Proposed Conceptual Changes in Financial Reporting

The Problem of Competing Frameworks and Discbsure Overbad

A growing chorus comprising mainly small and mediumsized entities (SME) has asserted that the excessive volume and complexity of current accounting standards-that is, "standards overload"-has created difficulties for financial statement preparers, auditors, and users. But such concerns are not new. "Accounting Standards Overload: Relief Is Needed" was published more than 30 years ago in the Journal of Accountancy, winning its 1982 Lawler Award (Gerald W. Hepp and Thomas W. McRae, May 1982). More recently, the 2001 Annual Financial Accounting Standards Advisory Council Survey cited standards overload as a continuing problem. The February 28, 2002, edition of the FASB Report, published by the board, reported that a similar problem-disclosure overload-was causing confusion among financial statement users.

The underlying issue is a disagreement between varying constituencies over what should be included in GAAP; different subsets of users demand specialized information that meets their particular needs. As a consequence, financial statements include information that satisfies one subset of users but holds no interest for others. This proliferation of information then results in an overload of both standards and disclosures.

In response to these concerns, FASB has proposed the following changes to GAAP:

* Convergence with IFRS (issued by the IASB)

* Changes in disclosure requirements

* Modified measurement and disclosure requirements for private companies.

Reporting entities not using GAAP have traditionally applied other comprehensive bases of accounting (OCBOA), such as an income tax basis or modified cash basis. On June 10, 2013, the AICPA issued yet another OCBOA, designed specifically for SMEs.

This activity reflects the fragmentation of the concept of a single set of accounting principles generally accepted by all entities; instead, each project addresses the needs of a different constituency. In an effort to correct standards overload, the accounting profession now faces accounting basis overload. To highlight the importance of this issue, this discussion will provide an overview of the different accounting bases being proposed and will consider the purpose of financial reporting.

Convergence with IFRS

IFRS aims to provide a common set of high-quality accounting principles that are generally accepted worldwide. Although applying accrual accounting, IFRS's less detailed rules give financial statement preparers greater latitude in achieving accounting objectives than GAAP does.

The SEC has pursued the development of a single worldwide framework of accounting principles since 1973. In 2007, file SEC permitted companies to use IFRS when filing in U.S. capital markets. In July 2012, it proposed the latest of a series of work plans on the adoption of IFRS, Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for Issuers, which noted that the vast majority of U.S. capital market participants support exploring the adoption of IFRS under certain conditions but do not support complete adoption.

Although the SEC has not made any policy decision to require U.S. issuers to apply IFRS, it is encouraging condorsement-that is, the convergence of certain international and U.S. accounting standards and the endorsement of specific IFRSs into GAAP. The convergence process has been a collaborative effort by FASB and the IASB to eliminate the differences between GAAP and IFRS by issuing joint accounting standards; endorsement occurs when U.S. standards setters either accept or reject the incorporation of specific IFRSs into GAAP. Although condorsement has been deemed a method for promoting the acceptance of IFRS, its very nature-changing current IFRS and reserving the right to reject any pronouncements-raises concerns as to whether IFRS is really a highquality basis of accounting after all.

Since the process began in 2002, convergence between IFRS and U.S. GAAP has made some progress, but it remains incomplete. The two bases are now similar in certain areas, such as business combinations, debt, share-based compensation, and earnings per share. Fundamental differences remain, however, in accounting for asset impairment; property, plant, and equipment; acquired intangible assets; inventory; research and development; income taxes; bank loan losses and litigation contingencies. The expected completion date for major projects, originally scheduled for June 2011, was extended to 2014.

IFRS's greater flexibility is inherently inconsistent with a goal of improving the comparability of financial statements across countries, industries, and companies. Although a 2011 SEC analysis noted that company financial statements generally complied with IFRS standards, it also observed a diversity of practice caused by explicit options permitted under IFRS, the absence of guidance, and noncompliance (http://www.sec.gov/spotlight/global accountingstandards/ifrs-work-plan-paper111611 -gaap.pdf; http://www.sec/gov/ spotlight/globalaccountingstandards/ifrs-workplan-paper-111611 -practice.pdf). Most countries do not consider IFRS authoritative and apply some type of endorsement procedure. The greater flexibility and endorsement approach permits different countries to create their own versions of IFRS-defeating the purpose of a single set of international financial accounting standards.

