THE FINANCIAL REPORTING FRAMEWORK FOR SMALL- AND MEDIUM-SIZED ENTITIES—PART 4

CPA Firm Support Services, LLC

By Larry L. Perry, CPA

LEARNING OBJECTIVES

  • To learn the presentation format for the statement of cash flows under the FRF for SMEs.
  • To learn accounting and disclosure principles for special issues under the FRF for SMEs.

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

  • Presentation of the statement of cash flows under the FRF for SMEs
  • Principles of accounting and disclosure for:
  • Subsequent events
  • Related party transactions
  • Subsidiaries
  • Consolidations
  • Joint ventures
  • Business combinations
  • New basis accounting
  • Foreign Currency

BASIC FINANCIAL STATEMENT PRESENTATION ISSUES

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 Cash Flows
  3. Consolidated Statement of Cash Flows
  4. Each statement should include this reference or other descriptive wording under the statement title: (FRF for SMEs Basis).
  5. 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.
  6. 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 CASH FLOWS

As it is with U.S. GAAP, whenever a statement of financial position and a statement of operations are presented, a statement of cash flows is required. When consolidated statements are prepared, all intercompany transactions and balances are eliminated.

Cash and Cash Equivalents

Depending on an entity’s circumstances, either the title “cash” or “cash and cash equivalents” should be used both in the statement of financial position and the statement of cash flows. Cash normally includes cash on hand and demand and time deposits in banks or other depositaries. Cash equivalents are normally financial instruments held for the purpose of meeting short-term cash commitments as opposed to investing and other purposes.

To qualify as a cash equivalent, the financial instrument must be readily convertible into cash and have little risk of changes in value due to fluctuating earnings rates. Normally, a cash equivalent will have a maturity date of three months or less from the date of acquisition by the reporting entity. An entity should establish a policy as to which short-term, highly liquid investments will be classified as cash equivalents.

Because bank borrowings are treated as financing activities on the statement of cash flows, any changes in bank overdrafts not having a legal right of offset should also be treated as financing activities.

Restricted cash balances, such as compensating balances required by credit grantors, should be presented separately from cash and cash equivalents in the statement of financial position; increases or decreases in restricted balances should be included in investing activities on the statement of cash flows.

Classifications of Cash Flows

Similar to U.S. GAAP, the statement of cash flows classifies the sources and uses of cash as operating activities, investing activities and financing activities.

Operating Activities:

Revenue producing activities are the primary sources of cash flows from operating activities. Examples include:

  • Cash receipts from:
  • The sale of products, merchandise or other goods.
  • Providing services.
  • Investment earnings.
  • Other revenue.
  • Cash payments for:
  • Materials, merchandise and other goods purchased from vendors.
  • Outside services
  • Salaries and wages.
  • Operating expenses.
  • Income and other taxes.
  • Other expenses.

As under U.S. GAAP, management may elect either the direct or the indirect method for reporting cash flows from operating activities. Under the direct method, the gross amounts of cash receipts and cash payments that arise from operating activities should be presented separately. Use of the direct method also requires a schedule presenting a reconciliation of net income to net cash flows from operating activities (as presented under the indirect method).

Presentation of the indirect method includes adjusting net income or loss for:

  • Changes in current assets and liabilities during the period.
  • Non-cash items such as depreciation and amortization, undistributed profits of equity investees, and deferred tax provisions or benefits.
  • Any cash flows or payments presented in investing or financing activities.

Investing Activities

Examples of cash flows sources and uses from investing activities include:

  • Tangible and intangible assets acquisition.
  • Proceeds from the sale of tangible and intangible assets.
  • Payments to acquire equity or debt securities, other equity investments and investment contracts.
  • Proceeds from the sale of investments.
  • Loans and advances made to others and their repayments.
  • Aggregate cash flows from business combinations under the acquisition method and disposals of business units (presented separately).

Financing Activities

Examples of cash flows sources and uses from financing activities include:

  • Proceeds from, and payments for, equity transactions.
  • Proceeds from, and payments for, long-term obligations, including capital leases.
  • Dividends and interest payments charged to retained earnings.

Non-cash Transactions

Non-cash transactions should be excluded from the statement of cash flows and disclosed separately, either on the bottom of the statement or in a footnote. Examples include:

  • Capitalized leased assets.
  • Acquiring assets by assuming liabilities.
  • Acquiring an entity in exchange for equity interests in the reporting entity.
  • Conversions of debt to equity interests.

Disclosures

Cash and cash equivalents disclosures:

  • Management’s policy for presenting cash equivalents, including any presented as investments.
  • Restricted cash.

