Coming Soon: Private Company Exceptions to GAAP

For years, small companies and their accountants have complained about the increasing complexity and costs of complying with Generally Accepted Accounting Principles (GAAP). So the Financial Accounting Standards Board (FASB) solicited feedback from private company lenders and other stakeholders about the usefulness of certain complex accounting rules.

The feedback revealed that many lenders disregard complicated accounting measures — including the subsequent reporting of goodwill following business combinations, impairment losses and simple interest rate swaps — when evaluating a company’s financial condition and operating performance.

In January 2014, FASB released two Accounting Standards Updates (ASUs) that offer private companies alternate reporting methods. It’s important for lenders to understand these new GAAP exceptions, which go into effect for most private companies at the end of 2014. Early adoption is permitted, too.

Goodwill: Amortize or test for impairment annually

The first GAAP exception for private companies applies to those that report goodwill following a merger or an acquisition. Goodwill is “a residual asset calculated after recognizing other (tangible and intangible) assets and liabilities acquired in a business combination,” according to FASB Accounting Standards Codification Topic 350, Intangibles — Goodwill and Other.

Put another way, goodwill is the portion of the purchase price that’s left over after a buyer allocates fair value to all identifiable assets and liabilities. Goodwill can be a valuable asset. It’s commonly associated with professional practices, but retailers, manufacturers and even contractors can possess some elements of goodwill that are transferable in a business combination.

The fair value of goodwill can decrease over time, especially if a deal falls short of the buyer’s expectations. So GAAP requires companies to test for impairment, which occurs when the carrying value of goodwill exceeds its fair value. Public companies and nonprofits must test for impairment at least annually and more frequently if triggering events occur.

Accounting Standards Update (ASU) 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill, offers an alternate method for private companies that acquired goodwill in a business combination. Instead of testing for impairment annually, private companies may elect to amortize goodwill straight-line over 10 years (or fewer, if they can justify a shorter useful life).

Private companies still need to test for impairment when triggering events occur. But they need to compute impairment at only the entity level.

In a nutshell, here’s what lenders need to know about the goodwill exception’s alternate method: Fewer private borrowers will incur impairment losses, because amortization will automatically lower the carrying value of goodwill over time. The alternate method also makes reporting more predictable and reduces the need for valuations.

But be aware that, because impairment is tested at the entity level, strong business segments may temporarily hide underperforming acquisitions. So if a private borrower reports impairment under the alternate method, lenders should take it seriously.

A simpler alternative for interest rate swaps

The second GAAP exception applies to “plain vanilla” interest rate swaps. Following the financial crisis, some borrowers could obtain only variable rate loans, so they used simple interest rate swaps to receive the consistency of fixed rate payments. This strategy, however, inadvertently opened a Pandora’s box of complex, costly accounting requirements that many private companies were unprepared to handle.

Under GAAP, swaps are customarily considered derivatives that need to be reported at fair value. ASU 2014-03, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps — Simplified Hedge Accounting Approach, offers an alternate method. It allows private companies to measure qualifying swaps at settlement value, rather than fair value. So interest expense is essentially the same as if the borrower had entered into a fixed-rate loan directly.

Private borrowers can elect the alternate method on a swap-by-swap basis. New and existing swaps may qualify for the simplified treatment.

FASB hopes the alternate method will make financial statements easier to understand and less costly to prepare for small businesses. And lenders can expect to see fewer confusing earnings fluctuations that previously resulted from changes in the fair value of their borrowers’ simple interest rate swaps.

Welcome changes for borrowers and lenders

Some accounting rules were originally drafted with public companies in mind. Small companies tend to operate more simply — and FASB’s move toward allowing exceptions for private companies is being applauded by many small companies and their constituents.