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Other Comprehensive Basis of Accounting methods: non-GAAP-based financial statements.

Financial statements prepared using other comprehensive bases of accounting [OCBOA] are growing in popularity. Many smaller, nonpublic entities are over burdened with the accounting and reporting guidance issued by the Financial Accounting Standards Board [FASB] and feel that the costs of adhering to the stringent accounting and reporting guidance issued by the FASB exceed the related benefits. Consequently, many of these entities are choosing to prepare OCBOA financial statements when the circumstances are appropriate.

Technical Guidance for OCBOA Financial Statements

Currently, there is minimal technical guidance related to accounting and reporting issues for OCBOA financial statements. The reason for this "lack" of guidance is that the accounting literature only relates to GAAP-based, as opposed to non-GAAP-based, financial statements. The technical guidance that practitioners should consider when preparing financial statements based on an OCBOA are as follows:

* SAS No. 62, entitled "Special Reports." [1989]

* SSARS No. 7, entitled "Omnibus Statement on Standards for Accounting and Review Services." [1992]

* AICPA Technical Practice Aids [TPA], Section 1500, entitled "Financial Statements Prepared Under an Other Comprehensive Basis of Accounting." [1995]

* AICPA Technical Practice Aids [TPA], Section 9210.10, entitled "Change From Generally Accepted Accounting Principles [GAAP] to an Other Comprehensive Basis of Accounting [OCBOA] pf From OCBOA to GAAP." [1995]

* AICPA Practice Aid Series [PAS] document, entitled "Preparing and Reporting on Cash and Tax Basis Financial Statements?' [1998]

* Auditing Interpretation No 14, [an interpretation of SAS No. 62], entitled "Evaluating the Adequacy of Disclosure in Financial Statements Prepared on the Cash, Modified Cash, or Income Tax Basis of Accounting."

What Are the Acceptable OCBOA Methods?

It is important to recognize that the use of OCBOA financial statements is an alternative to the use of GAAP-based statements. The primary guidance related to OCBOA financial statements is found in the auditing literature. Specifically, SAS No. 62 delineates the acceptable alternatives to GAAP-based financial statements. Exhibit 1 reports the OCBOA methods that are listed in SAS No. 62 and provides a related example for each method. It should be noted that the cash-and tax-basis OCBOA methods are the most prevalent in accounting practice.

In addition to specifying acceptable OCBOA methods, SAS No. 62 also specifies certain bases of accounting that are not considered OCBOA. These include: (I) a loan agreement that requires the borrower to prepare consolidated financial statements in which assets [e.g., accounts receivable] are presented on a basis that is not in conformity with GAAP [or any OCBOA], and (2) an acquisition agreement that requires the financial statements of the entity being acquired to be prepared in conformity with GAAP except for certain assets [e.g., inventories and properties] for which a valuation basis is specified in the agreement.

Determining Whether to Use an OCBOA Method

OCBOA financial statements typically are less costly to prepare than GAAP-based statements. Tax-basis financial statements result in cost savings because the tax returns and the financial statements are prepared using the same information. Cash-basis statements are less costly because the detailed records needed to comply with GAAP reporting are unnecessary. Though OCBOA financial statements generally are a cost-effective alternative, it is important to determine whether OCBOA statements are appropriate given the nature of the entity. The AICPA PAS document identifies characteristics of entities that should consider issuing cash- or tax-basis financial statements. Exhibit 2 highlights some of these characteristics as well as instances where OCBOA statements probably should not be issued.

The cost savings associated with OCBOA statements primarily result from the ability to prepare financial statements using simpler measurement principles [e.g., cash- and modified cash-basis statements] or measurement principles that already have been incorporated into other documents [e.g., a tax return]. Since disclosure requirements for OCBOA statements generally parallel disclosure requirements for GAAP-based statements, there usually will be only limited cost savings because of different disclosure requirements. The issuance of Auditing Interpretation No. 14 provided additional guidance to practitioners related to disclosure requirements in OCBOA financial statements. As a result of this Interpretation, there is more of a disclosure advantage when issuing OCBOA financial statements than there has been previously.

Though OCBOA financial statements may be audited, reviewed, or compiled, the disclosure requirements essentially are the same. The SSARS No. 7 disclosure requirements for compiled [or reviewed] OCBOA financial statements are similar to the SAS No. 62 disclosure requirements for audited OCBOA financial statements. In all cases, practitioners should have an understanding of GAAP disclosure requirements to ensure the OCBOA statements comply with the reporting requirements [e.g., making disclosures that communicate the substance of GAAP disclosures].

