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    • FINANCIAL REPORTING AND DISCLOSURE A CONTINUING PROBLEM FOR SMALL BUSINESSES John E. Elsea, University of Northern Colorado Allen W. McConnell, University of Northern Colorado ABSTRACT Small businesses continue to be faced with financial reporting and disclosure problems caused by the need to generate financial statements in conformance with generally accepted accounting principles (GAAP). This paper reviews the Big GAAP-Little GAAP controversy, identifies areas where disclosure is a problem, and discusses options available to the Financial Accounting Standards Board in dealing with small businesses. Managers of small businesses need to be aware of financial reporting services provided by CPAs, such as audits, reviews, and compilations. How do GAAP and other comprehensive basis of accounting relate to these reporting options? A BRIEF HISTORY Generally accepted accounting principles (GAAP) consist of the rules, procedures, and practices utilized in financial statement preparation and presentation. From 1939 to 1959 Accounting Research Bulletins were issued by the AICPA's Committee on Accounting Procedure dealing with a wide array of accounting topics. In 1959 the AICPA replaced the Committee on Accounting Procedure with a part-time Accounting Principles Board that was charged with the responsibility, of developing accounting principles and bringing consistency to the profession. The Financial Accounting Standards Board (FASB), consisting of seven full-time members, replaced the Accounting Principles Board in 1973 and has been active in the promulgation of accounting principles from that date to the present. Today, it is commonly recognized the three most influential forces in structuring accounting principles practices are the FASB, the Securities and Exchange Commission, and the American Institute of Certified Public Accountants. Throughout history, regardless of the promulgating board, a concerted effort was made to develop principles that would be applicable to financial statements of all firms, large and small and publicly or privately held. The result of board actions, however, was a proliferation of accounting standards leading to accusations that pronouncements were oriented toward large businesses and ignored the needs of small companies. Owners and managers of small businesses complained that accounting costs were too high and that information contained in financial statements was lacking in usefulness. Rule 202 of the AICPA Code of Professional Ethics does not allow for differentiation in generally accepted auditing standards due to client size except where GAAP specifies financial reporting exemptions for non-public entities [3]. Consequently, CPA firms tended to encourage complete adherence to GAAP for all clients. As a result of the above conditions some CPAS, small business executives, and others began to push for a separate set of generally accepted accounting principles to be developed for small businesses. In response to the pressure for a "Little GAAP" various groups including the American Institute of Certified Public Accountants and the Financial Accounting Standards Board appointed committees and conducted research relating to this problem. Research results have been identified and discussed by other authors. Nair and Rittenberg identified four AICPA committee reports and discussed the report of the Technical Issues Committee of the AICPA Private Companies Practice Section [17]. Jefcoat and Loudell [7] and Lippitt and Oliver [13], explained the recommendations of the AICPA Committee on Generally Accepted Accounting Principles for Smaller and/or Closely Held Businesses and the AICPA Committee on Small and Medium Sized Firms. In addition, Lippitt and Oliver reviewed the preliminary results of a survey sponsored by the FASB and the University of Florida [15]. Knutson and Wichmann also addressed the Report of the AICPA Committee on Generally Accepted Accounting Principles for Smaller and/or Closely Held Businesses as well as the Report of the Standards Overload Committee [9]. Finally, Korn discussed a study by the Financial Executives Research Foundation [11]. Table 1 lists the various reports by year and highlights significant items from the articles mentioned above. TABLE 1 SUMMARY OF REPORTS RELATING TO APPLICATIONS OF GAAP TO SMALL BUSINESS Year Report or Study Highlights
    • 1976 Report of AICPA Committee on Gener- * Identified two problem areas - measure- ally Accepted Accounting Princi- ment and disclosure. ples for Smaller and/or Closely * Opposed different measurement proc- Held Businesses esses for small businesses. * Contended the measurement process should be independent of the nature of the users. 1980 Report of AICPA Committee on Small * Concluded that some of the measurement and Medium Sized Firms standards required by GAAP lacked eco- nomical justification or were not useful for small companies. * Recommended the FASB review GAAP applicability to small business and study effects of standards on small business before issuance. 1982 Survey by FASB and the University * Indicated small CPA firms, small busi- of Florida nesses, and bankers were not suppor- tive of a separate set of accounting standards for small businesses. 