THE FINANCIAL REPORTING FRAMEWORK FOR SMALL- AND MEDIUM SIZED ENTITIES—PART 3

CPA Firm Support Services, LLC

By Larry L. Perry, CPA

LEARNING OBJECTIVES

  • To learn the presentation format for the statements of operations under the FRF for SMEs.
  • To understand the basic principles in the FRF for SMEs for presentation and disclosure of certain account classifications in the statements of operations.
  • To learn accounting treatment and disclosures for accounting changes and risks and uncertainties.

INTRODUCTION

The AICPA has recognized that many non-public, small- and medium-sized companies are not required to use U.S. GAAP as their reporting framework. These companies are generally those with long-range ownership interests, those in specialized industries and/or those with no intentions to file for public offerings of their securities. While other special purpose frameworks may be appropriate for some of these entities, others are looking for ways to provide more comprehensive financial information to financial statement users that are not as burdensome as U.S. GAAP. Detailed guidance for the FRF for SMEs is available at

For these reasons, the AICPA has developed this non-authoritative, special-purpose framework to provide simplified, consistent and relevant financial statements. Characteristics of the framework include:

  • A combination of traditional accounting methods from special purpose frameworks such as the cash basis and the income tax basis.
  • A historical cost basis with some modifications for market values.
  • Specific, simplified footnote disclosures.
  • Uncomplicated, consistent and principles-based accounting.
  • A consolidation model that excludes variable interest entities.

In these materials, part three of a four-part series, we will present these topics for the FRF for SMEs:

  • Presentation of the statements of operations.
  • Principles of accounting and disclosure for:
  • Revenues
  • Expenses
  • Leases
  • Pension and post-employment benefit plans
  • Income taxes
  • Accounting changes
  • Risks and uncertainties

PRESENTATION OF STATEMENTS OF OPERATIONS

Some basic presentation issues under the FRF for SMEs are as follows:

  1. The titles of these statements are not limited to a prescribed title. Some common options are:
  2. Statement of Operations
  3. Statement of Revenues and Expenses
  4. Statement of Revenues, Expenses and Retained Earnings
  5. Consolidated versions of above statements
  6. Each statement should include this reference or other descriptive wording under the statement title: (FRF for SMEs Basis).
  7. As with other frameworks, a comparative format is considered the most meaningful but is not required. In fact, for the first period of application of the FRF for SMEs, restating prior period financial statements prepared using another framework will usually be cost-prohibitive. Single period financial statements will usually be the most appropriate in the first period of application.
  8. Line item references to footnotes aren’t required but a reference on the bottom of the statement to the notes and an accountant’s report is required. Example: “See Independent Accountant’s Review Report and Notes to Financial Statements.”

STATEMENT OF OPERATIONS

Results of operations should be presented fairly in the statement of operations in accordance with the provisions of the FRF for SMEs. Three basic categories are normally included in the statement:

  • Income or loss before discontinued operations—major elements comprising this category include sales and other revenues, costs of sales, operating expenses, income taxes and other expenses.
  • Discontinued operations—results of operations of components that are sold, abandoned, otherwise disposed of or held for sale should be classified in this category.
  • Net income or loss—when statements are consolidated the portion attributable to non-controlling interests and to the parent should be presented.

Treatment of Major Classifications on the Statement of Operations

Recognizing Revenues

Recognizing revenue under this FRF requires completion of performance of a transaction and reasonable assurance of collection of invoices and billings. Similar to U.S. GAAP, revenue must be earned or realizable to be recognized.

Specifically for the sale of goods, performance is achieved when the seller has transferred ownership of the goods to the buyer and the seller retains no continuing involvement in the goods transferred.

When services are provided under long-term contracts, performance should be determined under the percentage of completion method or the completed contract method. The method that best relates the revenue to the work performed should be used.

Achievement of performance occurs when:

  • There is persuasive evidence of an arrangement.
  • Goods have been delivered or services have been provided.
  • The seller’s price is fixed or determinable.

Evidence of an arrangement:Business practices or prior transactions with a customer, side agreements, consignment sales, the right to return a product or requirements to repurchase a product may be indicators of whether an arrangement exists.

Delivery:Delivery generally occurs when a product is delivered to a customer’s facility or another specified site. As it is when recognizing revenue under other reporting frameworks, consideration of several factors may be necessary. Such factors include bill and hold agreements, required customer acceptance, layaway sales, non-refundable fees, licensing and other fees and who bears the risk of loss.

Seller’s price: Factors that should be considered to determine if a price if fixed or determinable include cancellable provisions, the right of return of a product, price protections or inventory credit arrangements and refundable fees for service agreements.

Generally, performance of a transaction determines when revenue is earned and recognized. For the sale of goods or providing services, performance is considered achieved when a seller has transferred goods to a buyer or provided services, i.e., a point of sale or delivery has occurred, when the buyer assumes the risks and rewards of ownership of a product or accepts the services, when there is reasonable assurance a specified amount of consideration will be received (collectability) in return and when an appropriate allowance for returns of products has been determined. A sale would not be recorded when the seller retains significant risks of ownership, such as in the case of consignment sales. An appropriate allowance for uncollectible accounts should be provided based on the evaluation of collectability.