Consistent with the endorsement concept, the SEC has identified certain potential permanent differences between GAAP and IFRS. One such difference, the accounting for litigation contingencies, could create a significant issue for auditors. Pursuant to a 1975 agreement between the AICPA and the American Bar Association, attorneys provide letters regarding the existence and status of litigation to the preparers' auditors. Some attorneys have asserted that the additional information required by IFRS could violate the attomey/client privilege, which may result in attorneys refusing to provide important audit evidence. In these circumstances, auditing standards require auditors to issue a qualified audit opinion or a disclaimer of opinion, which the SEC does not accept for filings by public companies.

A second difference pertains to the IASB's resistance to issuing industry-specific guidance. Instead, the IASB asserts that its guidance applies to all transactions, regardless of industry, and that industryspecific guidance only complicates accounting standards. This position conflicts with U.S. regulatory practice.

Federal and state regulators govern certain activities of certain industries, such as investment companies, broker/dealers, financial institutions, oil and gas companies, and rate-regulated utilities. Regulators rely on specific industry guidance when approving utility rates, assessing the soundness of financial institutions, and determining the permissibility of costs for federal procurement contracts. The adoption of IFRS by public companies could result in different accounting bases applied by private and public companies in regulated industries or in the SEC imposing a model on federal and state regulatory agencies and private companies over which it has no authority. Moreover, federal and state laws and regulations, which are difficult to change, would need to be aligned with IFRS prior to implementation.

To date, regulatory authorities have not performed any comprehensive analysis, but they have identified certain differences between GAAP and IFRS. For example, GAAP requires that capital shares issued by certain investment companies, such as mutual funds, be classified as equity (a fun- damental regulatory measurement), whereas IFRS requires that such shares be classified as liabilities. Funds applying IFRS would be deemed as having no equity. Investment companies have already advised the SEC that the current GAAP more accurately presents their investing activities and results of operations. Canada, which has adopted IFRS, has expressed similar concerns; thus, it permits investment companies not to adopt international standards.

Adoption of IFRS could require revisions to contracts, debt instruments, and other agreements that rely upon GAAP measurements to determine compliance with covenants. Private companies entering into these agreements would not have an accounting model other than IFRS and would be forced to adopt the international standards. A subset of IFRS is available to SMEs that publish financial statements but are not held to public accountability. No one has determined whether the recognition, measurement, and disclosure differences permitted by IFRS for SMEs are acceptable to regulatory authorities or contractual counterparties. The SEC work plan hopes that the Private Company Council (PCC), discussed later, will address tie needs of private companies.

The proposed adoption of IFRS accommodates one set of constituents, international companies and their investors, but not another, private companies. Multinational companies, which consist of some subsidiaries applying GAAP and others applying IFRS, have supported the concept of one accounting basis for a consolidated reporting entity. Rather than assuming that international standards will simplify financial reporting, standards setters should consider the impact that adoption of IFRS could have on significant, complex regulatory compliance and accounting issues with private companies and government regulators.

FASB's Disclosure Framework

On July 12,2012, FASB issued an invitation to comment on its disclosure framework, which proposed significant changes in the nature of disclosures required by GAAP. The proposed framework has the stated purpose of improving flie effectiveness of disclosures by limiting financial statement notes to only the information that is most important to users. The disclosure framework was prepared in cooperation with certain European advisory groups responsible for addressing the technical quality of IFRS.

A motivating factor of this project is users' concerns about disclosure overload, which is attributed to the actions of auditors, legal advisors, and regulators. In fact, most disclosures are required by current accounting standards and are enforced by regulators tasked with protecting the public interest. Auditors and preparers are under significant legal pressure to comply with disclosure requirements. Although the objective of reducing unnecessary disclosures is appealing, the mechanisms outlined in the disclosure framework might create more confusion than currently exists.

