Since May 2012, the Financial Accounting Standards Board (FASB) has been working with the Private Company Council (PCC) to determine whether alternatives to existing US Generally Accepted Accounting Principles (GAAP) standards are appropriate for private company financial statements. Two new accounting standard updates mark the first concrete steps toward providing relief from burdensome and costly requirements for private companies that need or are required to have financial statements prepared in accordance with GAAP.
Accounting Standards Update (ASU) 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill, and ASU 2014-03, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps—Simplified Hedge Accounting Approach, give these companies options that will simplify goodwill impairment and extend hedge accounting to certain interest rate swaps. Both ASUs were released in January 2014.
Emergence of GAAP alternatives for private companies
The updates stemmed from PCC proposals that FASB endorsed in 2013. The PCC was established in May 2012 by the Financial Accounting Foundation, FASB’s parent organization, to improve the process of setting accounting standards for private companies that adhere to GAAP.
Toward the end of 2013, FASB and the PCC published new guidance, Private Company Decision-Making Framework: A Guide for Evaluating Financial Accounting and Reporting for Private Companies (the Guide), for determining whether private companies should be allowed to apply alternative standards in the areas of recognition and measurement, disclosures, display/presentation, effective date, and transition method. For each of these areas, the Guide lays out criteria FASB and the PCC will use to evaluate whether to allow alternative guidance. ASU 2014-02 and ASU 2014-03 represent the first of the alternative guidance.
Traditional GAAP treatment of goodwill
The term “goodwill” refers to the residual asset recognized in a business combination, such as a merger, after all other identifiable assets acquired and liabilities assumed have been recognized. GAAP requires that goodwill be carried on the books at its initial value less any impairment. It isn’t subject to amortization.
Goodwill is impaired if the implied fair value of goodwill in a company’s reporting unit — basically, an operating unit that has its own discrete financial information, separate from the overall company — drops to an amount less than its carrying amount, or book value, including any deferred income taxes. Companies must test for impairment at least annually, and more frequently under certain conditions.
GAAP allows a company to begin the impairment testing process with a qualitative evaluation to determine whether it’s more likely than not (that is, a likelihood of more than 50%) that a reporting unit’s fair value is less than its carrying amount. If the company determines it’s not more likely than not that fair value is less than the carrying amount, it can skip the quantitative two-step impairment test. If it is more likely than not, the company must perform the two-step test.
In the first step, the company computes the reporting unit’s fair value and compares that amount with the reporting unit’s carrying amount, including goodwill. If the carrying amount exceeds the fair value, the company performs the second step: measuring the amount of the goodwill impairment loss, if any, by comparing the implied fair value of the reporting unit’s goodwill with the goodwill’s carrying amount. To do this, the company must conduct a hypothetical application of the acquisition method to determine the implied fair value of goodwill after measuring the reporting unit’s identifiable assets and liabilities.
The new goodwill option
Preparers and auditors of private company financial statements have voiced concerns about the cost and complexity required to comply with the existing GAAP goodwill standards. And users of these financial statements have noted that the requirements provide limited benefits to them because they usually pay little attention to goodwill and impairment losses when analyzing a company’s financial condition and operating performance.
The alternative standards in ASU 2014-02 are intended to respond to these realities. They permit a private company to amortize goodwill after its acquisition — and initial recognition and measurement — on a straight-line basis during a period of 10 years, or less if the company establishes that another useful life is more appropriate. The company can revise the remaining useful life of goodwill if warranted by events and changes in circumstances, but the cumulative amortization period can’t exceed 10 years.
A company that opts for the alternative must make an accounting policy decision to test goodwill for impairment at either the company level or the reporting unit level. Testing is only required, however, when a triggering event (for example, a significant adverse change in business climate) occurs that suggests the fair value of a company or a reporting unit may be below its carrying amount.
The alternative standard also eliminates the hypothetical application of the acquisition method in the second step of the current impairment test. Rather, the amount of the impairment equals the amount by which the carrying amount of the company or reporting unit exceeds its fair value. Impairment loss may not exceed the company’s or reporting unit’s carrying amount of goodwill.
The aggregate amount of goodwill net of accumulated amortization and impairment should be reported as a separate line item in the company’s statement of financial position. The amortization and aggregate amount of goodwill impairment will appear in income statement line items within continuing operations unless the amortization or impairment is associated with a discontinued operation, in which case amortization and impairment must be included on a net-of-tax basis within the results of discontinued operations.
The alternative requires disclosures similar to those required by existing GAAP. But a company that elects the alternative need not present changes in goodwill in a tabular reconciliation.
Advantages of the private company alternative
Private companies that elect the goodwill alternative could enjoy significant cost savings because of the combination of the amortization method and the elimination of the annual impairment testing requirement. Amortization should reduce the odds of impairments, and testing might be necessary less often. If impairment testing is required, the elimination of the second step and the ability to test at the company level — as opposed to the reporting unit level — should reduce the cost of testing.
The goodwill alternative applies prospectively. A company will amortize existing goodwill as of the beginning of the period of adoption in which the alternative is elected. New goodwill recognized after the beginning of the annual period of adoption will also be amortized.
The new interest swap option
Private companies can have trouble obtaining fixed-rate loans. Lenders may require them to enter into an interest rate swap (a derivative instrument) to convert their variable-rate loans to fixed-rate loans.
Current GAAP guidance requires a company to recognize all of its derivative instruments in its balance sheet as either assets or liabilities and measure them at fair value, but a company can elect cash flow hedge accounting to mitigate income statement volatility if certain requirements are satisfied. Many private companies, however, just don’t have access to the resources and expertise needed to comply with the requirements, leaving them vulnerable to volatility.
Under the alternative standards in ASU 2014-03, nonfinancial institution private companies can apply a simplified hedge accounting approach to their receive-variable, pay-fixed interest rate swaps if the terms of the swap and the related debt are aligned. A company electing this option will present interest expense in the income statement as if the company had directly entered a fixed-rate loan, instead of a variable-rate loan and an interest rate swap. Companies choosing the alternative will have until the issuance of their financial statements to complete the required hedging documentation.
The alternative standard also permits a private company to recognize the swap at its settlement value (which doesn’t consider nonperformance risk), rather than at fair value. Because settlement value is generally easier to determine than fair value, it could lead to cost savings. The variability of the fair value or settlement amount will be recorded as accumulated other comprehensive income (part of equity).
The election of hedge accounting can be made on a swap-by-swap basis, so eligible companies can apply the standard to both existing and new qualifying swaps. Private companies that opted against hedge accounting in the past because of the difficulty involved in complying with the requirements can now take advantage of the method.
The new alternatives will become effective for annual periods beginning after Dec. 15, 2014, and interim periods beginning after Dec. 15, 2015. Early adoption is permitted, meaning an eligible private company that hadn’t made its financial statements available before the release of the ASUs could elect to apply the alternatives on its 2013 financial statements.
Many hope the new ASUs are only the beginning to the relief private companies will receive from GAAP requirements.
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