For long-term contracts or rendering services, performance should be determined under either the percentage of completion method or the completed contract method, whichever best presents revenues in relationship to the work that has been accomplished. Revenue should be recognized under the percentage of completion method base on some systematic, rational and consistent basis such as sales value, related costs, and extent of progress or number of acts. Amounts billed are an appropriate basis only if they are indicative of work completed.

The completed contract method normally should be used when the extent of progress cannot be reasonably estimated. Management may elect to use the completed contract method when it is used for income tax reporting or when the financial position and results of operations are similar to the percentage of completion method. This may occur when an entity performs numerous short-term contracts.

Contract claims may be recorded when amounts have been awarded or received or at times when it becomes probable the claims will result in additional contract revenue (if amounts can be reasonably estimated). In the latter case, revenue should be recorded only to the extent related costs are incurred.

Multiple Deliverable Arrangements

For multiple deliverable arrangements, performance of transactions should be considered separately in accordance with the recognition criteria above. An example would be the sale of software with separately priced installation, training, maintenance and warranty agreements. Revenue from elements such as maintenance and warranty agreements will normally be recognized on a straight-line basis over the term of the agreement unless the services are provided in an identifiable, significantly different pattern.

U.S. GAAP includes provisions for recognizing revenues in connection with arrangements that have multi-deliverables. ASU 2009-13 clarified those requirements by requiring a sales price to be assigned to each of the deliverables at the inception of an arrangement.

Under the FRF for SMEs, similar provisions will apply. When a sales transaction includes the delivery or performance of multiple products, services or rights to use assets, and the delivery or performance occurs at different times, revenue recognition criteria will be applied to each of the deliverables. A vendor of large appliances, for example, will ordinarily sell the product, charge additionally for delivery, and make warranty and/or maintenance agreements available for separate purchase. Separate revenue recognition criteria would be applied to each of these deliverables. For fixed fee warranty or maintenance agreements, revenue would be recognized over the term of the agreement, ordinarily on a straight line basis.

Other Income

Investment income is recognized similar to U.S. GAAP. Interest is recognized over time, royalties are recognized as they accrue under an agreement and dividends are recognized when a shareholder has the right to receive payment.

Principal vs. Agent

Also like U.S. GAAP, an agent in a transaction will report only commissions as revenues.

Companies that conduct business as agents rather than as principalssometimes face a dilemma as to how to record revenues, gross amount of billings or net amounts of commissions. Judgment based on facts and circumstances should guide resolution.

Indicators of gross revenue reporting include whether the entity:

  • Is the primary obligor in the arrangement.
  • Has general inventory risk.
  • Has latitude in establishing price.
  • Changes the product or performs part of the service.
  • Has discretion in supplier selection.
  • Is involved in the determination of product or service specifications.
  • Has physical loss inventory risk.
  • Has credit risk.

Indicators of net commission reporting include:

  • The supplier, not the entity, is the primary obligor in the arrangement.
  • The amount the company earns is fixed.
  • The supplier has credit risk.

Improper Revenue Recognition

For the FRF for SMEs, improper revenue recognition may occur in any of these and other situations:

  • Letters of intent are used in lieu of signed contracts.
  • Products are shipped before the scheduled shipment date without the customer’s approval.
  • Products can be returned without obligation after a free “tryout” period.
  • Customers can unilaterally cancel a sale.
  • Obligations to pay for products are contingent on a customer’s resale to a third party or on financing from a third party.
  • Sales are billed for products being held by the seller before delivery.
  • Products are shipped after the end of the period.
  • Products are shipped to a warehouse (or other intermediate location) without the customer’s approval.
  • Sales are invoiced before products are shipped.
  • Part of a product is shipped and the part not shipped is a critical component of the product.
  • Sales are recorded based on purchase orders.
  • Obligations to pay for the product depend on the seller fulfilling material unsatisfied conditions.
  • Products still to be assembled are invoiced.
  • Products are sent to and held by freight companies pending return to the seller for required customer modifications.
  • Products require significant continuing vendor involvement (such as installation or debugging) after delivery.

Improper Revenue Recognition in Smaller Entities

Many CPA firms have experienced revenue recognition problems with smaller reporting entities. Here are a few examples:

  • A nightclub that continually reports a very low gross margin from beer and liquor sales (Skimming).
  • An operator of nursing homes includes numerous relatives on multiple payrolls (Inflating Medicaid reimbursements).
  • A construction contractor that purchases all materials for certain contracts to increase actual costs before its year-end (Dumping materials at sites to inflate the percentage of completion).
  • A trailer leasing company that bills customers for extra, unused trailers each month (Fraud).
  • Products shipped subject to customer approval are recorded before receiving such approval (Improper cutoff).
  • Billing customers for products shipped on consignment, or before products are shipped and recording revenue prematurely (Inflating revenues).
  • Recording multi-year contracts or revenues benefiting future periods, at the date of the contract or customer order (Improper matching of costs and revenues).
  • Recording grant revenues when received rather than as expended (Improper matching costs and revenues).
  • An entity that won’t provide inventory quantities and pricing information until the CPA informs management of the taxable income before the inventory adjustment (Fraud).