The proposed framework promotes flexibility by establishing disclosure objectives, but not content. Its fundamental principles are that the notes to the financial statements should be limited to information that is-

* unique to the reporting entity or its industry,

* not apparent from the financial statements or not readily available from public sources, and

* able to make a material difference in assessments of future cash flows.

The framework's assumption that users have information on general business risks and general economic conditions, as well as an awareness of GAAP, common pricing models, and reporting requirements, seems to be more applicable to brokers and analysts than to less sophisticated users.

Permitting greater preparer judgment in determining the relevancy of disclosures is an attempt to reduce their volume without reducing their effectiveness. Although this approach is theoretically sound, it does not provide guidance on reliability and materiality, which are important considerations in preparing relevant information. Reliability is defined by Statement of Financial Accounting Concepts (SFAC) 2, Qualitative Characteristics of Accounting Information, as information that is representationally faithful, verifiable, and neutral. The disclosure framework's objective of providing enough information to make a difference in a user's decisions on providing resources does not address the potential relationship between the reliability of information and the continued allegations of misleading financial statements. Unreliable information is not useful in making decisions and, thus, is not relevant. Including information in the financial statements that can be reasonably verified (e.g., audited) with any degree of precision should reduce the incidence of alleged misleading financial statements. The disclosure framework also specifically excludes materiality from its scope, despite its objective to limit note disclosures to information that could make a material difference in assessing future cash flows. The inadequate guidance does not shield preparers and auditors from the legal consequences of omitting information that seems insignificant at the time of financial statement issuance but proves to be significant in the future.

The proposed framework results in an incomplete presentation of net cash available for future cash obligations. It emphasizes cash flows derived from the sale of investments, and it omits cash flows from future operations. Many entities generate a significant portion of their funds from operations and use those funds to settle future obligations-for example, mortgage principal and interest due on commercial real estate is typically settled using net proceeds from tenant leases. The proposed presentation would be complete only in financial statements of certain specialized industries, such as investment companies and employee benefit plans.

The disclosure framework's assumption that future events can be accurately forecasted does not recognize that future cash flows related to equity and credit instruments and operations are speculative. For example, the framework recommends the disclosure of the terms of financial instruments and other binding arrangements, as well as the likelihood of counterparty nonperformance. Although they are capable of assessing the possible failure to perform, most preparers do not control the counterparty and cannot identify, with any degree of certainty, specific counterparties that are currently in compliance with contract terms but might not be in the future. In addition, most contracts have recourse and "escape" clauses, contingent upon specific events; these create additional uncertainties. Disclosures of uncertainties based on counterparty nonperformance and contingent contractual terms would be extensive and defeat the purpose of limited disclosures.

On November 12, 2013, FASB directed its staff to prepare an exposure draft that would add a chapter on disclosures to SFAC 8, Conceptual Framework for Financial Reporting. If the exposure draft is consistent with the disclosure framework, it would require preparer and auditor judgment to identify user needs; accordingly, guidelines and parameters on identifying and disclosing such information would be needed. In addition, this exposure draft should provide sufficient guidance on reliability and materiality before proposing any guidance derived from the framework's invitation to comment.

The PCC

In December 2009, the Financial Accounting Foundation (FAF) Board of Trustees (the parent of FASB), the AICPA, and the National Association of State Boards of Accountancy (NASBA) established the Blue Ribbon Panel on Standard Setting for Private Companies to address concerns that certain accounting standards were not relevant to many private company financial statement users, and that they created unnecessary complexity and significant costs for preparers and auditors. Some private companies were avoiding GAAP requirements by accepting qualified audit opinions or by adopting OCBOA.

