Differential reporting

By Annie Mersereau

A CHANGE IN CANADIAN GAAP THAT WILL BE
OF INTEREST TO MOST CANADIAN CORPORATIONS

As of this year, private Canadian companies have the opportunity to tailor their financial reporting to the needs of the users of their financial statements. Companies that qualify under the recently issued Differential Reporting, Handbook Section 1300 may choose to apply some or all the accounting options set out in certain standards for years beginning on or after January 1.

Although the big GAAP/little GAAP debate is not new, recent trends in standard-setting have increased the differences between the needs of users of financial statements. After extensive research and consultation, including discussions with other standard-setters who have made similar changes, the Accounting Standards Board (AcSB) decided it was time for action. The idea that accounting requirements for nonpublic companies may differ in certain areas from those applicable to public companies has become reality.

Recent years were marked by rapid and widespread developments in financial reporting. A number of these developments were designed primarily to address the information needs of users of financial statements of public companies in response to the needs of international capital markets. While these developments are justified for public companies on the grounds of public interest, applying the same accounting requirements to all profit-oriented enterprises became more open to question.

In Canada, the pace of harmonization with US standards has also been a contributing factor to the need for change. In the US, bylaw standards are only applicable to public companies, but in Canada federal and provincial statutory regulations require all Canadian corporations prepare financial statements in accordance with Canadian GAAP. The universality of this approach has led public accountants to report increasing concerns amongst their nonpublic clients regarding work and related costs necessary to comply with certain GAAP requirements perceived to be of limited value. To limit the costs of engagements, some clients chose to depart from certain GAAP requirements and to have qualified audit or review reports, or moved from audited or reviewed statements to compilation engagements.

In adopting Section 1300, the AcSB is the third major standard-setter to implement a differential reporting approach. In 1997, Britain set out a separate reporting standard for smaller companies, and the New Zealand standard-setter implemented a framework for differential reporting. Other jurisdictions, such as South Africa and Hong Kong, have launched differential reporting projects and the issue is emerging at the international level.

Section 1300 and the related amendments to other sections that set out the options available to enterprises qualifying for differential reporting result from a thorough research and consultative process. Development of the new standards started with the recommendation of the CICA Task Force on Standard Setting that the AcSB address the issue of small business financial reporting. The AcSB commissioned a research report, "Financial Reporting by Small Business Enterprises," that was published in 1999 and recommended the establishment of a differential reporting principle within Canadian GAAP. In May 2000, the AcSB established the Small Business enterprises Advisory Committee (recently renamed the Differential Reporting Advisory Committee) as a standing committee to provide input to the standard-setting process from a nonpublic enterprise perspective and to consider further the need for differential reporting and the ways to make the principle operational. The advisory committee supported introducing differential reporting into Canadian GAAP and made a number of practical recommendations to the AcSB. The exposure draft approved in July 2001 by the AcSB attracted more than 120 letters. Although the proposal to allow differential measurement options generated some controversy, in general the comment letters strongly supported the introduction of differential reporting.

Different users, different requirements
Financial Statement Concepts, Section 1000, states that the content of financial statements must be driven by financial statement users" needs. The differential reporting principle acknowledges that the information needs of users of nonpublic companies" financial statements differ from those of the users of public entities" financial statements. Public company financial statements are widely circulated and available to an unlimited number and wide variety of users who benefit from access to a broad range of detailed financial information.

The circulation of financial statements of nonpublic enterprises beyond management is controlled by the board of directors or other governing body. It is generally restricted to owners that are not involved in the management or governance of the enterprise and to lending institutions. The latter may also have access to additional information given their economic leverage while the former, in certain circumstances, may have agreed access to internal information.

The fewer the users of an enterprise's financial statements and the greater their ability to gain access to information in addition to that provided in the financial statements, the smaller the benefits to be derived from information contained in financial statements. Therefore, the AcSB accepts that the application of a benefit/ cost test may lead to the differential application of GAAP to nonpublic enterprises, in limited circumstances. Differential reporting means tailoring requirements to the circumstances, not necessarily fewer requirements for financial statement preparers or less information for users.

Which enterprises qualify
To qualify for differential reporting, profit-oriented enterprises must first have no public accountability. The public accountability criterion, as defined in Section 1300, encompasses public share ownership, public debt and other forms of public interest. Public enterprises are excluded from the scope of Section 1300, but so are cooperative business enterprises, regulated financial institutions (and regulated financial institution holding companies), rate-regulated enterprises and government business enterprises and government business-type organizations. Differential reporting does not apply to not-for-profit entities whose particular reporting needs are already dealt with in Handbook Sections 4400 to 4460.