Disclosures

Basic disclosures under the FRF for SMEs include the following:

  • Revenue recognition policies for all types of revenues, including the policies, recognition methods and determination of revenues from multiple deliverable arrangements.
  • All major categories of revenue should be disclosed in the statement of operations or in the footnotes.
  • When the completed contract method is used, an entity must disclose why the method is used instead of the percentage of completions method.
  • Revenue recognized from contract-related claims should be disclosed.
  • When management elects to record revenues from contract-related claims only when received or awarded, the amounts of claims due should be disclosed.

Discussion Exercise:

Referring to the Statement of Revenues and Expenses for Always Best Corporation in Appendix A, list below any additional disclosures you consider necessary for a fair presentation of revenue recognition.

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NONMONETARY TRANSACTIONS

Normally, the most reliable market value for the asset given up or the asset received should be the measure for assets received or exchanged in nonmonetary transactions. Exceptions include transactions that lack commercial substance (increases in cash flows), that are exchanges of products in the normal course of business, that have no reliable market values for assets exchanged, that are nonreciprocal transfers to owners and that are between related parties.

When these exceptions apply the carrying amount of the asset given up, adjusted for any monetary consideration in the transaction, should be used for measurement purposes. The party paying the monetary consideration values the nonmonetary asset received at the carrying amount of the asset given up plus the monetary consideration paid. The party receiving the nonmonetary asset values it at the carrying amount of the asset given up less the monetary consideration received. If the monetary consideration exceeds the asset’s carrying amount, a gain is recognized.

Other matters

  • Nonreciprocal transfers to owners that are spin-offs or other forms of restructuring in liquidation should be valued at the carrying amounts of nonmonetary assets or liabilities transferred.
  • Gains and losses from nonmonetary transfers should be reported in net income at the date of the transfer.
  • Restructuring or spin-off distributions do not result in gains or losses to the transferor.
  • Disclosures include the nature and amount of the transaction, the basis for measurement and the method of valuation used and any gains or losses.

OPERATING EXPENSES

The matching of costs with revenues in the same reporting period is a basic principle underlying the presentation of operating expenses.Costs of goods sold and other operating expenses should be recorded in the same period related revenues are recognized.

Generally, operating expenses are recognized on an accrual basis, when an expense is incurred. Fixed assets are depreciated over their useful lives. Intangible assets are amortized over their useful lives (or contractual periods as in the case of asset retirement obligations) or periods specified in the FRF for SMEs (goodwill is amortized over the period specified by the Internal Revenue Code or 15 years).

LEASE ACCOUNTING

The FRF provides guidance for lessees’ accounting for capital and operating leases, and for lessors’ accounting for sales-type, direct financing and operating leases. The principles are based on the view that property has benefits and risks related to ownership. Further, the FRF takes the position that when a lease transfers substantially all the ownership benefits and risks it is essentially an acquisition of an asset and the incurrence of an obligation and should be accounted for as a capital lease by the lessee and either a sales-type or direct financing lease by the lessor.

This guidance does not apply to copyrights, patents and other licensing agreements which are account for as intangible assets. Following is a discussion of basic lease accounting principles under the FRF.

One or more criteria in a lease agreement indicating transfers of substantially all the benefits and risks of ownership to lessees, similar to currently applicable U.S. GAAP, includes:

  1. Transfer of ownership at the end of the lease term or a bargain purchase option (that would cause the lessee to purchase).
  2. A lease term that will enable the lessee to receive substantially all the economic benefit from the asset. This would normally be a term that is 75% or more of the remaining useful life of the asset. This criteria normally would not apply to land unless there is reasonable assurance ownership will transfer at the end of the lease term.
  3. The lessor has some assurance of recovering the cost of the assets and earning a return on that investment. This assurance exists if, at the inception of the lease, the present value of the minimum lease payments excluding executory costs is 90% or more of the market value of the asset. The discount rate that should be used to determine present value is the lower of the lessee’s incremental borrowing rate or the interest rate implicit in the lease if it can be obtained or estimated (the implicit rate will be used by a lessor).

For lessors, the benefits and risks of ownership normally are transferred when:

  1. Any one of the criteria above is met.
  2. Credit risk is similar to other receivables.
  3. Non-reimbursable costs likely to be incurred by the lessor can be estimated to determine if substantial risks are retained, thereby preventing capitalization of the lease

A lease of an asset that transfers substantially all the benefits and risks of ownership should be accounted for as a capital lease by the lessee and a sales-type or direct financing lease by the lessor.