The Financial Accounting Standards Board (FASB) has issued two updates to generally accepted accounting principles (GAAP) intended to reduce the cost and complexity of financial statement preparation for private companies that elect either or both of the alternatives. As outlined in 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, the alternative standards streamline the method for goodwill impairment and make it easier for certain interest rate swaps to qualify for hedge accounting.
These two updates grew out of proposals from the Private Company Council (PCC) and were endorsed by the FASB last year. The Financial Accounting Foundation (the FASB’s parent organization) formed the PCC in May 2012 to improve the process of setting accounting standards for private companies that prepare their financial statements in accordance with GAAP.
In December 2013 the FASB and the PCC released the Private Company Decision-Making Framework: A Guide for Evaluating Financial Accounting and Reporting for Private Companies, which steers their decisions on reducing the complexity and costs of preparing financial statements for private companies that follow GAAP.
On the same day the FASB issued ASU 2013-12 to define a public business entity and clarify what types of companies are excluded from the framework— a definition that also serves as a foundation in determining which entities can elect to apply the goodwill and/or interest rate swap accounting alternatives.
In short, an entity must qualify as a private company per ASU 2013-12 to apply either of the accounting alternatives. Note that not-for-profits and employee benefit plans are specifically excluded. See our December 2013 Alert for a more thorough discussion of the definition of a public business entity.
Existing GAAP for Goodwill
Goodwill refers to the residual asset recognized in a business combination—such as a merger or acquisition—after all other identifiable assets and liabilities have been recognized. Since June 2001 GAAP required that goodwill be carried at its initial value, less any impairment, without amortization.
Goodwill is considered impaired when the fair value of its reporting unit (an operating unit within a company that has its own financial information, separate from the overall company) falls to an amount less than its carrying amount or book value. Under existing GAAP, companies are required to test for impairment at least annually—and more frequently under certain conditions.
In 2012 GAAP was modified so that a company could choose to perform a qualitative evaluation of goodwill by determining whether it’s more likely than not (that is, more than 50 percent likely) that a reporting unit’s fair value is less than its carrying amount. If the company determines the reporting unit’s fair value is more than likely not less than the carrying amount, the company doesn’t need to perform the quantitative two-step impairment test. But if it is more likely, the company must proceed with the quantitative test.
In the first step of the quantitative impairment test, the company calculates the fair value of the reporting unit 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 carrying amount of that goodwill. This means applying a hypothetical acquisition method to determine the implied fair value of goodwill after measuring the reporting unit’s identifiable assets and liabilities at fair value.
Private Company Goodwill Alternative
Preparers and auditors of private company financial statements have expressed concern over the cost and complexity of meeting the existing GAAP accounting requirements for goodwill. Moreover, users of financial statements have indicated that the requirements are of limited use to them: They often disregard goodwill and impairment losses when analyzing a company’s financial condition and operating performance.
The alternative approach in ASU 2014-02 is designed to address these concerns. It allows private companies to amortize goodwill on a straight-line basis over a period of 10 years—less if the company demonstrates that a shorter useful life is more appropriate. The company can revise the remaining useful life of goodwill in response to events and changes in circumstances that warrant a revision, but the cumulative amortization period can’t exceed 10 years.
A company that elects this alternative must make an accounting policy decision to test goodwill for impairment at either the company level or the reporting unit level. But goodwill needs to be tested for impairment only when a triggering event occurs (such as a significant adverse change in business climate, negative financial performance, legal issue, or loss of key personnel) that indicates the fair value of the company (or reporting unit) may be below its carrying amount.
The accounting alternative also eliminates the second step of the existing impairment test, a costly and complicated hypothetical application of the acquisition method. Instead the amount of the impairment equals the amount by which the carrying amount of the company (or reporting unit) exceeds its fair value. The goodwill impairment loss can’t exceed the company’s (or reporting unit’s) carrying amount of goodwill. The qualitative approach to evaluating whether the carrying amount of the company (or reporting unit) exceeds its fair value may still be used to determine if the quantitative impairment test is necessary.
Under the alternative, the aggregate amount of goodwill—net of accumulated amortization and impairment—will appear as a separate line item in the company’s statement of financial position. The amortization and aggregate amount of goodwill impairment will be presented in income statement line items within continuing operations unless the amortization or impairment is associated with a discontinued operation. Such amortization and impairment must be included on a net-of-tax basis within the results of discontinued operations.
