FAR EXAM CHANGE: BIG GAAP VS. SMALL GAAP
Featuring Mark Dauberman, CPA – Senior Editor, Roger CPA Review

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Hello, my name is Mark Dauberman, I’m the senior editor at Roger CPA Review, and it is my pleasure to chat with you today about a new area of accounting that is a recent development.

The FASB issued several pronouncements in the first quarter of 2014 and as a result, this topic will be eligible for testing on the FAR section of the CPA exam as early as the fourth quarter of 2014.

You may be familiar with a very significant controversy that’s been going on in the accounting profession for a number of years. There are a number of members of the profession that feel that accounting is getting too burdensome.

And they feel that for the non-public company, following GAAP has reached a level where the cost exceeds the benefit of the financial reporting. They feel that between the complexity of some of the methods, and the extent of some of the disclosures, that the non-public company is spending too much on it’s financial reporting.

On top of that, they feel that because of the access that the users of the financial statements that the non-public companies have, to the management of non-public companies, and the ownership of non-public companies, that this level of accounting is often unnecessary.

Well the FASB has finally responded. They established a new organization called the Private Company Counsel, I’ll be referring to it as the PCC. And the PCC addressed three areas in the first quarter of 2014.

The three areas we’ll be talking about today are: number one, Goodwill, number two, Derivatives, and in particular, Interest Rate Swaps, and number three, Variable Interest Entities, and again, in particular, when we have a commonly owned lessor and lessee involved in a leasing arrangement.

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Let’s start out talking about goodwill. As you know, goodwill can only be obtained as a result of a business combination. And when a company is involved in a business combination, if they pay more for a company than the fair value of its underlying net assets, the difference is recognized as goodwill.

In a simple situation, the company that was acquired, may represent a single reporting unit, the company may maintain one set of books and records for that company, in which case the goodwill will be in that reporting unit.

However, if a company acquires a more complex business, it might have more than one reporting unit, and as a result, the goodwill would be allocated to each of them.

It’s possible for a company that gets involved in numerous acquisitions, each of which is of a complex company, with several different reporting units, that company might have several different goodwills on their financial statements, and each one has to be accounted for separately.

Under current GAAP, a company that has goodwill will do the following: number one, it’s considered a permanent asset. It is not amortized, it remains on the books at its original amount. No costs are capitalized to goodwill other than the original amount recorded when the company is acquired.

Then, at least annually, the company is required to assess goodwill to see if it’s been impaired. They have the option of first performing a qualitative assessment, and if they can demonstrate that goodwill has not been impaired through that qualitative assessment, then that’s all they need do.

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However, if they can’t demonstrate that goodwill has not been impaired with a qualitative assessment, then they’re required to perform a quantitative assessment. And that can be quite burdensome because it involves determining the fair market value of each reporting unit that has goodwill.

Many companies have spent a lot of money on testing goodwill for impairment, and quite frankly, the non-public company feels that the cost of doing so, far exceeds the benefit.

Well, the Private Company Counsel, or PCC of the FASB issued a pronouncement, as I indicated, in the first quarter of 2014, that provides what’s referred to as an Alternative Accounting Approach for non-public companies.

All three of the areas that we’re talking about, involve what is called an Alternative Accounting Approach that a non-public company may elect to use but is not required to use. And as you know, any time a company has a choice between two or more acceptable methods of accounting, they are required to disclose, in their footnotes, in particular in the summary of significant accounting policies, what choice they’ve made.

So a private company, or non-public company, that elects to use any one of the three alternative accounting approaches that we talk about today, will have to make an election by disclosing their choice in their summary of significant accounting policies.

So on that note, let’s get back to goodwill. A private company, or non-public company that elects that alternative accounting approach will do the following: number one, they will amortize goodwill. It will be amortized on the straight line basis and its useful life will be 10 years, unless the company can demonstrate that a shorter period of time is better.

