, PH.D. |
Back in 2014, the Private Company Council (PCC) issued four
Accounting Standards Updates (ASU) that offered relief to private
entities with respect to accounting for goodwill, certain intangible
assets acquired in a business combination, certain interest rate
swaps, and variable interest entities. However, the PCC found the
costs associated with applying the financial reporting requirements
often outweighed the benefits of applying them. Thanks to revised
transition guidance and amended effective dates in ASU 2016-03,
this is no longer the case.
Today, the alternatives to private company GAAP are more
accessible — and attractive. The 2016 transition guidance alleviated
the need to assess preferability as well as, in certain instances, the
requirement for retroactive application. This significant relief
provides private entities more time to learn, adopt, and implement
the simplified alternatives to private company GAAP — but it has
gone overlooked by many.
If you are an auditor or accountant for a private entity that has not
adopted one or more of the PCC’s alternatives to private company
GAAP, it is time to reconsider whether the alternatives make sense.
The PCC has made adoption easier, and significant time and cost
savings could be uncovered by looking at these alternatives before
year-end reporting and auditing.
Here is when and why choosing to adopt an alternative might be
in your private entity’s best interest.
GAAP generally treats goodwill as an asset with an indefinite
life that undergoes costly impairment testing at least annually.
The exceptions under the PCC’s alternative, ASU 2014-02,
“Intangibles — Goodwill and Other (Topic 350): Accounting for
Goodwill,” relieve privately held entities from performing annual
impairment tests on goodwill.
Instead, private entities choosing the alternative must amortize
goodwill over a period of not more than 10 years. In addition, ASU
2014-02 states any goodwill existing when the company adopts
the alternative is to be “amortized prospectively on a straight-line
basis over 10 years, or less than 10 years if an entity demonstrates
that another useful life is more appropriate.”
While this does not completely relieve private entities from
goodwill impairment testing, it is generally agreed the alternative
under ASU 2014-02 reduces costs associated with goodwill
accounting. Our interviews with auditors of privately held
companies indicated that family-owned and closely held
businesses tend to take advantage of this alternative.
Reducing artificial inflation of goodwill is one reason acquisition
method accounting requires the identification of all identifiable
intangible assets associated with a business combination. The
rationale is that if all intangibles related to marketing, customers, artistic rights, contracts, and technology are separately identified
and valued, then goodwill is not harboring assets that should be
separately valued and reported and, therefore, the cost of these
assets is not obscured.
That said, separate identification of, and accounting for, certain
intangibles in a business combination fails a cost-benefit test for
private entities. From the preparer’s perspective, the identification
and valuation of certain intangibles is costly and requires valuation
expertise. From the user’s perspective, many of these intangibles
do not provide value-relevant information because the users of
the closely held financial statements are focused on hard assets
and cash flows.
The PCC alternative, ASU 2014-18, “Business Combinations
(Topic 805): Accounting for Identifiable Intangible Assets in a
Business Combination,” allows the private entity to avoid
separately valuing and accounting for non-competition agreements
and customer-related intangibles that are not capable of being sold
or licensed separately from the business. So, if a private entity
purchases another entity, these intangibles explicitly associated
with the acquired company can be combined with goodwill. One
caveat is if the private entity elects the alternative to not separately
identify the non-compete agreements and customer-related
intangibles, then the private entity also must adopt the alternative
for accounting for goodwill.
A common risk, is the uncertainty associated with variable-rate debt
or borrowing. While private entities can hedge variable interest rate
risk without applying hedge accounting, doing so means their
financial statements will not reflect the economics of the hedge.
Hedge accounting permits the financial statements to reflect interest
expense as if the entity had fixed-rate debt.
The simplification in ASU 2014-03, “Derivatives and Hedging
(Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed
Interest Rate Swaps — Simplified Hedge Accounting Approach,”
alleviated the complexities of accounting for interest rate swaps by
providing private entities relief from GAAP requirements of
assessing effectiveness of interest rate swaps. It also allows a private
entity to price a swap at settlement value rather than fair value.
Certain documentation is required, but the entity can complete the
documentation by the date on which the first annual financial
statements are available to be issued rather than at hedge inception.
Our conversations with audit partners revealed that many private
companies are not using this simplification. One reason is because
the recent interest rate environment did not incentivize hedging
against rising interest rates. However, many experts now expect
further interest rate increases. Between rising interest rates and the
change in guidance on when and how this alternative is adopted,
private entities should reevaluate the use of swaps on current and
prospective hedges of variable interest rate risk and keep the
interest rate swap/hedge accounting alternative in mind.
Until the PCC issued its alternative, ASU 2014-07, “Consolidation
(Topic 810): Applying Variable Interest Entities Guidance to
Common Control Leasing Arrangements,” private entities were
required, like public companies, to consolidate variable interest
entities (VIE) for which they were the primary beneficiary. However,
in situations where a private entity leased property from a VIE under
common control of the private entity, the resulting consolidated
financial statements were not decision-useful. In its summary of the
private company alternative, the PCC noted that many users of
private company financial statements request schedules that allow
them to “deconsolidate” VIEs consolidated in private company
financial statements. The PCC also noted that private entities have
differing motives for establishing VIEs and their lease arrangements.
In general, private company VIE leasing arrangements are for tax,
estate planning, or legal-liability purposes. In contrast, public entity
VIE leasing arrangements are often used to structure off-balance-sheet
financing (ASU 2014-07, p. 1).
Because of the costs and distortions involved with consolidation of
certain VIEs, the PCC alternative requires disclosures but not
consolidation. The PCC made the alternative available if the
primary activities between the private entity and the lessor entity
under common control (the VIE) relate to leasing. In addition, the
PCC requires that the amounts of any guarantees the private entity
made or collateral it provided to the lessor (VIE) are less than the
value of the asset leased (ASU 2014-07, p. 2).
MINDING THE GAAP
The PCC accounting alternatives are most helpful to family-owned
or closely held private companies (versus private equity-owned)
because they not only simplify the application of the accounting
standards, but also fit the needs of their financial statement users.
Further, family-owned private companies often have relatively
small accounting staffs that need more time to learn and
implement new standards. The reprieve for transition to the PCC
alternatives is good news for family-owned and closely held
private entities, and now is as good as ever to reconsider putting
them into practice.
The authors are professors in Northern Illinois University’s
Department of Accountancy and are CPAs licensed in Texas and
registered in Illinois. Mark Riley, Ph.D., Dean and Brenda DuCray
Associate Professor, can be reached at [email protected]. Pamela A.
Smith, Ph.D., KPMG Endowed Professor and Illinois CPA Society
honorary member, can be reached at [email protected].