Alternative GAAP for Smaller Entities - Essay Example

Alternative GAAP for Smaller Entities a) Need for separate GAAP for Smaller Entities Basically accounting serve two purposes. One is to provide information for contracting purposes and other is for the purposes of valuation. Time and again these two objectives of accounting information create conflicts. “The nature of this type of conflict in SMEs, where there is greater emphasis is on contracting, and public corporations where the greater emphasis is on valuation…. It is unclear whether single set of GAAP, or a GAAP with exclusions of SMEs , can provide an appropriate balance between primary objectives for both public corporations or SMEs.”(Anthony Ariganello, 2004)1 Hitherto GAAP have been developed for all type of entities, be those smaller or larger and public or private. Development of alternative accounting standards on the basis of size of the entity is like preparing students at earlier stages to cope with burden of higher studies. But in business the smaller entities some time carry more accounting complications than larger entities as generally less or reduced number of regulatory compliances create a habit of carelessness and thus allowing smaller problems growing into complexities. Before analyzing the needs of smaller entities for alternative GAAP, it is pertinent to ascertain the present international scenario. In United States private companies are not even required to issue financial statements, what to talk to issuing compliances in the shape of standards. Private entities can assess the cost and benefit before following the reporting standards out of the three alternatives available to them. First is to follow the US GAAP in full; the second alternative is reporting under GAAP but such entities can depart from one or two alternatives; and the third alternative is to adopt OCBOA (other comprehensive basis of accounting). UK presents an altogether different approach towards smaller entities. Financial Reporting Standards for Smaller Entities (FRSSE) were developed in 1997 and those were made applicable to smaller and private entities defined and distinguished on the basis of specifies thresholds in sales, assets, and number of employees. With the advent of International accounting standards and their convergence with local standards, the issue of separate standards for smaller entities have again been taken to the fore, mainly because smaller is larger in numbers and they do not need to waste resources comparing the benefits they would receive. Convergences with IFRS are progressing but the issue has remained the same when FRSSE were required on establishment of FRSs. Now IFRS are getting converged with local standards, as those have already made applicable in EU since January 2005, and there is a demand for separate set of standards for smaller entities. As usual opinions stand both in favour of and against the establishment of alternative standards for smaller entities. Given this scenario let us first analyze the arguments favoring the need for an alternative set of accounting standards. There is general feeling that disclosure required to be made under IFRS are numerous and that is why notes to the accounts formulate a long list of declaration of accounting principles and policies adopted by the entity. The list is so ling that notes carry more importance than the financial figures in the financial statements. What difference it would make if a simple declaration is made that the entity has followed all the applicable laid down principles in standards except those have been listed in the notes to statements. In case smaller entities most of standards as laid down in IFRS remain inapplicable. Therefore there is need in the case of smaller entities that they be freed from making longer disclosures in the notes. Notes should remain a part of financial statements and not that financial statements should become part of the notes. If we analyze the published accounts it will be found that company after company is simply repeating the similar language over standards that require some sort of disclosure in notes irrespective of their applicability to the transitions reported in the financial statements. So notes need to be truncated to be smaller for smaller entities. There has been another opinion that is making round in IASB circles. It is suggested that in order to cover up some SMEs for the time being IFRS may be extended to all entities that are publically accountable irrespective of the fact whether group accounts are required or not. Even companies that are listed in secondary markets such AIM and OFEX should be covered up for the application. Then there were also suggestion from various quarters that FRSSE be extended to medium sized entities. But this suggestion has met opposition on the ground that the scope of FRSSE could become too broad and consequently FRSSE may not be as simple as it now appears. In other words majority of suggestion from those, whom draft standards for SMEs were circulated, are of the opinion that a separate set of IFRS be introduced for SMEs in order to preserve their identity> In numbers SMEs are manifold larger than larger entities, and in that respect SMEs deserve a separate set of standards of their own. It has been noticed in many studies established to assess the impact of implementation of IFRS on larger companies that most of companied adopted cost model instead of fair value wherever the option was available. In the meeting ‘smaller business Advisory Committee of FASB’ held on June 27th, 2008, this matter was debated in detail. Leonard Steinberg2, SBE Council Representative, stated that “the discussion related to the difficulty using fair value since private companies do not go into private markets for securitizations and borrowings. Therefore, the use of fair value exposes preparers and users