United States: FRF for SMEs: The GAAP Alternative That Can Save The Day

Last Updated: July 5 2019
Article by Yesenia Cardona and Erika Ballo

For the last few years, the accounting community has been galvanized about two of the most talked about Accounting Standards Updates (ASUs); Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842). These long-awaited changes will have a significant impact on businesses and the accounting profession alike. Both standards are already in effect for public and non-public companies. The revenue standard became effective for annual periods beginning after December 15, 2018, and the lease standard will be effective for annual periods beginning after December 15, 2019.

The Revenue Standard

The objective of the new revenue standard is to develop a single, principle-based revenue standard. This serves to (1) align Generally Accepted Accounting Principles (GAAP) with international accounting standards; and (2) make it easy to compare companies across different industries. In order to comply with this standard, companies must analyze all customer contracts—in relation to the five defined steps in the standard—in order to properly recognize revenue under the new ASU. Companies will also be required to disclose much more information than was previously required in the past. Gone are the days of industry-specific revenue recognition practices. The application of the standard among industries will be relatively the same, but the impact will vary by industry.

The Lease Standard

Previously, capital leases were reflected on an entity's balance sheet while an operating lease was expensed in the statement of operations. Under the new standard, all leases, regardless of being capital or operating leases, must be reported on the balance sheet as an asset and a liability. In addition, gone is the bright-line test to determine whether a lease is capital or operating. Implementation of this new standard will be a challenge for many companies because each lease must be separately evaluated and accounted for based on whether the lease is a finance lease (previously called a capital lease) or an operating lease. There could be a tremendous impact on the balance sheet of companies, as well as many of their financial ratios, which may cause some entities to violate their existing loan covenants. The lease standard will effect almost every company with any type of lease agreement (office rental agreements, equipment leases, etc.) making this a tedious task of calculating the financial statement impact of leases under the new ASU.

For public companies, the implementation of these two new standards will require additional personnel and added costs. For non-public companies, this financial burden is even greater. So what are non-public companies going to do? Public companies cannot escape, but private companies have the ability to implement the FRF for SMEs.

FRF for SMEs or the Financial Reporting Framework for Small and Medium-Sized Entities is an alternative basis of accounting to GAAP. The FRF for SMEs is not new, but it will probably become even more popular.

In June 2013, the American Institute for CPAs released an alternative to GAAP with the goal of making it easier for privately owned businesses to prepare their financial statements. However, at that time, FRF for SMEs did not gain much traction. Banks were not really interested, and owners did not want to learn another basis of accounting. And since it was non-GAAP, there was really no enthusiasm from the banking community to make the change. However, with the two new GAAP standards mentioned earlier, FRF for SMEs is a great way to escape the pains of implementation and reporting of the two new standards.

FRF for SMEs is a non-GAAP basis of reporting, also known as a special purpose reporting framework. It is based on traditional accounting principles and provides meaningful financial information without needless complexity. It is a good alternative to GAAP for owner-managed, closely held businesses that have no complicated regulatory reporting requirements or foreign subsidiaries as well as entities that have no intention of going public.

There are many differences between FRF for SMEs and GAAP, but the most significant difference for the purposes of this discussion is the treatment of revenue recognition and lease accounting.

Leases

FRF for SMEs Accounting Framework

U.S. GAAP

Lessees

  • Leases are classified as either operating or capital leases.
  • Balance sheet: Capital leases are recorded on the balance sheet as a fixed asset and a liability.
  • Income statement: Operating leases are expensed as rent. Depreciation and interest expense are recorded with capital leases.
  • Leases are classified as either operating or finance leases.
  • Balance sheet: Both finance leases and operating leases are recorded on the balance sheet as right-of-use asset and as a liability.
  • Income statement: For operating leases, amortization and interest expense are recorded as rent expense. For finance leases, amortization and interest expense are recorded as such.

Lessor

  • Treats leases as sales type, direct financing or operating.
  • Lease classified as financing or sale.

Revenue Recognition

FRF for SMEs Accounting Framework

U.S. GAAP

  • Broad principle-based guidance.
  • Revenue should be recognized when performance is achieved and ultimate collection is reasonably certain.
  • For goods: Performance is achieved when the entity transfers the risks and rewards associated with the goods to the customer.
  • For services: Performance should be determined using either percentage-of- completion method or completed- contract method. Performance is achieved when reasonable assurance exists regarding the measurement of the consideration that will be derived from rendering the service or performing the long-term contract.
  • There is no industry-specific guidance.
  • Core principal: Recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods or services.
  • Steps to apply under new method of revenue recognition:
    1. Identify contract with customer.
    2. Identify the performance obligations.
    3. Determine transaction price.
    4. Allocate the transaction price.
    5. Recognize revenue as a performance obligation is satisfied.

The new revenue and lease standards are extensive and time consuming to implement, but they are here to stay. However, for small businesses, FRF for SMEs could be both a time- and money-saving alternative. Make sure you get the approval from your banker, family members or partners before implementing the FRF for SMEs. And don't forget to talk with your accountant about implementing FRF for SMEs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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