Center for Plain English Accounting AICPA s National A&A Resource Center available exclusively to PCPS members

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1 REPORT April 19, 2017 Center for Plain English Accounting AICPA s National A&A Resource Center available exclusively to PCPS members Common Questions About Special Purpose Frameworks By: Mike Austin When many consider financial statements, the default assumption is that they are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP). While true for many sets of financial statements, there are other widely-used alternatives to U.S. GAAP which are collectively referred to in the authoritative literature as special purpose frameworks. These are other frameworks that also are referred to as other comprehensive bases of accounting (OCBOA), which include: Cash Basis: A basis of accounting that the entity uses to record cash receipts and disbursements and modifications of the cash basis having substantial support Tax Basis: A basis of accounting that the entity uses to file its tax return for the period covered by the financial statements Regulatory Basis: A basis of accounting that the entity uses to comply with the requirements or financial reporting provisions of a regulatory agency to which jurisdiction the entity is subject Contractual Basis: A basis of accounting that the entity uses to comply with an agreement between the entity and one or more third parties other than the auditor Other Basis: A basis of accounting that uses a definite set of logical, reasonable criteria that is applied to all material items appearing in financial statements Practice Note: International Financial Reporting Standards (IFRS) are not considered a special purpose framework. This is due to the AICPA designating the International Accounting Standards Board (IASB) as the body to establish professional standards with respect to international financial accounting and reporting principles. This results in IFRS, as well as IFRS for small and medium-sized entities (IFRS for SMEs), being considered generally accepted accounting principles.

2 The CPEA frequently answers questions related to special purpose frameworks. In this report, we provide responses to twelve common questions regarding special purpose frameworks. While there are multiple frameworks which are considered special purpose frameworks, this report focuses only on the two which are most commonly used -- the cash basis and the tax basis. 1. What is the authoritative guidance for financial statements prepared under a special purpose framework? While U.S. GAAP includes volumes of authoritative guidance surrounding how transactions should be accounted for, implementation guidance, and interpretations, that is not the case for special purpose frameworks. The primary sources of guidance are: AU-C 210, Terms of Engagement, which require auditors to determine the acceptability of the financial reporting framework AU-C 800, Special Considerations -- Audits of Financial Statements Prepared in Accordance with Special Purpose Frameworks, which is the primary auditing resource SSARS 21, Statements on Standards for Accounting and Review Services: Clarification and Recodification, which is the primary review resource You may have noticed that the guidance above deals with how practitioners should approach an engagement under a special purpose framework, opposed to providing guidance on how transactions should be accounted for in accordance with a special purpose framework. This is due to the lack of authoritative accounting guidance on either the tax or cash basis of accounting. A leading authority is the AICPA produced practice aid, Accounting and Financial Reporting Guidelines for Cash- and Tax-Basis Financial Statements (the AICPA Practice Aid). In addition, other organizations are relied upon for guidance as well and produce their own practice aids, such as the practice aid produced by Practitioners Publishing Company (PPC Practice Aid). If you or your firm has cash or tax basis engagements, we suggest obtaining a high-quality practice aid to assist in ensuring that the framework is being applied appropriately. 2. When can an entity prepare special purpose framework financial statements? Entities can prepare special purpose framework statements whenever they are not otherwise required to issue U.S. GAAP statements. Requirements to prepare financial statements in accordance with U.S. GAAP can arise from a variety of sources, with loan covenants, equity investor requirements, and incorporation agreements being the most common. Absent such requirements, special purpose framework statements can potentially provide benefits to all parties. Specifically, cash or tax basis presentations:

3 Can be easier to understand and can potentially be more relevant based on the use of the financial statements Are usually less costly to prepare Have less complex measurement requirements than U.S. GAAP Are based on concepts more easily understood by staff who may not have the knowledge required to follow complex U.S. GAAP requirements While there are benefits, there are downsides as well, including: Statements may not meet the requirements of certain users or regulators May not provide a comprehensive measure of an entity s complete economic condition due to potential manipulation of timing of receipts and distributions when using the cash basis Diversity in practice of how statements are prepared which may lead to confusion 3. An entity changes its accounting basis (also known as financial reporting framework) from U.S. GAAP to a special purpose framework such as income tax basis. How should the change in financial reporting framework be accounted for and reported in the financial statements and how does the change impact the auditor's or accountant's report? This specific issue has resulted in questions frequently enough to warrant a response in the nonauthoritative AICPA Technical Questions and Answers publication: Inquiry: A company that has previously issued financial statements prepared in accordance with U.S. GAAP has decided to change to the income tax basis (or vice versa). How should the change in accounting basis be accounted for and reported in the financial statements and how does the change impact the auditor's or accountant's report? Response -- Accounting Issues: Authoritative literature does not address accounting for a change in accounting basis. FASB ASC 250 provides guidance for reporting accounting changes within the same basis. However, the situation described above is considered to be a change in accounting basis rather than an accounting change. When only current year financial statements are presented, it is common practice to present the effect of the change in the accounting basis by showing beginning retained earnings as previously reported with an adjustment to convert to the new basis. Although not as common in practice, precedent also exists for either showing opening

4 retained earnings on the new basis or showing the effects of the change as a cumulative-effect adjustment in the income statement. However, if comparative financial statements are presented, the prior year(s) should be restated and presented under the basis to which the company has changed. Restatement is necessary to ensure comparability with all periods presented. In both cases, the change in accounting basis should be disclosed in the notes to the financial statements. Response -- Reporting Issues: Auditing literature indicates that a change in accounting basis does not represent a lack of consistency and, consequently, that report modification is not required. However, the literature allows for the inclusion of an emphasis-of-matter paragraph in the auditor's report to emphasize a matter regarding the financial statements. A summary of the relevant authoritative references follows: Paragraph.A1 of AU-C section 708, Consistency of Financial Statements, indicates that the consistency reference in the auditor's report refers to consistent application of principles within a basis of presentation. The standards do not address the consistent use of a basis of presentation; therefore, a change in accounting basis does not require the auditor to modify the report for a lack of consistency. Paragraph.06 of AU-C section 706, Emphasis-of-Matter Paragraphs and Other- Matter Paragraphs in the Independent Auditor's Report, indicates that an auditor should include an emphasis-of-matter paragraph in the auditor's report if the auditor considers it necessary to draw users' attention to a matter appropriately presented or disclosed in the financial statements that, in the auditor's professional judgment, is of such importance that it is fundamental to users' understanding of the financial statements. A sample emphasis-of-matter paragraph for an audit report on comparative financial statements in the year of change to a special purpose framework follows:

5 Emphasis-of-Matter Paragraph As discussed in Note A to the financial statements, in 20X4 the Company adopted a policy of preparing its financial statements on the accrual method of accounting used for federal income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles. Accordingly, the accompanying financial statements are not intended to present financial position and results of operations in accordance with accounting principles generally accepted in the United States of America. The financial statements for 20X3 have been restated to reflect the income tax basis of accounting accrual method adopted in 20X4. Accountants performing review or compilation engagements also may consider adding an explanatory paragraph for these basis changes. CPEA Observation: The AICPA Technical Questions and Answers are in the processes of being reviewed with revisions potentially being made during summer or fall As a result, practitioners should be aware that some information included may change. To illustrate the diversity in opinions surrounding a change to a special purpose framework, the authors of the PPC Practice Aid disagree somewhat with the position taken above that disclosures related to changes in accounting basis should be disclosed in the notes to the financial statements. They take the position that it is a matter of judgment if those disclosures would be helpful to users, but are not required since FASB ASC does not apply to a change in financial reporting framework. The authors of that publication also take the position that if comparative financial statements are being presented, consideration should be given as to whether the framework used in the current year would have materially changed the results of the prior year financial statements had it been used. If the new framework would not have materially changed the results of the financial statements, the prior year results could be shown as originally issued, which differs from the position taken in the AICPA Technical Question and Answer above which indicates that prior years should be restated when comparative financial statements are issued. 4. What is the difference between the cash basis and modified cash basis of accounting? The cash basis of accounting in its pure form is rare, and only commonly used in limited industries or circumstances. This is because under the pure cash basis, transactions only are recognized when cash is received or disbursed, with no subsequent capitalization or