In response, the FAF established the PCC on May 30,2012. The PCC is responsible for identifying any exceptions or modifications to GAAP with respect to private company financial statements, developing proposed modifications, and exposing such proposals for public comment. FASB must agree with the PCC's agenda and approve any proposed modifications or exceptions. The PCC also serves as the primary advisor on the appropriate treatment of proposed accounting rules for private companies.

On December 23, 2013, FASB and the PCC issued Private Company DecisionMaking Framework, A Guide for Evaluating Financial Accounting and Reporting for Private Companies. The guide had the stated objective of identifying the circumstances in which alternative recognition, measurement, disclosure, display, effective date, and transition guidance should be permitted for private company reporting under GAAP. It identified the following factors as differentiating private from public companies:

* Types and numbers of financial statement users and their access to management

* Investment strategies of primary users

* Ownership and capital structure

* Accounting resources

* Preparers learning about and implementing new financial reporting guidance.

Reporting entities are permitted to apply PCC modifications unless specifically excluded. Not-for-profit entities and employee benefit plans may not apply PCC modifications unless specifically permitted on a standard-by-standard basis. Public business entities, as defined in Accounting Standards Update (ASU) 2013-12, Definition of a Public Business Entity, are also prohibited from applying PCC exceptions and modifications. A public business entity is defined as meeting any one of the following criteria:

* It is required by the SEC to file or furnish financial statements.

* It is required to file or furnish financial statements with a regulatory agency.

* It is required to file or furnish financial statements with a foreign or domestic regulatory agency for purposes of issuing securities.

* It is a conduit bond obligor for conduit debt securities that are traded in a public market.

* Its securities are not subject to contractual restrictions on transfer and it is required by law, contract, or regulation to prepare GAAP financial statements to be made publicly available on a periodic basis.

The final pronouncement clarifies that entities issuing securities traded on websites (as opposed to formal exchanges)- permitted by the Jumpstart Our Business Startups (JOBS) Act of 2012-are public business entities.

The classification of conduit bond obligors as public companies remains a controversial issue. Conduit bond obligors are responsible for settling conduit debt securities, which are debt instruments issued by state or local governments for the purpose of providing financing to a specified third party. Although the debt instruments are often in the name of the governmental issuer, a third party is responsible for the servicing and payment of the debt. A common conduit debt security, for example, is issued by the Dormitory Authority of the State of New York.

A conduit bond obligor is deemed a public company when its conduit debt securities are traded in a public market. As conduit bond obligors are indirectly accessing the public debt markets, FASB concluded that the users of financial statements of privately held conduit bond obligors often have information needs similar to investors in public company corporate debt securities. Certain FASB members have acknowledged that some private company conduit bond obligors face similar resource constraints as private companies, and they have expressed a willingness to consider deferred effective dates.

One major issue pertains to private companies that choose not to apply, or are not eligible to apply, all or some of the PCC modifications. FASB and the PCC concluded that private companies may choose not to apply any or all PCC modifications, provided that such decisions are properly disclosed in the financial statements. In addition, private companies not eligible to apply PCC modifications will be identified, on a standard-by-standard basis, by factors such as user needs. For example, regulated private companies would be subject to the same industryspecific accounting guidance as public companies. This position reflects a presumption that the unique nature of some industries and their often-specialized accounting guidance are generally relevant to financial statement users of both public and private companies.

In January 2014, FASB issued Accounting Standards Updates (ASU) 2014-03 and 2014-02 on "plain vanilla" interest rate swaps and goodwill. Projects on other derivatives, intangible assets, and variable interest entities remain in various stages of consideration.

The FAF and FASB recognize that extensive PCC exceptions and modifications could result in substantially different accounting standards for public and private companies; however, this risk can be mitigated if the PCC has a clear mission, coordinates with FASB, and is overseen by the FAF. FASB has asserted that its guide is not a new conceptual framework that fundamentally differs from the one used by public companies. In addition, the FAF specifically prohibits the PCC from adding competing projects to its agenda that are already under consideration by FASB. In effect, PCC modifications are a subset of GAAP.