Secondly, all voting and nonvoting owners of the enterprise must consent in writing to the application of differential reporting. This is to protect the position of nonmanaging owners for whom financial statements may be the primary source of information. When all owners consider that differential reporting fulfils their needs, this signals that owners consider the costs of applying certain accounting requirements exceed the benefits to their enterprise and to themselves.

There is no size cap. The AcSB deliberated whether size should be a criterion for differential reporting and rejected a size test, as differential reporting is justified by the users" characteristics rather than by the enterprise's. Regardless of their size, all nonpublicly accountable enterprises share a common feature that distinguishes them from publicly accountable entities: they have a narrower range of users of their financial statements. This lack of a size condition is consistent with current Canadian public policy decisions with respect to nonpublic companies. Most nonpublic companies, regardless of size, are not required to make their financial statements publicly available and shareholders, by unanimous consent, may waive an audit of the financial statements.

Differential reporting is designed to help private companies produce more useful and understandable information for the users of their financial statements, and is optional. Therefore, 2002 presents an opportunity for a nonpublicly accountable enterprise to re-examine the objective of its financial reporting and tailor it to the users" needs. In practice, management of a nonpublicly accountable enterprise will make a first assessment of whether

to adopt differential reporting and which options to apply, since selective application is permitted. In certain circumstances -- for example if the enterprise is likely to go public in the future or report to a public investor -- differential reporting may not be an appropriate decision. Management will benefit from consulting with its public accountant and banker(s). Creditors" information needs were carefully considered by the AcSB in deciding which differential reporting options to include in standards. However, lenders" acceptance of differential reporting may vary, depending on an enterprise's characteristics, circumstances and the type and size of loan.

Management must provide owners with appropriate information before inviting them to consent to the application of the selection of differential reporting options it proposes. Section 1300 requires consent to the application of differential reporting options be obtained in writing, prior to the date of completion of the first financial statements to which they apply. This won't be a practical issue, as consents may remain in force unless rescinded, or until ownership or the selection of differential reporting options changes. The selection of the differential reporting options consented to in writing by all owners establishes the basis for preparing a qualifying enterprise's financial statements within Canadian GAAP.

Differential reporting options
Six differential reporting options (see page 30) have been made available initially. As a result, the deferral of the application of Interim Financial Statements, Section 1751; Income Taxes, Section 3465; and of certain requirements in Section 3860 lapsed on December 31, 2001. The provisions in Section 3050 dealing with nonconsolidated special purpose financial statements were also withdrawn on that date. Nonconsolidated financial statements prepared by qualifying enterprises for years beginning on or after January 1, are no longer deemed to be special-purpose financial statements, but must be labelled as prepared under a nonconsolidated basis.

No differential reporting options have been provided in respect to Section 1751, but amendments have been made to clarify the interpretation of that section for enterprises not subject to a periodic interim reporting requirement.

In the future, the AcSB will examine differential reporting issues as new accounting standards are developed, so that potential differential reporting options may be considered in a timely manner. In its next step, the AcSB will consider recommendations by the advisory committee regarding certain standards recently issued or still under development.

How to read financial statements
Differential reporting requirements are part of Canadian GAAP effective January 1. Canadian GAAP requires that disclosure be provided when a selection has been made from alternative acceptable accounting policies and methods. Such disclosures enable users to discern and evaluate differences between the nature and effects of accounting choices across different reporting entities. The same rationale applies to the selection of differential reporting options. Therefore financial statement users should look for the accounting policies note. Under Section 1300, a qualifying enterprise that elects to use differential reporting options is required to disclose in its summary of accounting policies the fact that it has adopted differential reporting and to identify which differential reporting options it has applied. The following shows the application of disclosure requirements: Company X, with the unanimous consent of its shareholders, has elected to prepare its financial statements in accordance with Canadian GAAP, using the differential reporting options available to nonpublicly accountable enterprises. The company has elected to apply the differential reporting measurement option allowed for income taxes and, accordingly, to account for taxes using the taxes payable method. It has also elected not to disclose fair value information about financial assets and liabilities for which fair value wasn't readily obtainable.

Differential reporting represents a big step in the Canadian GAAP development. It is good news for many, a controversial change for some. Those involved in nonpublic company reporting now have a choice that should be welcomed. The effectiveness of this new approach in practice will need to be monitored and responded to appropriately in due course. Differential reporting adopters as well as financial statement users are invited to make any implementation issues known to the Differential Reporting Advisory Committee. The AcSB has indicated its intent to undertake a comprehensive review of differential reporting three years after its initial application to evaluate if it meets users" needs as expected. The AcSB may need to reassess its approach in light of future developments in standard-setting. Meanwhile, the success of differential reporting lies in the hands of privately held businesses and their accountants.

Annie Mersereau is a principal with the Canadian Accounting Standards Board Staff of the CICA.

T echnical Editor: Robert T. Rutherford, FCA, Vice-president, Standards, CICA..