Asset Based Lenders Need to Understand the New GAAP Exceptions

By Freed Maxick Tax on May, 19 2014
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Freed Maxick Tax

Author: John Costello

FASB releases new ASUs regarding alternate reporting methods but don’t worry – it’s good news for Asset Based Lenders!

For a number of years, small businesses and their accountants have complained about the growing complexity and costs of complying with Generally Accepted Accounting Principles (GAAP). That led the Financial Accounting Standards Board (FASB) to solicit feedback from private company lenders and other stakeholders about the usefulness of certain complex accounting rules.

Accounting standard updatesThe feedback showed that many lenders are disregarding complicated accounting measures — including the subsequent reporting of impairment losses, goodwill following business combinations, and simple interest rate swaps — when evaluating a business’s financial condition and operating performance.

In January 2014, FASB released a couple of Accounting Standards Updates (ASUs) that offer private companies some alternate reporting methods. It’s critical for lenders to understand the new GAAP exceptions, which will go into effect for most private businesses at the end of 2014. Early adoption is permitted, as well.

Reporting Goodwill After a Merger or Acquisition

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

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

The fair value of goodwill can decrease over time, particularly if a deal doesn’t live up to the buyer’s expectations. So GAAP requires that companies test for impairment. This occurs when the carrying value of goodwill exceeds its fair value. Nonprofits and public companies must test for impairment at least annually. And if triggering events occur, impairment testing should be even more frequent. (See the sidebar “Watch out for triggering events.”)

ASU 2014-02, Intangibles — Goodwill and Other (Topic 350): Accounting for Goodwill, offers a different method for private companies that acquired goodwill in a business combination. Instead of testing for impairment each year, private companies can elect to amortize goodwill straight-line over 10 years (or fewer, if they can justify a shorter useful life). Private businesses still need to test for impairment whenever a triggering event occurs. But they must compute impairment at only the entity level.

So, here’s what lenders must know about the goodwill exception’s alternate method: Smaller numbers of private borrowers will incur impairment losses, because amortization will automatically lower the carrying value of any goodwill over time. Moreover, the alternate method also reduces the need for valuations and makes reporting more predictable.

Understand that, because impairment is tested at the entity level, strong business segments may temporarily hide any “underperforming” acquisitions. So if a private borrower reports impairment under the alternate method, you should take it seriously.

An Easier Method for Interest Rate Swaps

The second GAAP exception applies to normal interest rate swaps. Following the recent financial crisis, certain borrowers could get only variable rate loans. So, they used simple interest rate swaps to get the consistency of fixed-rate payments. However, this strategy inadvertently opened up a can of worms of complex, and costly, accounting requirements that many private businesses weren’t prepared to handle.

Under GAAP, swaps are usually considered derivatives that must 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 another method. It allows a private company to measure qualifying swaps at settlement value, rather than fair value. That means interest expense is pretty much the same as if the borrower had entered into a fixed-rate loan directly.

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

FASB is hoping that the alternate method will make financial statements much easier to understand and a lot less costly to prepare for small businesses. And lenders can expect to see fewer confusing earnings fluctuations that used to result from changes in the fair value of borrowers’ simple interest rate swaps.

A Welcome Change

Certain accounting rules were originally drafted with public companies in mind. Small businesses tend to operate more simply, though, so FASB’s move to allow exceptions for private companies is highly lauded by many small companies and their constituents.

Even if there are no impairment losses recorded when a triggering event occurs, that event can still compromise debt service and disrupt operations. If you notice one or more of these events when monitoring your clients, ask about how management plans to mitigate its adverse effects.

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Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can help you reduce the risk of lending or assist your clients with our business advisory, audit, fraud detection and prevention, and tax services.

For more information about our business advisory, audit, and other accounting services contact us here, or call us at 716-847-2651.

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