Financial Reporting Framework (FRF) for SMEs

On June 10,2013, the AICPA issued the FRF for SMEs with the stated purpose of providing a less costly and complicated framework for SMEs. AICPA personnel deny that the new framework will compete with the PCC. The FRF for SMEs is intended for entities that issue financial statements but are not required to provide GAAP financial statements. Despite its title, the new framework does not define SMEs and is available to entities of all sizes; however, it should not be applied by entities that intend to go public.

The FRF for SMEs is another OCBOA, like income tax basis and cash basis. The framework notes that existing OCBOA may be insufficient or lack adequate standardization to meet the needs of entities not required to provide GAAP financial statements. For example, financial statements prepared in conformity with income tax basis theoretically reflect a reporting entity's income tax returns; however, the income tax basis of accounting does not require the disclosure of certain contingencies, such as material liabilities related to interest rate swaps. The FRF for SMEs requires certain disclosures of such instruments.

The FRF for SMEs blends GAAP and the accrual income tax basis of accounting. It presents financial statements using an income statement focus, rather than the balance sheet focus favored by GAAP. For example, the FRF for SMEs measures certain investments at adjusted cost as a result of actual transactions, such as purchase or impairment. Holding gains and losses are not recognized until the date of sale or disposal. In contrast, GAAP presents the economic wealth of the reporting entity at the end of the reporting period, recognizing the changes in value of certain investments as unrealized gains and losses in each reporting period.

The FRF for SMEs presents four qualitative characteristics of information that is useful to financial users: understandability, relevance, reliability, and comparability. Information is reliable if it is consistent with the actual underlying transactions, can be independently verified, and is reasonably free from error or bias. This independent verification provides a basis on which auditors can conclude that amounts are appropriate, as opposed to GAAP, in which certain estimates, such as the fair value of Level 3 investments (based on management's assessment of unobservable inputs), are based upon future events and subject to change.

Some FRF for SMEs guidance is not informative. For example, the proposal raises concerns about, but does not provide criteria on, the propriety of recognizing revenue from a bill-and-hold arrangement, which typically involves the seller holding the goods within its own premises after selling them to a specified buyer. These arrangements have been associated with fraud by reporting entities falsely claiming the sale of inventory still on premises. Entities issuing GAAP financial statements have traditionally followed the SEC's easily understood guidance on the recognition of bill-and-hold arrangements.

The AICPA has not justified why an additional OCBOA is necessary, given that other bases of accounting already exist. The AICPA has repeatedly asserted that privately owned SMEs are looking for a more relevant, less complicated, and more costbeneficial framework for their financial reporting needs and that bankers and other financial statement users need more easily understood, more useful financial statements based upon a reliable, principles-based framework. As discussed in the Blue Ribbon Panel's report, many SMEs have already found a simpler system: applying the income tax or modified cash bases of accounting. In addition, bankers and other users have not embraced the FRF for SMEs at the present time. In its related frequently asked questions, the AICPA recommended that preparers consult with lenders and other users before presenting financial statements prepared using the FRF for SMEs. This advice recognizes that many loan documents specify the basis of accounting to be applied to financial statements. The AICPA did not address why it did not meet the above needs by simply proposing enhanced disclosures for the income tax or modified cash bases of accounting.

In a June 13, 2013, letter, NASBA advised private companies not to adopt the FRF for SMEs. NASBA serves as a forum for state boards of accountancy, which regulate the practice of public accountancy in 55 U.S. jurisdictions. NASBA's opposition to the FRF for SMEs is based on the difficulty of regulating and enforcing nonauthoritative guidance, the failure to define SMEs within the framework, and the permitted use of GAAP financial statement titles without requiring the disclosure of differences from GAAP.

The Purpose of Financial Reporting

In an effort to address three decades of concern about standards overload, the SEC, FASB, and the AICPA have all proposed or implemented significant changes to accounting standards. But the sheer volume of proposed changes overwhelms the avowed purpose of reducing standards overload and undermines the conceptual goal of one set of accounting principles that is generally accepted by all. The multiple proposals reflect a disagreement over what should be included in GAAP. Multiple bases of accounting, many with significant conceptual weaknesses, will confuse users and create serious training and implementation problems for preparers and auditors.