of the private company statements to potential confusion regarding the accuracy of the presented amounts.” The reasoning is valid. When private or smaller companies are not required to reap the benefits of declaration of assets valuation as fair market, what is the need of putting up such exercise at a cost, the benefit of which will never accrue to smaller entities? Therefore this is quite a reasonable reasoning seeking separate standards for smaller entities. Then there is similar issue of intangible like Goodwill and other assets being tested for impairment. IFRS 3 does not permit amortization of expenses of Goodwill but seeks impairment value. In other words these assets have to go in for a yearly impairment test. There will be extra cost without benefits. This is a highly professional exercise that requires services of experts. Impairment is an exercise that suits larger companies who have to declare asset value to shareholders to assess the worth of their investments. Smaller entities will be following such standards only for compliance purposes without any particular advantage accruing any section of the society including the owners and other investors of smaller entities. Smaller entities must be freed from such unnecessary exercise just for the sake of reporting and a separate set of standards are required to meet this demand of smaller entities Most of the smaller entities are required to file statutory financial statements in most of the countries except in United States. This forces these entities to prepare the statements following full IFRS that are full of complexities and involve high cost of implementing and applying these standards. As per one estimate only around 700o listed companies in EU were implementing IFRS in 2005, whereas more than 5 million SMEs have to prepare their financial statements as per their national GAAP in order to meet statutory filing and other requirements (Barry Jay Epstein and Eva K. Jermakowicz, 2007)3. When requirement of statutory filing is from a large number entities, then accounting standards must be established as per convenience of those smaller entities. Large entities are very few and only because of those larger entities, some unnecessary costly exercises are required to be made under the pretext of statutory filings. There are opinions also against the establishment of standards for smaller entities. “They argue that, rather than simply streamlining existing standards, IASB should have taken a user based- more conceptual approach in creating differential accounting for SMEs. They insist that fundamental differences exist between the objectives of financial reporting of SMEs (being primarily focused on the role of stewardship) and those are reporting for large companies, and that these differences should be incorporated into the conceptual framework.”( Leonard Steinberg , June 2008)4 There is also an opinion against two separate standards that this will upset the entire process of accounting education of smaller entities. Accounting is basically such learning processes that develop with the development of business. When smaller entities are asked to follow separate and comparatively uncomplicated GAAP that serve only the purpose of information distribution, then these smaller entity may face a complicated GAAP when they develop into larger corporation. At that time every aspect of compliance will not only be burdensome but time consuming and costlier. Similar GAAP for both type of entities provide the required training to smaller entities to deal complicated accounting procedures and compliance with confidence on their growing into larger corporations. Whatever may be the opposing arguments accounting system without considering valuation aspect and catering only providing of information is not a complete system. But the requirements of smaller entities are not so major that need to meet the compliances of complicated nature. Therefore when a separate set of standards that has qualities of a perfect GAAP as well as less regulatory compliances and disclosures are framed for smaller entities, not only good accountant will be trained to handle GAAP for larger corporations, but proper and value based information will also be disseminated. b) Approach to design IFRS for SMEs The term ‘stand- alone self contained’ tells all about the nature of requirements of the framework of accounting standards for SMEs. To start with we have to search full IFRS for the ready material that can be used for IFRS for SMEs. In December 2005 meeting of IASB5 it was decided that “Standards in full IFRS that address transactions, events or conditions commonly encountered by SMEs should be included in the IFRS for SMEs either directly or by cross- reference back to full IFRS.” This is good proposal to be agreed upon when confronted with designing of standards for SMEs The second criteria to be agreed upon in a venture to frame IFRS for SMEs is also the decision of the board in December 2005 meeting when it was held that “if the IFRS for SMEs does not specifically address a transaction, event, or condition, an SME should be required to look to the requirements and guidance elsewhere in IFRS for SMEs dealing with similar and related issues (that is, select an accounting policy by analogy). Failing that, the SME should be required to look to the requirements and guidance in IFRSs and interpretations with IFRSs dealings with similar or related issues.” This is very good criteria and absence of such a requirement would enhance the amount of material to be taken from full IFRS and this is what the IASB’s point of view to be agreed upon. In most of the nations that are converging local standards with IFRS, SMEs are statutory required to meet some reporting compliances. For example legislation regulating companies of almost every such nation require the companies, irrespective of