Business combinations’ and disposals of business units’ disclosures:

  • Total consideration paid or received.
  • The portion of the consideration comprised of cash and cash equivalents.
  • The amount of cash and cash equivalents included in the acquisition or disposal.
  • The total other assets and liabilities included in the acquisition or disposal.

Other investing or financing activities not requiring the use of cash or cash equivalents should be disclosed on the face of the statement or in a footnote.

Preparation of the Statement of Cash Flows

Preparing a statement of cash flows can be facilitated by using a worksheet comparing financial statement classifications from the current and prior years’ balance sheets as illustrated below.

Account Classifications / Prior Year / Current Year / Period Change / Source or (Use) / Activity Type
Cash / 33,000 / 13,000 / (20,000) / Net / Cash
Trade accounts receivable / 363,000 / 500,000 / (137,000) / Use / Operating
Allowance for doubtful accounts / (12,000) / (12,000) / 0
Refundable income taxes / 12,000 / 0 / 12,000 / Source / Operating
Inventories / 500,000 / 400,000 / 100,000 / Source / Operating
Prepaid expenses / 2,200 / 1,300 / 900 / Source / Operating
Investments / 250,000 / 260,000 / (10,000) / Use / Investing
Fixed assets / 166,000 / 186,000 / (20,000) / Use / Investing
Accumulated depreciation / (76,000) / (108,000) / (32,000) / Source / Operating
Note receivable / 48,000 / 36,000 / 12,000 / Source / Investing
Other assets / 5,800 / 5,800 / 0
Total Assets / 1,363,000 / 1,337,100
Accounts payable / 400,000 / 430,000 / 30,000 / Source / Operating
Accrued expenses / 25,000 / (9,500) / (34,500) / Use / Operating
Deferred income taxes / 29,000 / 24,000 / (5,000) / Use / Operating
Accrued payroll taxes / 1,200 / 1,100 / (100) / Use / Operating
Long-term debt / 300,000 / 200,000 / (100,000) / Use / Financing
Capital stock / 45,000 / 45,000 / 0
Retained earnings / 562,800 / 646,500 / 83,700 / Source / Operating
Total Liabilities and Equity / 1,363,000 / 1,337,100

In addition to guiding the preparation of a statement, the schedule documents the amounts of classifications in the various activities. Additional guidance for preparing a statement of cash flows can be obtained at: .

RELATED PARTY TRANSACTIONS

Related party transactions in the ordinary conduct of business should be measured at arms-length, i.e., at values which are the same as for unrelated parties.

Common examples of related parties are:

  • An entity that is affiliated directly or indirectly with the reporting entity (subsidiary or parent entities).
  • An individual who directly or indirectly controls the reporting entity.
  • An entity accounted for by the equity or proportionate consolidation method when the reporting entity is either the investor or investee.
  • Management of the reporting entity.
  • An individual with an ownership interest that results in significant influence or joint control of the reporting entity.
  • Members of the immediate families of the individuals described above.
  • The other party to any management contracts.
  • Any party subject to significant influence of a party that has significant influence over the reporting entity (brother/sister entities). Significant influence can be from an ownership interest, management contract, and other management arrangements.
  • Any party subject to joint control by the reporting entity.

Disclosures

Disclosures for related party transaction include:

  • The nature of relationships with related parties.
  • The nature of the transactions.
  • The volume of the transactions and balances due to and from the related parties.
  • The basis for measuring the transactions.
  • Commitments with or involving related parties.

SUBSEQUENT EVENTS

Events occurring after the financial statements date, up to the date the financial statements are available to be issued, may create the need for adjustments of recorded amounts or additional disclosures. Similar to U.S. GAAP, these events are:

  1. Events that provide additional information regarding amounts recorded at the financial statement date (called type one events under U.S. GAAP). For example, a major customer of the reporting entity may declare bankruptcy during this subsequent events period. Depending on the materiality of the customer’s account and the recoverability of its balance, an adjustment of the allowance for uncollectible accounts may be necessary.
  1. Other events that indicate conditions arising after the financial statement date that don’t directly affect recorded amounts (called type two events under U.S. GAAP). A significant lawsuit filed by or against the entity would be an example.

For a reporting entity, financial statements are available for issue when they include all footnotes necessary for a fair presentation, no other adjustments are planned and management’s process for finalizing the financial statements has been completed. For auditors of non-issuers of financial statements, financial statements are available for issue when all levels of review required by the CPA firm’s quality control procedures have been completed andmanagement has finally approved the financial statements.

Disclosures

  • The date through which the subsequent events review was made and that this is the date financial statements are available for issue. This disclosure could be made in Note A or, if significant subsequent events requiring disclosure are discovered, in the separate note describing such events.
  • For significant subsequent events not affecting recorded amounts in the financial statements, these disclosures should be included in a separate footnote:
  • A description of the event.
  • An estimate of the possible affect on the financial statements, or a statement that such an estimate cannot be made.

