Think differential

By Greg Edwards
Illustration: Susanna Denti

No matter which side of the debate you’re on, new differential reporting options are focused on global standards

Harmonization and convergence, the current dual strategies of the Accounting Standards Board (AcSB), often cause alarm for private companies, which sometimes see themselves as being dragged, kicking and screaming, in the effort to achieve global accounting standards. Private companies are not ignored; the AcSB continually obtains advice from its Differential Reporting Advisory Committee (DRAC) on how existing and proposed accounting standards affect them. As a result of DRAC’s input, new differential reporting options for Section 3062, Goodwill and Other Intangible Assets, and the soon to be completed Section 3855, Financial Instruments — Recognition and Measurement, add to the initial suite of differential options.

The basis for differential reporting lies in the benefit versus cost con-straint, in the accounting conceptual framework. Differential reporting allows financial statements to focus on the needs of users. Typically, non-publicly accountable enterprises have a narrower range of users of their financial statements than publicly accountable enterprises. These users often have an intimate knowledge of the enterprise, they have the ability to gain access to information beyond the financial statements, and therefore they may place less reliance on financial statements. Fewer users, coupled with those deriving relatively lower benefits from financial statement information, result in greater costs of compliance with accounting requirements relative to the number of users and a greater likelihood that costs exceed the benefits of providing information in the financial statements. When the cost of financial statement information outweighs associated benefits, a differential reporting option is considered.

There is a trade-off in information usefulness when an enterprise accepts a differential reporting option. To ensure that this trade-off does not adversely affect the users of the financial statements, unanimous consent is obtained from the owners of the enterprise.

Consent on each differential reporting option is required in writing, prior to completion of the financial statements to which they apply, to document clearly the decisions made by owners. This is not an annual requirement; consent remains in force until ownership or the selection of differential reporting options change. Un-animous consent from owners assumes that creditors can demand additional information, should they desire it.

Some critics suggest that obtaining unanimous consent is too onerous. Some cite that it only takes one shareholder to object to differential reporting — for whatever reason — for all shareholders not to benefit from differential reporting. Unanimous consent is important as it avoids suppression of information to minority shareholders, who may rely on the financial statements as their primary source of information.

Although minority rights protection exists in legislation, the unanimous consent requirement exists due to a need for pro-active protection.

How the system works
DRAC recommends differential reporting options to the AcSB using a decision model based on estimated costs versus benefits. It advises the AcSB and EIC on actual or potential problems that existing and proposed accounting standards cause for non-publicly accountable enterprises.

DRAC is composed of 10 volunteer members representing a cross-section of auditors, preparers and users of financial statements of non-publicly accountable enterprises. The committee meets four to five times a year to discuss new and existing accounting standards in the context of differential reporting. DRAC aims to review all exposure drafts before they are issued as well as exposure draft responses that raise differential reporting issues. Input from constituents also forms a basis for topics discussed by the group. (Suggestions for DRAC discussion, along with rationale for consideration in the context of the cost versus benefits decision model, can be forwarded to the DRAC secretary: greg.edwards@cica.ca.)

Comparing the costs and benefits of an accounting standard, or of a requirement within a standard, is a complex task. Despite several efforts to rationalize the approach, it remains a judgmental process as acknowledged in Section 1000, Financial Statement Concepts.

DRAC proceeds with analyzing the costs and benefits of a particular standard when it is satisfied an issue is significant enough to merit consideration. To ensure maximum consistency in decisions, DRAC and AcSB apply the evaluation process (described below) in reviewing various potential differential reporting options.

Benefits to users are assessed in relation to three of the four fundamental qualitative characteristics of financial information set out in Section 1000, Financial Statement Concepts: understandability, relevance and reliability.

Comparability is not used as a criterion because it fundamentally conflicts with providing accounting alternatives. When a conflict arises between the characteristics of relevance, reliability, comparability and understandability, a trade- off needs to be found that enables the objective of financial statements (i.e., decision usefulness) to be met. Assessment of benefits is made in relation to the two identified groups of users of the financial statements of non-publicly accountable enterprises: the non-managing owners and the creditors.