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As a result, every year, as you know, goodwill is getting lower and lower. And as a result of that as well, it makes it less and less likely that goodwill has been impaired. The lower the amount is, the less likely it is that it is greater than its fair value.

Secondly, a company is only required to test goodwill for impairment if there is a triggering event indicating that is it more likely than not that goodwill has been impaired. When that is the case, the company will apply a more simplified one-step numerical approach.

Regardless, the non-public company has the option of assessing goodwill at the entity level rather than the reporting unit level. The advantage there is, no matter how many acquisitions a non-public company has been involved in, no matter how many reporting units each acquisition contained, a non-public company electing to do so, will have only one assessment of goodwill. And that will be done at the company level, rather than at the reporting unit level.

So, to summarize the basic differences. First of all, a company will receive or obtain goodwill in the same way, regardless of whether it’s a public company or a non-public company.

However, whereas a public company will retain that asset at its original amount indefinitely, a non-public company will amortize it over a period not to exceed ten years.

Number two, both public and private companies will be required to assess goodwill for impairment, but a public company will have to do it at the reporting unit level, which means there may be several assessments every year.

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A private company will have the option of assessing goodwill for impairment only at the entity level. Let’s go through a quick example of that. I’ve taken a multiple choice question from a previous exam and altered it slightly to test the information that is covered by this new pronouncement.

So let’s assume that a company is involved in a business acquisition at the end of year one, and they determine that they have goodwill of $100,000. They immediately spend another $20,000 so that they can enhance and preserve that goodwill. They’ve elected the alternative accounting approach.

And the question is, what will be the carrying value of goodwill at the end of year two?

The four choices that we’re given, in this particular question are: Choice A, $100,000, Choice B, $120,000, Choice C, $90,000, and Choice D, $108,000. Let’s go through it.

First of all, goodwill is originally recorded at $100,000. The $20,000 that was spent to enhance and preserve goodwill, is considered an expense in the period incurred, and cannot be capitalized.

So we can immediately eliminate any number that is in excess of $100,000. So we know the choice has to be either A, $100,000, or C, $90,000.

Going one step further, if this were a public company, they would not be allowed to amortize goodwill, in which case the answer is A.

However, since this is a non-public company, that did elect the alternative accounting approach, they will amortize goodwill over 10 years. Amortization in year two will therefore be 10 percent or $10,000, reducing the carrying value of goodwill to $90,000.

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Those of you that got C, pat yourselves on the back, you are one step closer to passing the CPA exam. There is a point that you’ve just earned, congratulations.

The second area we’re going to talk about, is derivatives. And in particular, we’re going to talk about one type of derivative that is very, very commonly used. It’s called the Interest Rate Swap.

When a company borrows money, they will often find that they can get a much more favorable interest rate if they borrow using what is called, a Variable Rate Loan, rather than a Fixed Rate Loan. This means that the interest that they will pay will change as market rates change.

So initially, the interest rate will be the market rate plus usually some factor, perhaps it’s prime rate plus one or two points. And then, as that prime rate fluctuates their interest rate will increase or decrease accordingly.

Needless to say, if interest rates go down, that’s a benefit to the company because it means their interest expense will go down. However, if interest rates go up, it means that their payments will increase and their interest expense will increase.

Well many companies are not willing to take the risk that interest rates will go up. And so they’ll enter into a very common type of derivative, called an Interest Rate Swap. Basically, they’ll find someone that believes that interest rates are going to go down. And they’ll enter into an agreement that basically says, “We will pay this other party interest based on the same principle amount at a fixed rate of interest, and they in turn will pay us a variable rate based on that same principle amount.”

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So, if I owe, let’s say, a million dollars, that bears interest at prime plus two, I enter into an interest rate swap where I’m receiving prime plus two on a $1,000,000, and paying six percent.