In many cases, third-party users create a "roadblock" to using an OCBOA method. In these cases, third-party users may be more inclined to accept 0GB GA financial statements when additional information outside the basic financial statements is provided. For example, when a partnership has borrowed under a line of credit where the lending limit is established based on the level of the partnership's accounts receivable, the lender might agree to accept tax-basis financial statements, as opposed to GAAP-basis statements, if the partnership also provides an aged accounts receivables list.

Cash-Basis Financial Statements.

It should be noted that the phrase "cash-basis financial statements" typically is used to refer to both pure and modified cash-basis financial statements. Pure cash basis of accounting suggests that transactions are recorded on the basis of cash receipts and disbursements. Consequently, revenues [and the related assets] generally are recognized when received rather than when earned and expenses are recognized when paid rather than when the obligation is incurred. Pure cash-basis financial statements do not include capitalized assets, depreciation, amortization, accruals, or prepaid assets. Thus, for example, a statement of assets and liabilities prepared using a pure cash basis only would include cash and equity. Pure cash-basis financial statements may be appropriate for certain smaller entities when cash flow is of primary importance to the financial statement users [e.g., management].

Often, cash-basis financial statements include certain modifications intended to increase the usefulness of the financial statements. This modified cash basis of accounting combines elements of the cash and accrual basis of accounting. For example, a modified cash-basis balance sheet may include the capitalization of long-term assets and inventory, but no accrual of accounts receivable or recognition of prepaid assets. Though SAS No. 62 only describes modifications related to depreciation on fixed assets and accruing income taxes, other modifications to cash-basis financial statements may be appropriate. According to the TPA Section 1500, all modifications to the cash basis of accounting should have substantial support. The TPA indicates that a modification would have substantial support if the modification exhibits both of the following:

* The modification is equivalent to the accrual basis of accounting [e.g., capitalization of fixed assets].

* The modification is logical [i.e., consistent with GAAP].

When making modifications to cash-basis financial statements, practitioners should ensure that interrelated accounts [e.g., plant and equipment, accumulated depreciation, depreciation expense, long-term debt, and interest expense] are reported using the same basis of accounting. According to an AICPA survey of Private Company Practice Section firms, the most frequent modifications to cash-basis financial statements include capitalizing fixed assets and recording borrowings. It is important to note that TPA Section 1500 also suggests that the modifications to cash-basis statements may be so extensive that the statements are equivalent to accrual-basis financial statements. In these situations, the financial statements should not be considered OCBOA statements, but rather they should be considered GAAP-basis statements with a departure from GAAP.

Tax Basis Statement

The income-tax basis of accounting is based on the principles and rules of accounting for transactions pursuant to the federal income tax laws and regulations. The income-tax basis of accounting includes various bases [ranging from cash to full accrual] depending on the nature of the taxpayer. Obviously, tax returns are not considered financial statements. However, when financial statement amounts agree with the entity's tax return, those statements should be considered income-tax-basis statements.

An issue that typically arises in the preparation of income-tax-basis financial statements relates to the presentation of nondeductible revenues and expenses. Since certain transactions are not recognized pursuant to tax laws, entities may have significant nondeductible revenues [e.g., life insurance proceeds] and expenses [e.g., officer's life insurance premiums] that should be reported in the financial statements or related notes. Nontaxable revenues and nondeductible expenses generally are recognized in tax-basis statements of revenue and expenses. The AICPA PAS indicates three acceptable alternatives for the presentation of nontaxable income and nondeductible expenses in tax-basis financial statements. The most common presentation is to report these items as separate line items in the revenue/expense sections of the statement of revenues and expenses. Or, these items may be reported as additions [deductions] to [from] net income or simply disclosed in the notes.

Another issue that may arise in the preparation of tax-basis statements relates to assessed taxes [for prior years] that result from IRS examinations. The additional taxes may be treated either as a

* current period expense when the assessment does not affect balance sheet amounts [e.g., to capitalize expenses] and the amount does not result from a clear error in the prior year return,

or a

* prior-period adjustment when the assessment affects balance sheet amounts [e.g., by requiring disallowed expenses to be capitalized] or the amount results from a clear error in the prior year return.

Because of the potential adjustment that could result from an IRS examination, practitioners may include a statement in the basis of accounting policy note similar to the following: Because transactions are susceptible to varying interpretations pursuant to federal and state income tax laws and regulations, the amounts reported in the accompanying financial statements may be subjected to change at a later date upon final determination by the taxing authorities.

