FASB and AICPA seek small, private company input

The Financial Accounting Standards Board and the American Institute of CPAs have announced a joint project whose aim is to seek “constituent feedback on proposed enhancements to the FASB’s standard-setting procedures that would determine whether the Board should consider differences in accounting standards for private companies.”

This is the classic conundrum commonly known to those in the biz as “big GAAP little GAAP.” (Link via Jack Ciesielski’s AAO Weblog.)

What this refers to is GAAP for “big”, public companies and “little”, private companies. It’s about striking a balance between the cost of complying with accounting standards for small companies with its relative benefit to financial statement users.

In Canada, the profession has responded to the issue with something called “differential reporting”, which is a set of options that non-publicly accountable entities can choose to make their financial reporting cheaper, without sacrificing quality.

The most common options that I see in my work have to do with accounting for subsidiaries and other significantly-influenced investments, and income taxes. Ordinarily controlled entities are required to be consolidated in the financial statements with the parent company, but under differential reporting you can use easier methods such as the equity or cost method. They don’t provide the same level of disclosure or quality of information, but in smaller companies this isn’t the end of the world.

For income taxes, the taxes payable method is an option that can be used instead of the future income taxes method, allowing a company to forgo measuring their future income taxes, which are taxes that are likely to be assessed in future periods and arise from timing differences between financial accounting and tax laws.

In order to use differential reporting options, all the shareholders must agree to use it. As you can imagine, it is easiest and used most often in companies with owner-managers or only a handful of shareholders. It is useful because these types of shareholders are privy to information in the companies that ordinary shareholders in public companies simply aren’t, by virtue of their increased involvement in the daily operations.

Accounting Standards

More discussion of rules versus principles

Dennis over at AccMan Pro has commented on the difference between rules-based US GAAP and international principles-based IFRS, and his thoughts echo mine:

Recent commentary has suggested the idea of convergence between US GAAP and IFRS won’t happen until hell freezes over. I’ve long held the view that the rules based US GAAP system is primarily responsible for many of the problems US based companies have experienced. It is the structural defect of being rules driven. Any time there are rules in place, companies and individuals will seek to find ways around them. It allowed CA and PeopleSoft to engage in creative accounting practices, which, in the case of CA, have been deemed fraudulent. And which eventually led to the corporate nose bleed that is SOX.

I’m discouraged that he seems so certain that convergence of US GAAP and IFRS won’t happen any time soon. Canadian GAAP is moving towards convergence, as is the rest of the world it seems.

I suppose we’ll have to wait until the US is no longer a superpower (which will no doubt happen in my lifetime) before they start to work with the rest of the planet. Rules are meant to be broken, or so the saying goes, and its been played out for all to see in the cases mentioned by Dennis above and with Enron and WorldCom and countless others.

Under a principles based system, professional judgement takes centre stage and the aim is to reflect the substance of the transaction as opposed to fitting it into the rules as they exist. It allows the professionals to do their job: Determining whether the statements are fairly presented. It doesn’t take a professional to figure out if the rules are met.

Accounting Standards

Lease accounting to get overhaul

Apparently FASB is going to overhaul the US GAAP for leases. I’m not sure what exactly is going to be changed, or why it needs changing, but it’ll be interesting to see. Of course, Canadian standards are moving towards harmonization with International Financial Reporting Standards (IFRS), so we might not see Canada following the US revision like we usually have seen occur in the past.

I’ve been discussing the current method of accounting for leases with Greg, whose site I stumbled upon today searching Technorati for accounting-related content. He was blogging about an article in Business Week, and what follows is a quote from that article that may give us some insight into the possible changes:

One new model that FASB will explore, says Herz, would treat a lease as a “right to use” the property, which would be given a value and included among the liabilities and assets of the company that is leasing it. Companies argue that information about these leases is not secret, but is readily available in the footnotes of their annual reports. However, Bear Stearns analyst Chris Senyek has found that such disclosure is far from consistent, with some companies leaving out vital information such as the length of the lease. And the databases that many investors consult to sort through a company’s performance generally don’t include the data from footnotes.

Not sure what the “right to use” means as far as the difference between current rules about leases goes, given that we already have a good method for valuing a lease (the present value of minimum lease payments) asset and corresponding liability. Basically the FASB believes the rules need to be clarified because the criteria have been abused to show more leases as operating versus capital. But that’s just the difference between US rules-based accounting and Canadian and international principles-based accounting.

Plus, the article even notes that the information is already contained in the notes to the financial statements. My firm has a footnote on every page of the financial statements we produce that clearly states “The accompanying notes are an integral part of the financial statements.” If investors are ignoring that information, is this really an accounting problem?


Materiality in auditing

Materiality is a concept in auditing that attempts to set a dollar value guideline for the scope of evidence testing at the substantive level, analytical procedures, and to a lesser extent, controls testing.

According to Krupo:

“Materiality is the smallest misstatement of a company’s finances that would cause a person to change how they value the entity in question.”

That sums it up nicely. It’s really based on what’s important to someone with a stake in the financial health of the entity.

For audits of for-profit companies, materiality is usually based on a percentage of revenues or income (pre-tax). 1-2% of revenues or 5-10% of net income is the benchmark. In non-profit organizations, materiality is usually 1-2% of expenditures.


Revenue recognition and Nortel

Nortel BramptonNortel Networks Corp. once again will have to restate its financial results to fix accounting mistakes, the company said on Friday as it posted a fourth-quarter loss of $2.2 billion.

Their chief executive maintains that the revenue was just recognized in incorrect periods, from 2002 through 2005.

Revenue recognition is definitely a touchy subject these days, I know we certainly spend more time nowadays on it than we used to. We have checklists to ensure we’ve considered every different aspect of sales arrangements and there is a note to the financial statements concerning how and when revenues are recognized.

Since Nortel is large (complicated) and public (risky), the audit could take quite long and I wouldn’t be surprised if there are a handful of public accountants who are there each year more often than they are at their own office.