their size large or small, to submit some statistical data in the shape of annual or other periodic reports, that help country to build economic sensibility in the nation. Accordingly, IFRS for SMEs should incorporate flexibility into the standards that seek and create such general statistical information that satisfy at least basic requirements of any nation. Though this is a very difficult and complicated task, at least some general and basic data can be developed that help companies in meeting local statutory compliances. At least one section in the entire framework of standards for SMEs can be devoted to meet local statutory requirement taken the local accounting body into confidence. This will further instill a feeling of compliances of statutory requirements that are meant to serve SMEs in their own nation. European Financially Advisory Group (EFRAG) reply to letter from IASB seeking suggestion on IFRS for SMEs made few commendable suggestions that should form part of IFRS for SMEs. EFRAG6 seeks identification of common principles among broad categories of assets, financial liabilities, and non- financial liabilities in areas, namely, measurement on initial recognisition; subsequent remeasurements and depreciation/ amortization; determination of cost of acquisition or production; fair valuation; and derecognition. The point to note in EFRAG’s suggestion is asking for standards that take care of fair valuation of assets. This strengthen the belief that even if the objective of IFRS for SMEs is not to put SMES on the course of complicated disclosure and compliances, but at the same time such standards should also take care of preparing the SMEs to comply with full IFRS requirements on their becoming larger corporations. However, the standards seeking valuation of assets should not be repetition of what the full IFRS have asked for. It can be like that fair valuation opinion can be formed by the management of SME itself without seeking outside professional guidance. Management can do so as by using or deploying a particular asset to achieve the objective of the entity, the management get experienced about working and performance of the assets. So management is in a better position to make fair value evaluation of those assets that are employed with the entity’s regular operations. This will also take care cost/ benefit equation while making compliances with standards. Also thereby theoretical attributes of providing information and valuation will get together strengthening the quality of IFRS for SMEs. Standards from SMEs should be principle based and not merely rule based. It is believed that standards that are not principle based might be forced upon into a rule based approach in order to cover up this weakness. The problems with IAS 32 and IAS 39 are examples for these rule based approach towards setting the standards. That is why we come across one criticism or the other against these standards. These principles can be taken from say already established local standards, those have developed over a passage of time, and accordingly amended number of time to remove weaknesses and objections rose from various quarters. Present standards suffer from certain disadvantages, and it is suggestible that standards from SMEs should be devoid of those weaknesses. David Tyrrall7 in his article has stated that present standards suffer from four disadvantages. Those disadvantages are as under: a) Present standards stifle independent judgment b) The competition of ideas is reduced as very entity feel that the bench mark is set by the standard to achieve. c) Some time bad accounting might be legitimize. d) These standards mislead the users by unnecessary raising the standard of expectations. All these four disadvantages are worth considering while laying the framework of standards from smaller entities. The standards can be dissuaded from these disadvantages only when those are flexible and open for the changes required with passage of time. So far bad accounting is concerned that should be taken care of at the time of setting the standard. Circulation of drafts standards will do the necessary scrutiny of the proposed standards. Creating awareness among smaller entities would be the exercise which the board will have to undergo in order to see the success of IFRS for SMEs. Criticism is bound to arise; but healthy criticism brings in fresh ideas. One suggestion is that SMEs be asked to follow the draft IFRS on trial basis and observe the practical difficulties in implementation of IFRS for SMEs. That unofficial application will bring in actual limitations of the standards to the fore as smaller entities would not be wary of mistakes in the trial period. Once the trail is successful over a period of time ranging from say two to three years, then standards can be formulated legally and then the final version would become applicable officially for SMEs. Bibliography: Anthony Ariganello, Preliminary views on Accounting Standards for SMEs, 2004, http://www.cga-canada.org/en-ca/ExposureDraftResponses/ca_exd_2004-09-24_iasb.pdf Barry Jay Epstein and Eva K. Jermakowicz, International Standards for Small and Medium- Sized Entities, The CPA Journal, October 2007, http://www.nysscpa.org/cpajournal/2007/1007/essentials/p38.htm David Tyrrall, The advance of IFRS threatens to render many national standard –setting bodies obsolete, financial Management (UK), Oct 2006 Leonard Steinberg, Notes on Small Business Advisory committee meeting held on June 27th, 2008, http://sbecouncil.org/content/display.cfm?ID=2777 IASB December 2005,ED for SMEs, meeting summaries, http://www.iasb.org/Current+Projects/IASB+Projects/Small+and+Medium-sized+Entities/Meeting+Summaries+and+Observer+Notes/IASB+December+2005.htm EFRAG, Reply and Suggestions for IASB SME Project, February 2006, http://www.cnc-cbn.be/NL/New/2006/NL_new%202006-02-13.doc Read More