Although both GAAP and tax law use an accrual method, the methods are not the same. The fundamental difference is that GAAP methods measure revenue and expenses while tax methods measure gross income and deductions. GAAP methods are general in nature and typically allow few exceptions whereas tax laws have a high degree of specificity and typically allow numerous exceptions. Exhibit 3, on page 18, shows the differences between GAAP and tax-accrual accounting methods.

Definite Criteria Applied to All Items and Regulatory Basis of Accounting

As previously noted, an example of a definite set of criteria applied to all financial statement items is price-level accounting. Arguably, this OCBOA method provides a basis for other methods, such as fair-value accounting. However, Auditing Interpretation No. 14 suggests that fair-value financial statements typically are not appropriate unless those statements are presented as a supplement to historical financial statements. Consequently, it is recommended that the fair-value accounting not be considered an OCBOA method. When considering the use of a regulatory basis of accounting, practitioners should be aware that these OCBOA statements must be restricted as to use by the entity [and the regulatory agency] according to SAS No.62. The use of financial statements prepared on a regulatory basis generally should be limited to situations where the statements are filed with the applicable regulatory agency.
EXHIBIT 1

Acceptable OCBOA Methods

OCBOA METHOD EXAMPLE

Basis of accounting that the entity Cash [or full accrual] income tax
uses [or expects to use] to file basis of accounting.
its income tax return for the
period covered by the financial
statements.

The cash receipts and disbursements Pure cash basis with no
basis of accounting with no modifications to record items such
modifications. as fixed assets and the related
 depreciation.

The cash receipts and disbursements Modified cash basis with certain
basis of accounting with modifications to record items such
modifications that have substantial as depreciation on fixed assets,
support. income taxes, or long-term debt.

Definite Set of criteria having Price-level basis of accounting.
substantial support that is applied
to all material items appearing in
the financial statements.

Basis of accounting that the entity Basis of accounting insurance
uses to comply with the companies use pursuant to the rules
requirements [or financial reportin of a state insurance commission.
provisions] of a governmental
regulatory agency to whose
jurisdiction the entity is subject.

EXHIBIT 2

Considerations for OCBOA Financial Statements

DECISION CHARACTERISTICS

OCBOA financial statements * The owner/manager is actively
probably appropriate involved and understands the
when: entity's financial condition.
 * The entity is a small, closely-held
 business with little or no
 unsecured debt.
 * The entity is not highly leveraged.

OCBOA financial statements * The entity anticipates going public.
probably not appropriate * The entity has loan covenants
when: requiring GAAP-based statements.
 * The entity has numerous absentee
 owners.
 * The entity has substantial unfunded
 obligations, commitments, and
 contingent obligations that would
 not be recorded on an OCBOA basis.

EXHIBIT 3

Differences Between GAAP and Tax Treatments

ISSUE GAAP TREATMENT

Revenue Recognition Recognize revenue when it is
 both realized [or realizable] and
 earned.



Expense Recognition Recognize expenses, in general,
 when they are incurred [in an
 effort to match expenses
 with related revenue].



Unrealized Gains and Recognized in current earnings
Losses on Investments in the year of the change in
 fair value for securities
 classified as trading.

Start-up and Organization Typically are expensed as incurred.
Costs

Immaterial Transactions Departures from GAAP are permitted
 for transactions that are
 immaterial to the financial
 statements.

Impairment of Long-Lived Impaired assets must be written
Assets down to their market value [or
 present value of expected cash flow].

Loss Contingencies Loss contingencies are recorded when
 the loss is probable and estimable.

ISSUE INCOME TAX TREATMENT

Revenue Recognition General criteria for revenue recognition
 include: (1) all events have occurred that
 entitle the taxpayer to the income, (2)
 right to the income is fixed by contract,
 and (3 amount is determinable.

Expense Recognition General criteria for expense recognition
 include: (1) all events have occurred that
 require the taxpayer to pay for the
 expense, (2) obligation to pay the
 expense is fixed, and (3) amount is
 determinable.

Unrealized Gains and Gains and losses are recognized when they
Losses on tnvestments are realized.



Start-up and Organization May be amortized over several years.
Costs

Immaterial Transactions Noncompliance with the tax laws is not
 permitted for immaterial transactions.



Impairment of Long-Lived Losses generally are not allowed for
Assets impaired assets.


Loss Contingencies Loss contingencies are not recorded.


John Stephen Grice, Sr., CPA, PhD, is an Associate Professor of Accounting at Sorrell College of Business at Troy State University, Troy, AL.
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Author:Grice, John Stephen
Publication:The National Public Accountant
Geographic Code:1USA
Date:Apr 1, 2003
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