The disagreement is fueled by FASB's favoring one subset of users over all other stakeholders. SFAC 8 asserts that the objective of financial reporting is to provide financial information that is useful to existing and potential investors, lenders, and other creditors in making decisions about allocating resources. FASB's guide, however, classifies investors, lenders, and other creditors as primary users of private company financial statements-and implies that vendors, customers, lessors, insurers, regulators, and trustees of employee stock ownership plans are secondary users. The guide's position is based on the unsupported assumption that private company financial statements users have greater access to management to obtain additional information. In fact, not all users have access to the same information and cannot be assumed to have less need for detailed disclosures than users of public company financial statements. In addition, financial statement preparers and auditors have considerable legal exposure to regulators, sureties, agents, and insurance providers and, accordingly, consider them as important as designated primary users.

The financial statements should provide a baseline of measurements and disclosures on which users can request specific additional information that they might require. This baseline is important because information outside the financial statements is generally not audited, and it might omit important information or contain misleading information. As a consequence, the use of financial statements to validate or corroborate information obtained from sources other than financial statements can result, on occasion, in the discovery of information that has been overlooked or misunderstood.

The guide and the disclosure framework might create legal problems for auditors. Presumably, the future exposure draft derived from the invitation to comment will include FASB's preliminary decision to provide users with information on "past events and existing conditions that have not yet met the criteria for recognition in the entity's financial statements, but that are capable of making a difference in decisions about providing resources" (Board's Decision Process, http://www.fasb. org/jsp/FASB/FASBContent_C/Project UpdatePage&cid=l 176163077030). Financial statement preparers and auditors do not have full knowledge of the specific information requirements of all users. The nature of this information is only understood by the user; furthermore, it is subject to change over time. Any process whereby auditors have contact with users to identify specific information needs might, in some states, create privity between those users and the auditors. Such privity could result in even greater legal exposure for the auditors if users deem the financial statements to be incomplete.

Standards setters need to determine whether the quality of IFRS is as high as advertised, given the continuing differences and extensive changes proposed in the condorsement process. The actual quality of the standards needs to be addressed, given the potential impact that IFRS could have on regulatory compliance and accounting issues.

In commenting on various proposals, the NYSSCPA disagreed with the notions that certain users are more important than others and that financial statement disclosures should be limited to information that the preparers and auditors think might be of interest to a particular subset of users. As the designated U.S. accounting standards setter, FASB should consider whether this bias has created an environment where different users are demanding specific accounting information that is more responsive to their particular needs. To avoid the proliferation of accounting bases, FASB should define the objectives and purposes of financial reporting-addressing the needs of all constituencies by giving equal weight to the concerns of preparers, auditors, and users. The end result should be clearly understood accounting rules that facilitate the preparation and verification of financial information.

Establishing a Balance

Accounting standards should align with the needs of users and the ability of preparers and auditors to provide that information with a reasonable degree of precision. The impact of users' apparently insatiable requests for information on disclosure, which has arguably resulted in standards overload, must be considered as well.

Preparers provide information in order to obtain access to bank loans or to the capital or debt markets. Auditors provide a level of comfort by verifying that the information fairly presents the reporting entities' financial position, results of operations, and cash flows. Standards setters should be sensitive to the constraints on preparers and auditors imposed by the cost of presenting and auditing the required information, as well as their concerns about litigation exposure if that information proves wrong or incomplete. ?

The AICPA has not justified why an additional OCBOA Is necessary, given that other bases of accounting already exist.

Standards setters should be sensitive to the constraints on preparers and auditors imposed by the cost of presenting and auditing the required information.

Robert A. Dyson, CPA, is the director of quality control at MBA F CPAs LLC, New York, N.Y. He is a member of The CPA Journal Editorial Board.