For years, the Financial Accounting Standards Board (FASB) has talked about easing its rules for small private firms. This summer, FASB finally proposed some revisions to Generally Accepted Accounting Principles (GAAP) to accommodate the needs of private businesses and their stakeholders.
Breaking it down
The proposals target four specific areas: intangible asset recognition, amortization and impairment of goodwill, certain types of interest rate swaps, and variable interest entities. Here’s how these proposals might affect your private borrowers’ financial statements.
Intangible asset recognition. Current GAAP requires companies to recognize intangible assets acquired in business combinations at their fair value on the acquisition date. Intangibles must be reported as separate line items if they meet either the contractual-legal criterion or the separability criterion.
Examples of contractual-legal intangibles include trademarks, domain names and customer contracts. Examples of separable intangibles include customer lists, recipes and unpatented technology.
FASB’s proposed change allows private firms to recognize only contractual-legal intangibles on the acquisition date. Other intangible assets would be combined with goodwill. This proposal would potentially cause private companies to recognize fewer intangible assets and more goodwill in business combinations.
Goodwill. Goodwill is the residual intangible asset recognized in a business combination after recognizing all other identifiable assets and liabilities assumed. Currently, GAAP requires companies to record goodwill at its fair value on the acquisition date. Then, it is tested annually for impairment at the reporting unit level.
Reporting units may be based on geography or product lines. Interim impairment testing may be necessary if a triggering event — for example, the loss of a major customer or discontinued product line — takes place. Impairment happens when the fair value of a reporting unit’s goodwill falls below its book value.
FASB proposes that private companies amortize goodwill on a straight-line basis over a useful life that’s not to exceed 10 years. Private firms would only test for goodwill impairment when a triggering event occurs. The proposal also simplifies impairment testing to apply at the entity level, not at the reporting unit level.
Under the proposed changes, private companies would make fewer and less complicated computations to report goodwill in business combinations. Instead, goodwill would receive similar treatment as other finite-lived intangible assets, such as copyrights and patents.
Interest rate swaps. When borrowers have difficulty qualifying for inexpensive fixed rate debt, they can obtain variable rate debt and then enter into an interest rate swap with another entity to reverse their exposure to interest rate risk. Parties that engage in an interest rate swap do not trade debts. Instead, they agree to make each other’s interest payments as if they’d swapped debts.
GAAP generally requires companies to use complex hedge accounting techniques to report interest rate swaps at fair value. Or companies can measure debt at its amortized cost and a swap separately at fair value. Both methods create income statement volatility over the life of the swap.
FASB proposes two simpler methods for private companies that use interest rate swaps: the simplified hedge approach and the combined instrument approach. The simplified hedge approach is similar to the current GAAP rules for reporting swaps, except qualifying interest rate swaps are valued at settlement value, not fair value.
Under the combined instrument approach, qualifying interest rate swaps aren’t reported separately on the balance sheet, except for periodic accruals from interest rate settlements.
Variable interest entities. On the coattails of the Enron scandal, FASB initially required consolidation of variable interest entities with their parent companies to prevent management from using them to disguise lackluster performance or fraud.
Consolidation has proven burdensome for small business owners who own buildings personally and lease them to their companies. Under this proposal, private firms wouldn’t have to consolidate results from a lessor entity if they are under common control, have a formal lease agreement and substantially all of their interactions relate to leasing activities. But the proposal would require detailed disclosures of leasing arrangements.
Following an ongoing debate
FASB and the Private Company Council are expected to discuss the comments received on these four proposals this fall. You may hear later this year whether FASB will enact the changes and, if so, when they’ll become effective.