Customarily, accounting principles generally accepted in the United States of America (GAAP) has been considered the gold standard in financial reporting. All ‘serious’ companies – public and private – used GAAP as their financial reporting framework. Entities in the middle market use GAAP in the preparation of financial statements, because it is typically required in their loan documents, even though there is no regulatory requirement to do so.
In recent years, GAAP has become increasingly complex and unwieldy for most middle market companies. The Financial Accounting Standards Board (FASB) was established in 1973 and issued its first Statements of Financial Accounting Standards (SFAS) in December of that year. Over the next 36 years, the FASB issued 168 SFAS. In the 11 years since the creation of the Accounting Standards Codification in 2009, the FASB has issued 179 Accounting Standards Updates (ASU) as of December 31, 2019.
The quickening pace of changes to accounting standards coupled with the complexity of the changes required by GAAP is making it extremely difficult for many middle market companies to keep pace. The middle market is characterized by owner-managed businesses that, historically, have a close relationship with their banker. These businesses often have a bookkeeper and maybe a controller, neither of whom, generally, are CPAs nor follow the activities of the FASB closely, if at all. The accounting systems used by middle market companies are basic; what is needed to get the job done – pay bills and invoice customers. More sophisticated middle market companies may have inventory costing systems or production management systems, but even these tend toward the bare necessities. The expense and complexity of a sophisticated ERP system is largely beyond their reach.
Related Event: “Alternatives to GAAP that Bankers Need to Know”
GAAP’s Impact on Small and Middle Market Companies
Traditionally, financial statements were prepared using historical cost. However, over the last 15 or so years, more and more of a company’s financial position and results of operations are based on management estimates, as required by GAAP. This means that the financial statements are less likely to be based in fact and more likely to be based on guesswork subject to management bias in forming the estimates used.
Recent significant changes to GAAP – revenue recognition, leases and current expected credit losses (CECL) – are heavily reliant on management estimates. Revenue recognition requires the entity to examine every contract with their customers and go through a five-step process to determine how much revenue should be recognized. Several of these steps require significant management judgement to determine the amount of revenue to ultimately recognize. The new leasing standard will require all companies to put their long-term leases on the balance sheet using an estimate of the appropriate discount rate in computing the value of the asset and liability. Additionally, this standard will likely put many companies out of compliance with their loan covenants, as the lease liability will be recorded as both a current and long-term liability while the right of use asset will be entirely non-current, thereby negatively affecting working capital. Finally, CECL requires management to estimate credit losses up front which could result in companies recording higher allowances for bad debts and recognizing greater losses on contracts with their customers.
These are sophisticated standards, which have little impact on the decisions the owner-manager makes in running the middle market company on a day-to-day basis, but wreak havoc when it comes to the end of the year and the financial statements need to be prepared for the bank. Accordingly, many middle market companies are seeking alternatives to GAAP for their financial reporting needs.
An Alternative to GAAP
One such alternative is the Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEsTM), which is a comprehensive financial reporting framework promulgated by the American Institute of CPAs (AICPA). Unlike other GAAP alternatives – cash basis or income tax basis – the AICPA created an entire financial reporting framework including required disclosures, which can be found on the AICPA website. The framework is intended to be suitable for the preparation of general purpose financial statements. The primary benefit of the FRF for SMEsTM is that it provides meaningful financial results to the owner-manager of the middle market company – results that are understandable and decision-useful. The secondary benefit of the FRF for SMEsTM is that, unlike GAAP, it was created to be a stable financial reporting framework that does not undergo frequent significant changes. No substantive changes have been made to the framework since its release in 2013, while FASB has issued 102 ASUs since 2013.
The framework is very similar to GAAP 10 or 15 years ago:
- Revenue is recognized when earned and realizable;
- Expenses are recognized when incurred;
- Assets are recorded at cost;
- Liabilities reflect the amounts the company owes;
- Variable interest entities don’t exist; and
- Operating leases give rise to rent expense on the income statement.
In creating the FRF for SMEsTM, the AICPA ensured that the framework was objective, complete, measurable and relevant. Thus providing the owner-manager and the bank with financial statements that are readily understandable.
Alternatives to GAAP that Bankers Need to Know
If you are a middle market company or banker who would like to learn more about the Financial Reporting Framework for Small- and Medium-Sized Entities, please contact us or register for our upcoming seminar, Alternatives to GAAP that Bankers Need to Know, on Tuesday, January 21.