I have generally considered the developments regarding accounting standards for private companies over the past couple of years to be distractions from my focus on public company financial reporting. But it has come to the point where I have to write something about the AICPA’s recently released Financial Reporting Framework (FRF) — for two reasons.
Reason #1 is that I strongly support simplifying accounting standards; but not as in the FRF, by permitting a company to pick and choose freely from a smorgasbord of options. The far better way is to measure all assets and liabilities at current value; for the simpler business structures of SMEs, barriers to implementation should not be high.
Reason #2 is that however I regard the effectiveness and independence of the FASB, past history tells us that no investor should want the AICPA to play accounting standards setter ever again. That, I believe is the fundamental reason why NASBA (and it seems most of its associated state boards of accounting) has objected so strenuously to the issuance of the FRF. The good ol’ days might have been chicken salad for auditors and their clients, but it’s clearly not consistent with the “P” in CPA. So says NASBA, and I heartily agree.
Let’s start with some background. In 1971, the AICPA finally conceded after decades of controversy that accounting standards should be set independently from the profession and its clients. That led to the formation of the FASB to promulgate new standards under GAAP. But, there was a hitch: CPAs may also audit non-GAAP financial statements, e.g., tax and regulatory bases. To establish some sort of quality control over those non-GAAP engagements within the framework of auditing standards, SAS 62 (1989) eventually introduced the concept of OCBOA (“Other Comprehensive Basis of Accounting) to constrain the kinds of non-GAAP financial statements that could be audited in accordance with GAAS, and how the audit report should be written. Here’s the last two paragraphs taken from a sample:
“As described in Note 1, these financial statements were prepared on the basis of accounting the company uses for federal income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles.
In our opinion, the financial statements referred to above present fairly, in all material respects, the assets, liabilities and stockholders’ equity of Ann Wholesale Inc. as of December 31, 2002 and 2001, and its revenues and expenses for the years then ended, on the basis of accounting described in Note 1.” [emphasis added]
As an aside, I can’t resist pointing out the absurdity of the premise that tax basis financial statements could be “fairly presented”; for if that were the case, then why do we even need the FASB and GAAP? Obviously, “fair presentation” under OCBOA is little more than lipstick on a pig.
But the main point I want to make is that the FRF is not really about ameliorating overly high costs of preparing GAAP financial statements. It’s about providing small audit firms and their clients with a new recipe for chicken salad — i.e., something that tastes really good and is easy to chew. That why the AICPA decided it needed to get back into the accounting standards business.
In the process of getting to that point, the AICPA issued SAS 122 in 2011, in which the term OCBOA was replaced with “special-purpose framework.” This was done ostensibly to converge terminology with international auditing standards without changing the substance of U.S. GAAS in this respect. But, it did set the stage for a subsequent amendment that replaced the “substantial support” condition with “a definite set of logical, reasonable criteria.”
I’m pretty fuzzy about the meaning of the new terminology, but the one thing I’m certain of is that we’re back to 1971. Once again, it need not matter to a CPA reporting on financial statements that the basis of accounting applied by her client arose from a process that lacked independence from issuers and auditors in order to protect the investing public. Unlike all of the OCBOAs or special-purpose frameworks that preceded the FRF, the AICPA takes on a god-like role: they created the FRF, and they saw that it was good.
I don’t think it takes a mindreader to appreciate the motivations of the AICPA’s leadership. It is generally known that membership has been declining, and the Center for Audit Quality is now where the Big Four and about 600 other firms spend their lobbying dollars. For smaller firms to find it worthwhile to support the AICPA, there has to be some tangible benefit, and a basis of accounting that will help them to serve clients without undue risk of misapplying accounting standards seems to be the benefit they want.
I have a number of specific concerns about the provisions of the FRF — or absence thereof:
Scope — There is no precise definition of an SME; hence, the scope depends on vaguely-worded “characteristics of typical entities that may utilize the … framework.” Among these is, “key users of the entity’s financial statements have direct access to the entity’s management.”
I readily concede that lower quality accounting might be tolerable if investors in a company also have access to management for additional information, and they know the right questions to ask. But, what if there is one or very few “key users,” e.g. a lender or two, and 299 shareholders (i.e., one short of being required to register with the SEC)? It seems to me that there are some very large private companies with absentee owners that the AICPA did not scope out. It leaves the impression that the AICPA is more focused on making the FRF as widely available as it possibly can, and is choosing to punt on consideration of scenarios under which FRF-based financial statements could be misleading to a large number of users.
In fact, I think it’s fair to state that the AICPA is itself engaging in misleading conduct by using the SME descriptor — the same one that the IASB uses, albeit strictly defines.
Standards anarchy — There are a whole host of loosey-goosey accounting options. Here’s a short list:
- Consolidate subsidiaries … or not.
- Striking “fair value” and substituting “market value” … which could mean pretty much anything.
- Accounting for deferred taxes … or not.
- No impairment testing of goodwill … amortization over an arbitrary period.
- Historical cost for financial assets and liabilities …. or not.
- Derivatives not recognized.
- Stock-based compensation not recognized
- Pension accounting on an accrual basis … or not.
- Off-balance sheet lease accounting will live on, no matter what the FASB does in the future.
- Intangible asset recognition in a business combination … or not.
But, my favorite is the R&D section, for it reveals the AICPA’s actual agenda. U.S. GAAP straightforwardly requires all R&D to be expensed; but, taking its cue from the pre-FASB period and extant IFRS, the FRF is more complicated and costly to implement. A company could capitalize its development costs … or not.
Cost-benefit considerations can be the only logical justification for different accounting by smaller companies. But in this instance, costs of implementation will actually be higher than under U.S. GAAP. Overall, the AICPA did a pretty good job of hiding the real reasons for the FRF; but it tipped its hand with R&D accounting.
Like Nailing Jell-o to a Tree — I also agree with NASBA’s position that the FRF is unenforceable. The AICPA has stitched together a system of financial reporting under which pretty much anything goes; hence, nothing short of fraudulently reporting non-existent assets or hiding liabilities can come back to haunt companies or their auditors. For the auditors’ part, it leaves little to do except for the very basics (which is what they want): taking some physical inventories; confirming some receivables and payables; doing a little ticking and tying; and signing a standard report chock full of highfalutin language about fair presentation in conformity with ersatz GAAP — while staying off the hook for management’s manipulations and machinations.
* * * * *
If current efforts to establish a more cost-effective system of financial reporting for non-public companies is a race to the bottom, the AICPA has opened up an insurmountable lead.