6 timing considerations. This results in the balance sheet effectively only showing cash on hand and equity, with no other asset or liabilities. The modified cash-basis uses logical and consistent modifications to events which are derived from cash receipts and disbursements. For example, common modifications would be recording a capital asset when acquired and recording depreciation of that asset over the useful life, or recording a liability when long-term debt is incurred. 5. How can we determine what should be recorded under the modified cash basis of accounting? The general rule of thumb is to think of the journal entry that would be required to record a transaction. If either the debit or credit side of the entry would be to cash, then it should probably be recorded. An accounting policy should meet the needs of the users of the financial statements while consistently applying the policy to transactions in order to ensure that the financial statements are not misleading. One of the main challenges practitioners face in evaluating transactions is separating themselves from the accrual mindset under U.S. GAAP. Transactions related to areas such as revenue can be troublesome since common financial statement line items like Accounts Receivable generally are not included in cash basis financial statements, while line items like Deferred Revenue generally are included in cash basis financial statements if the transaction is the result of receiving cash per the AICPA Practice Aid. As outlined above, in applying the modified cash basis, consistency is required in making modifications for all transactions as opposed to just picking and choosing what will be recorded as a modification. If an entity elects to record only certain types of cash transactions, for example, choosing to record capital assets acquired with cash but not inventories acquired with cash, the preparer should be able to defend how that decision is a logical and consistent application of the accounting policy which would not result in misleading financial statements. 6. Can we make too many modifications and still call the financial statements modified cash basis statements? Because there is no authoritative guidance on the modifications which must be made, and non-authoritative sources may disagree on certain modifications, it s a fine line that requires judgement. However, as additional modifications are made the potential increases that the financial statements which are being prepared are effectively moving away from a cash basis and more toward an accrual basis. No bright line exists for the number of modifications or specific modifications which would result in the financial statements being considered non-cash basis financial statements.

7 Consider if a preparer elects to make a modification such as recording trade accounts receivable and accounts payable on the accrual basis. These transactions clearly are not cash basis transactions. The PPC Practice Aid suggests that, in considering the totality of modifications, the basis still could conceivably be adjusted cash basis if the total modifications do not result in the financial statements being accrual basis. However, it would be difficult to reach that conclusion if trade accounts receivable and accounts payable are significant. 7. Must an entity be a taxable entity to prepare tax basis financial statements? No. Any entity that files a return, either income tax return or informational return with the IRS, may prepare tax basis financial statements. Therefore, C corporations, S corporations, partnerships, limited liability partnerships, limited liability companies, sole proprietors, and not-for-profits also may choose to prepare tax-basis financial statements if they determine that framework to be the most useful to the users of the financial statements. Practice Note: Entities with investors who are primarily interested in the tax consequences of the transactions are strong candidates to consider using tax basis financial statements. Using that framework can provide information to the users that they would find helpful beyond what can be found in a tax return. 8. When preparing tax basis financial statements, how are differences between U.S. GAAP and IRS rules handled? The general rule is that if the financial statements are being prepared on the tax basis, the treatment on the tax return would trump the presentation under U.S. GAAP. For example, consider the relatively recent guidance from ASU , Interest -- Imputation of Interest, Simplifying the Presentation of Debt Issuance Costs, which requires those costs to be presented as a component of interest expense as they are amortized. However, for tax purposes, amortization of those costs is grouped with depreciation opposed to interest expense. Thus, in tax basis financial statements, the amortization also would be classified with depreciation to match how the item is treated on tax returns. 9. In preparing tax basis financial statements, how are Section 179 of the Internal Revenue Code items treated? Section 179 allows some entities (C Corporations & pass-through entities) to treat a portion of qualifying property as deductions during the year as expenses that would otherwise require capitalization under U.S. GAAP. This difference would then have a trickledown effect of reducing the basis of depreciable assets. Per the authors of the PPC Practice Aid, there are two ways to address Section 179 items in tax basis financial statements:

8 Since Section 179 expense is included in depreciation on the tax return, present it as depreciation expense in the financial statements as well. Record the Section 179 adjustment on the statement of assets, liabilities, and equity. The adjustment could be recorded either as a contra account to accumulated depreciation (cost of the asset is tax basis at cost) or directly to the cost of the asset (cost of asset is tax basis net of the Section 179 adjustment). Many practitioners choose to keep the Section 179 expense included with depreciation on tax basis financial statements to match presentation on the income tax return. 10. Is taxable income on the tax returns required to match net income in tax basis financial statements? No. A typical objective of a set of financial statements is to show a measure of the results of operations for the entity. If an entity has nontaxable revenues and nondeductible expenses, those items would need to be included in tax basis financial statements to provide a complete picture of operations. From a more practical standpoint, excluding those items would result in unbalanced financial statements. For example, if an entity were to receive cash from tax exempt interest, there would be a debit to cash and there would need to be a corresponding credit to complete the entry. Additionally, depending on the type of organization filing the return, taxable income may or may not appear on the tax return. Showing taxable income in a set of tax basis financial statements is not required, nor is providing a reconciliation between net income and taxable income or disclosing the amounts of nontaxable income and nondeductible expenses included in net income. Practice Note: While the amounts are not required to be disclosed, the accounting policy note should include a statement reflecting that nontaxable income and nondeductible expense are included in the determination of the equivalent operating results or net income. 11. What is required to be disclosed in financial statements prepared under a special purpose framework? When special purpose financial statements contain items that are the same as, or similar to, those in financial statements prepared in accordance with U.S. GAAP, practitioners need to evaluate whether the financial statements include informative disclosures similar to those required in U.S. GAAP. Per the AICPA Practice Aid, when special purpose financial statements contain items that would require disclosure using U.S. GAAP, the special purpose statements may either provide the relevant disclosures that would be

9 required for those items in a U.S. GAAP presentation or provide information that communicates the substance of the U.S. GAAP disclosures. Practice Note: Disclosures included in policy notes in U.S. GAAP-based statements need to be included in special purpose framework statements, when the policy notes have applicability within the financial statements. Additionally, there needs to be policy note disclosures clearly-stipulating the primary substantive differences between U.S. GAAP and the special purpose framework, as well as describing the basis of accounting used within the financial statements. One of the common misconceptions related to special purpose frameworks is that there is a substantial reduction in disclosure requirements compared with U.S. GAAP. While there are some disclosures that are not required, other disclosures, as discussed above, are required in addition to those required to communicate the same information as U.S. GAAP disclosures. As such, any reduction in disclosure requirements when preparing special purpose framework financial statements may not be as substantive as initially expected. Conclusion As complexities continue to increase in U.S. GAAP, more entities are likely to consider special purpose frameworks. As this report indicates, practitioners need to exercise substantial judgment when deciding how items are recorded due to the lack of authoritative guidance for those frameworks. Further, judgment will need to be utilized by practitioners with regard to engagements associated with special purpose frameworks to ensure that the adjustments made by clients are consistent, reasonable, and appropriate for their basis of accounting. Center for Plain English Accounting aicpa.org/cpea cpea@aicpa.org The CPEA provides non-authoritative guidance on accounting, auditing, attestation, and SSARS standards. Official AICPA positions are determined through certain specific committee procedures, due process and extensive deliberation. The views expressed by CPEA staff in this report are expressed for the purposes of providing member services and other purposes, but not for the purposes of providing accounting services or practicing public accounting. The CPEA makes no warranties or representations concerning the accuracy of any reports issued. Copyright 2017 by American Institute of Certified Public Accountants, Inc. New York, NY All rights reserved. For information about the procedure for requesting permission to make copies of any part of this work, please cpea@aicpa.org with your request. Otherwise, requests should be written and mailed to the Center for Plain English Accounting, AICPA, 220 Leigh Farm Road, Durham, NC