The disclosures required under this alternative are similar to those of existing GAAP. A company that elects the alternative, however, isn’t required to present changes in goodwill in a tabular reconciliation.
Benefits of the Goodwill Alternative
Private companies that opt for the goodwill alternative may benefit from significant cost savings because of the combination of the amortization method and the elimination of the annual goodwill testing requirement. Amortization will result in a lower carrying amount which should also reduce the likelihood of impairments requiring testing and measurement. And when impairment testing is required, the removal of the second step, combined with the ability to test at the company level (rather than the reporting unit level), may reduce the cost of measuring the impairment loss.
Once elected, the goodwill alternative will apply prospectively. A company will amortize existing goodwill starting at the beginning of the period of adoption (when the alternative is elected), and new goodwill recorded after the beginning of the annual period of adoption will begin amortization upon its recognition.
Interest Rate Swap Alternative
A private company can find it difficult to obtain a fixed-rate loan. To avoid the risk of rising interest rates, a company must often enter into an interest rate swap (a derivative instrument) to economically convert a variable-rate loan into a fixed-rate loan. Existing GAAP requires the company to recognize all derivative instruments in its balance sheet as either assets or liabilities measured at fair value.
If certain requirements are met, a company may elect cash flow hedge accounting to mitigate income statement volatility for changes in the fair value of the swap. But many private companies lack the resources and expertise to comply with these requirements and instead remain vulnerable to volatility.
The alternative in ASU 2014-03 will allow private companies (excluding financial institutions) to apply a simplified hedge accounting approach to their receive-variable, pay-fixed interest rate swaps as long as the terms of the swap and the related debt meet certain criteria intended to limit this alternative to those that are closely aligned. Using this approach results in presenting interest expense in the income statement as if the company had directly entered into a fixed-rate borrowing (rather than a variable-rate borrowing with a receive-variable, pay-fixed interest rate swap), with the change in fair value of the swap not attributable to cash payments being reflected in other comprehensive income as opposed to net income. The cumulative change in the fair value will be reflected separately from retained earnings as accumulated other comprehensive income within equity.
Companies that apply the alternative will have until the issuance of their financial statements to complete the required hedging documentation. This helps alleviate one of the significant problems many private companies encountered under current GAAP by not having timely fulfilled the hedge documentation requirement.
The accounting alternative also allows a private company to recognize the swap at its settlement value, which measures the swap without consideration of nonperformance risk, rather than at fair value. Because settlement value may be easier to determine, private companies that apply simplified hedge accounting may enjoy cost savings from this measurement alternative.
The accounting alternative can be applied to both existing and new qualifying interest rate swaps and it can be applied on a swap-by-swap basis. This is good news for private companies that have chosen not to elect hedge accounting in the past due to the difficulty of complying with its requirements or who may have inappropriately applied hedge accounting and disclosed such as a departure from GAAP.
Evaluating Whether to Apply an Alternative
Before electing either of these alternatives, private companies should carefully consider the needs of their current and future financial statement users as well as any possible future changes in the company.
Even if a private company is otherwise eligible for the alternatives, financial statement users (including regulators, lenders, and other creditors) may require the company to continue applying traditional GAAP accounting standards as though it were a public business entity. A company that elects a private company accounting alternative could also subsequently become subject to public company reporting, either through a future IPO or acquisition by a public company. The company would therefore need to recast its prior periods as if it hadn’t elected the alternative. Depending on the circumstances, this could be a difficult and costly task.
Furthermore, the FASB is working on a project that addresses the subsequent accounting of goodwill for public companies and not-for-profit organizations. This could result in a change to the subsequent accounting of goodwill for all entities, including private companies that elect the goodwill alternative discussed above.
Both of these new alternatives will be effective for annual periods beginning after December 15, 2014, and for interim periods within annual periods beginning after December 15, 2015. Early adoption is permitted: An eligible private company could elect to apply either or both of the alternatives in its 2013 financial statements as long as the financial statements weren’t previously made available for issuance before the ASUs were issued.
We're Here to Help
If you have questions about how these updates will affect the preparation of your financial statements, or for help determining whether you should adopt either of the new alternatives, contact your Moss Adams professional.