Discussion Exercise

As CFO for the Always Best Corporation, you have completed preparation of its annual financial statements as of December 31. While drafting footnotes, you perform a subsequent events review. List the procedures you will perform for this review:

______

As auditor of these financial statements, what procedures would you perform for a subsequent events review?

______

SUBSIDIARIES

Management can elect either to use the equity method of accounting or to consolidate its majority-owned subsidiaries. A user of financial statements may require management to elect one or the other methods. For example, a lender may be primarily interested in an entity’s ability to service its debt from its operations and, therefore, prefer the equity method. If there is a material difference in the basis of accounting used by a subsidiary, neither method may elected. In this case investments would, by default, be accounted for using the cost method.

Under the consolidation method, a subsidiary is consolidated at the date an entity acquires control. There is no retroactive consolidation of the subsidiary. When an entity ceases to have control, it will no longer consolidate the subsidiary. Prior period’s consolidated statements are not retroactively restated.

When investments in majority-owned subsidiaries are not consolidated, they should be presented separately in the statement of financial position. Income or loss may be presented in the statement of operations in gross or net amounts.

Disclosures for consolidated statements include descriptions of all subsidiaries, income from each and the percentage of ownership for each. The same disclosures should be presented for non-consolidated subsidiaries.

Combined financial statements may be prepared for entities under common ownership, often referred to as brother/sister entities. Principles similar to the presentation of consolidated statements should be used for combined statements.

Consolidation Principles

At the date of acquisition of a subsidiary, the market values of its assets, liabilities, any non-controlling interests and goodwill will be determined. This process will be discussed further regarding business combinations below. Intercompany receivables and payables will be eliminated.

At dates subsequent to the initial consolidation, all intercompany balances and transactions would be eliminated upon consolidation. Acquisition values of a subsidiary’s assets are treated as purchases and are the bases for future calculations of depreciation and amortization.

Material differences between a parent and subsidiary’s bases of accounting preclude use of the consolidation method. Foreign subsidiary’s statements are, however, adjusted to conform to the FRF for SMEs. Differences in fiscal reporting periods of a parent and subsidiary don’t necessarily preclude use of the consolidation method. Adjustment of the periods presented would, of course, be necessary.

Changes in a parent’s ownership interest in a subsidiary that does not result in a loss of control should be accounted for as equity transactions. In such cases, changes in the carrying amounts of controlling and non-controlling interests and the market value of consideration paid or received should be recognized directly in equity.

Accounting Principles for the Cost and Equity Methods

Under the cost method, the investor records the investment at cost and recognizes dividends received from distributions of net accumulated earnings as income. Dividends received in excess of the accumulated net earnings of the investee reduce the cost of the investment. An other-than-temporary decline in the value of the investment should be recognized.

Under the equity method, the investor initially records the investment at cost and adjusts the carrying amount to recognize its share of earnings or losses as they occur. These adjustments in value are recognized in the investor’s net income after eliminating intercompany gains and losses and amortizing any difference between the investor’s cost and the underlying equity in the net assets of the investee. Dividends received from the investee reduce the carrying amount of the investment. Any other-than-temporary decline in value beyond that calculated under the equity method should also be recognized.

The equity method of accounting should be used when an investor’s investment in voting stock gives it the ability to exercise significant influence over the operating and financial policies of the investee even though the investee holds an investment of 20 to 50% of the voting stock. Significant influence can be indicated in these and other ways:

  • Representation on the board of directors of the investee.
  • Participation in policy making processes.
  • Material intercompany transactions.
  • Interchange of managerial personnel.
  • Technological dependency.
  • Concentration of other shareholdings (like a larger number of smaller shareholders.

Non-controlling Interests

A non-controlling interest, sometimes called a minority interest, is the portion of equity in a subsidiary not attributable, directly or indirectly, to a parent. Accounting policies include:

The ownership interests in subsidiaries held by parties other than the parent be clearly identified, labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity.
The amount of consolidated net income attributable to the parent and to the non-controlling interest be clearly identified and presented on the face of the consolidated statement of operations.
Changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary must be accounted for consistently. A parent’s ownership interest in a subsidiary changes if the parent purchases additional ownership interests in its subsidiary or if the parent sells some of its ownership interests in its subsidiary. It also changes if the subsidiary reacquires some of its ownership interests or the subsidiary issues additional ownership interests. All of those transactions are economically similar and they should be accounted for as equity transactions.
Entities must provide sufficient disclosures that present consolidation policies and clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners.

Principles of Consolidation Summarized