The costs of complying with individual accounting requirements are broken down into the following categories: preparation costs, communication costs (when appropriate), specialized expertise costs and related audit or review costs. Costs and users’ benefits are weighted on a three-point scale (low, moderate, high). The following situations are agreed upon as indicating a potential need for a differential reporting option:

• low benefits and low, moderate or high costs of compliance indicate a need for differential treatment;
• moderate benefits and moderate or high costs of compliance indicate a need for differential treatment;
• high benefits and high costs of compliance at most lead to a simplified treatment producing not significantly different results.

The need for a differential reporting option must be balanced with the complexity of the underlying transaction. It is generally thought that complex accounting may be necessary to allow an understanding of the financial statement effects of complex transactions. 

In approving differential reporting the AcSB intends that the number of differential reporting options be restricted to relatively few issues. Differential reporting will be provided only when the AcSB is satisfied the costs to non-public enterprises are excessive relating to the benefits to be derived from compliance with a Handbook requirement, and that, therefore, some reduction of comparability is justified.

Two schools of thought
There are a number of concerns some have with differential reporting. There are those who believe differential reporting does not go far enough. Some believe that eligibility criteria should be expanded to small-cap public companies. Others believe more differential reporting options should be included in GAAP. Still others believe a “reverse differential reporting” solution should be implemented. Under reverse differential reporting, GAAP would be applied to all private companies and public companies would adopt some additional requirements.  

Then there are those who strongly believe differential reporting has no place in GAAP. Subscribers to this school of thought point to both the lack of comparability that differential reporting allows and the lack of conceptual theory that underlies it. These arguments are rebutted with the fact that private company inter-company comparisons are less frequent than public companies, and that the cost/benefit constraint is a fundamental component of financial statement concepts that should not be ignored. When the relevance or understandability of a Handbook requirement is questionable for the users of non-public enterprises’ financial statements, and the cost of compliance exceeds the benefit of compliance, it may be appropriate to trade less comparability for greater relevance and understandability.

International perspective
The concept of differential reporting is not a new one; several national standard setters have adopted forms of “differential reporting.” International standard setters are also examining the concept. 

The International Accounting Standards Board (IASB) is currently working on a project to develop standards for small and medium-sized entities (SME). The importance of the IASB SME project is heightened due to some countries, which intend to follow IASB standards in the future, currently having differential reporting incorporated into their national standards. Preliminary indications are that the IASB SME project will result in a standard that is conceptually similar to Section 1300, Differential Reporting.

The US environment differs from Canada in that no legislation exists in the US requiring non-public enterprises to follow GAAP. US private companies have the ability to use an “other comprehensive basis of accounting,” such as a tax ba-sis, cash basis a modified cash basis of accounting.

In the US, the AICPA has formed the Private Company Financial Reporting Task Force to study the issue of financial reporting for privately held businesses. This task force originated, in part, due to some concerns raised by AICPA members about the relevance of the current body of US GAAP literature to smaller private businesses. The initial strategy for this task force is to determine if there is an issue with traditional GAAP financial statements of private companies, particularly among the ones that rely on those statements in making lending and other business decisions.

The Financial Accounting Standards Board (FASB), in an effort to obtain more active involvement by the small business community in the development of financial accounting and reporting standards, has established a small business advisory committee. While not a “differential” initiative, this marks an important step in the US accounting standards process as it formalizes the solicitation of the small business perspective.

AcSB strategy
DRAC’s importance has been emphasized due to the AcSB’s dual strategy of harmonization with US accounting standards and convergence with a single set of globally accepted international accounting standards. These strategies mean, to some degree, that the focus of Canadian GAAP is moving to align with FASB and IASB, organizations that historically have not had differential reporting or a focus on SMEs It also means as international GAAP becomes increasingly complex, so does Canadian GAAP.

With the publication of the Invitation to Comment and Discussion Paper, Accounting Standards in Canada: Future Directions, the AcSB is currently in the process of developing its strategic plan for the next five years (2005-2010). These documents have asked for the public’s views on an extensive range of questions, including: the current convergence and harmonization strategy, the scope of differential reporting and the content of differential reporting.

The future and direction of differential reporting will depend on the strategy adopted by the AcSB. Whatever the strategy, the AcSB will continue to listen to the private company perspective and factor it into the standard-setting decisions.