What will happen, in essence, is the prime plus two that I’m paying on my loan, will be offset by the prime plus two I’m receiving on the interest rate swap, and my net cost will be the six percent
that I am paying to that counter-party on the swap.

As a result, if interest rates go down, the variable rate I am paying on my loan goes down, the variable rate I’m receiving on the swap goes down but the six percent that I’m paying on the swap stays the same. If market rates go up, the interest rate I’m paying on the loan goes up, the variable rate I’m receiving on the swap goes up, but the fixed rate I’m paying on the swap stays the same.

So, if this were a perfectly effective swap, if it worked exactly the way it intended to do, as many of them do, then I would have converted this from a variable rate loan, to a fixed rate loan, bearing interest at six percent.

The best way to account for an interest rate swap that is obtained for the purpose of converting a variable rate loan into a fixed rate loan, is to use what is referred to as Hedge Reporting. But hedge reporting is an area that is very susceptible to abuse. And so the FASB set some very, very strict requirements on companies that want to use hedge reporting.

Number one, it must be highly effective as a hedge, it must accomplish what it is intended to accomplish. And the company must set up some very specific guidelines for how they’re going to determine whether or not this hedge is effective.

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There’s a lot of documentation associated with the acquiring of hedges, and the accounting for them as hedges, and all of that documentation is required to be done at the inception of the relationship. Which means on the date when the company acquires that derivative, when they enter into that interest rate swap, everything has to be complete.

Their documentation has to be complete, their method for testing for effectiveness has to be complete, and they have to be able to demonstrate that not only in the past would this swap have been effective, but it is likely to be effective in the future.

Well the cost of applying the hedge method of accounting can get pretty high. And non-public companies have complained that in many cases, even though hedge reporting would be most appropriate for them, because of the steps they’ve gotta go through in order to use hedge reporting, they’ve not be able to do so.

Well this is the second area that the PCC has addressed. And they’ve addressed specifically this type of arrangement, where a company has an obligation that bears interest at a variable rate, they enter into an interest rate swap, in which they are receiving a variable rate and paying a fixed rate.

And they may elect this alternative accounting approach, if the swap and the underlying obligation have almost identical terms. The amounts, the basis on which the interest rate is calculated, the timing of the payments, et cetera, et cetera. All of the terms have to be either the same, or very similar.

When that is the case, a private company has the option of electing this alternative accounting approach, and it means the following:

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Number one, much simpler to elect. They don’t have to have their documentation completed at the inception of the hedge, they have to have it completed by the time their first set of financial statements are completed and available to be issued. So this may be several months after this derivative is acquired.

Number two, they’re allowed to assume that the hedge is perfectly effective. They don’t have to test effectiveness, they can assume that it’s gonna work exactly as it’s intended to.

And number three, they’ve simplified the accounting. Instead of recording the hedge, or the derivative at fair value, like a public company is required to do, instead it will be reported at its settlement value, which is much easier to calculate.

And because, as a result, our journal entry may not balance, whatever we need to balance the journal entry will automatically be a debit or credit to other comprehensive income.

So they’ve made the accounting simpler, they’ve made it easier to elect hedge reporting, by the non-public company number one, and number two, when they’ve elected it, they’ve made it much simpler to apply the hedge method of accounting, and so their financial statements will reflect the economic substance.

The reason they got into the hedge was to convert the loan from variable to fixed, and that’s exactly what the accounting will reflect. So this is another area that many non-public companies will really benefit from.

The last area that we’re going to talk about is probably one of the most burdensome that has occurred in the last several years in relationship to non-public companies.

As you may be aware, Enron, and many of you may not have even heard of Enron, it’s been so long. But Enron was a situation of a publicly held company that used what were referred to as Special Purpose Entities, as a means of hiding liabilities from their balance sheet.

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They would have these entities formed, they would form them in a way that Enron was not a major stock holder, and so under accounting principles at that time, the company was not required to prepare consolidated financial statements. These special purpose entities would borrow money for the benefit of Enron, but because they did not prepare consolidated financial statements, they were not reported as loans on Enron’s books.

And as we know, at some point in time, Enron becomes unable to pay those loans, and it became obvious that Enron’s financial statements were materially misstated. And as you also probably know, the result was the passage of a major piece of legislation called Sarbanes Oxley.

All of you studying for the exam will be very familiar with many aspects of Sarbanes Oxley, because it is very important to auditors of publicly held companies.

Under Sarbanes Oxley, the SCC mandated that the FASB close the loophole that allowed Enron to ignore the liabilities of these special purpose entities. And as a result, they created this new area of accounting called the Variable Interest Entity.

Basically what this means, is a publicly held company, or actually every company, is required to evaluate their relationships with other companies, even other companies that they don’t own, with which they are doing a substantial amount of business. And there’s a time consuming, and potentially expensive analysis that they go through to determine whether despite the fact that they do not own a majority of the voting equity of that other company, do they anyway have a controlling financial interest.

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Upon completing the analysis, if they find they do have a controlling financial interest, they’re required to prepare consolidated financial statements. So we’ve got two burdens, both of which are potentially costly.

Number one, a costly analysis to determine whether or not the company does have a controlling financial interest over this special purpose entity referred to now as a Variable Interest Entity or VIE.

Number two, if they do, then they have to prepare consolidated financial statements.

Well, large and publicly held companies get involved with special purpose entities for a wide variety of reasons. Some of which might be for the purpose of hiding liabilities off of their balance sheets. Small and non-public companies tend to get involved with special purpose entities usually for tax purposes, or cash flow purposes, rather than to hide something, or to misrepresent information on their financial statements.

Despite that fact, if they want to prepare GAAP financial statements, they too are required to go through this extensive analysis to determine whether this separate entity is a variable interest entity, and whether it needs to be consolidated. And if so, they need to prepare consolidated financial statements.

The most common way the non-public company uses this type of entity is when a small group of owners of a company decide they want to buy assets in a separate entity. They might set up, for example, a separate LLC, and then they’ll buy the assets in that entity and lease it to their other company.

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Well, this LLC, for all practical purposes, may be a VIE that they would need to consolidate into their financial statements. The ironic thing is, number one, as we’ve talked about, the process is potentially expensive, and number two, the users of their financial statements usually would prefer that they did not get consolidated financial statements. They want to see what the company’s financial statements would look like if this were simply a conventional lease.

As a result, the PCC has once again established another set of standards. And this is exclusively available for non-public companies, that are involved with a related entity in a leasing arrangement.

Now this alternative accounting approach applies if we’ve got two companies that are under common ownership, one is the lessor, one is the lessee, and the lessee is the reporting entity. And for all practical purposes, the only significant relationship between them, is this lease.

When that is the case, a non-public company has the option of electing this alternative accounting approach. And under this alternative accounting approach they’re not required to analyze this entity at all to determine whether it is a VIE, and whether or not they have a controlling financial interest.

Instead, they will ignore the VIE provisions, they will account for this lease in the same manner as they account for all of their leases. It’ll be analyzed to determine whether it’s a capital lease or an operating lease. And in addition, the company will provide some additional disclosures because this is a related party transaction.

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So as you can see, the FASB has listened to the complaints of small companies, and they’re finally addressing this by presenting new pronouncements for non-public companies in the form of PCC, Private Company Counsel pronouncements.

So far we’ve got three, goodwill, derivatives and interest rate swaps, and variable interest entities, and although these are simpler area of accounting, keep in mind, you, in preparing for the exam, will need to know both, the method for public companies, and the alternative accounting approach for non-public companies.

To that end, I’ll be working with our team here at Roger CPA Review to make sure that our materials are updated so that you have the most up-to-date and complete information in preparing for this exam.

Good luck, we know that with our help, you can make this process efficient, effective, and most importantly, enjoyable. Thank you.