1982 Sunset Review Committee - Techni- * Completed review of GAAP to identify cal Issues Report from the Private measurement and disclosure require- Companies Practice Section Divi- ments not relevant to small and medium sion of CPA Firms size private companies or that required costs in excess of benefits provided. 1983 Report of Standards Overload Com * Recommended reconsideration of costly mittee of AICPA and/or burdensome disclosure require- ments. * Encouraged simplicity of new rules or principles. * Preliminary report recommended consid- eration of income tax basis for mail businesses (alternate to GAAP). 1982 Study by the Financial Executives * Supported one set of GAAP for all size 1983 Research Foundation firms, but was receptive to different disclosure rules due to size and nature of the entity. BIG GAAP - LITTLE GAAP CONTROVERSY In addition to the extensive studies identified in Table 1, numerous articles have been written addressing the merits and problems of a separate GAAP for small businesses or exploring other possible alternatives. Stanga and Tiller [21], Lippitt and Oliver [16], Knutson and Wichmann [10], Nair and Rittenberg [18], Korn [12], Friedlob and Plewa [6], Anderson, Dycus, and Welker [4], and Jefcoat and Loudell [8] have all identified and discussed arguments for and against separate accounting principles for small businesses. Table 2 consists of a compilation of arguments favoring and opposing a separate GAAP for small businesses selected primarily from the articles mentioned above. The cost of accounting services to small businesses relative to the benefit derived has been and continues to be an area of concern. A study conducted by Nair and Rittenberg found the banking community, business community, and CPAs all perceive that compliance with present accounting regulations is costly [19]. Benefits are not only difficult to identify but also to a large extent accrue to third party users. Costs, however, are readily identifiable and continue to increase. Factors pressuring costs upward include: (1) the need of the CPA to conform to Generally Accepted Auditing Standards (GAAS) and to determine that financial statements are in conformity with GAAP to avoid professional sanctions or litigation, (2) the need for CPA firms to undergo peer review that could easily cost $2500 to $3000, and (3) rapidly increasing liability insurance costs to CPAs that will be passed on to clients through higher fees. In spite of costs and a general belief that disclosure requirements are too stringent for small companies, there appears to be insufficient support to force the establishment of a separate set of GAAP for small businesses. Financial statement users find comfort in knowing that statements are prepared in conformance with some universally applied principles. CPAS, while recognizing the need for relief for small businesses, are reluctant to dilute the standards of the profession and lose credibility. They are, therefore, more likely to support one set of GAAP and hope the Financial Accounting Standards Board will exempt small companies from certain disclosure requirements. TABLE 2 ARGUMENTS FOR AND AGAINST A SEPARATE SET OF GAAP FOR SMALL BUSINESS Arguments For * GAAP are written primarily for users of financial statements of public companies, not small non-public entities. * Small companies find GAAP costly to apply relative to the benefits. * GAAP often deals with complicated situations
    • that do not apply or only partially apply to smaller companies. * Investors in large businesses and small businesses view the financial statements from a different perspective. * Small business owners have access to substantial amounts of internal information making detailed disclosures less important. * CPAs do not believe that disclosure requirements are equally applicable for large and small companies, or for privately owned and publicly owned companies. * User needs differ between small closely held businesses and large publicly held companies. * The Financial Accounting Standards Board is oriented toward large corporations. * Accounting standards which are numerous and detailed appear threatening to small business owners who often do not have a professional accounting staff. Arguments Against * Two sets of GAAP will tend to reduce credibility and cause confusion among statement users. One set would be looked upon as inferior. * The financial information needs of creditors are similar for small closely held companies and large public companies. * While there is a desire for relief from current standards for small business, preparers and users are reluctant to recommend separate GAAP for small and large companies. CPAS, bankers and businessmen tend to support uniform principles. * From a legal viewpoint form is more important than size in determining rights and obligations. * Separate sets of GAAP would have an adverse effect on consistency and the comparability of large and small businesses would be hindered. * Defining small business is difficult and determining who should use which set of GAAP would be controversial. * Companies in the same industry should be applying the same GAAP. * A common set of standards is necessary to insure quality and integrity in the accounting profession. * There are substantial similarities in the business processes of all firms. DISCLOSURE PROBLEM AREAS Financial reporting and disclosure problems for small businesses fall into two general areas or categories, measurement and disclosure. In 1976, the AICPA Committee on Generally Accepted Accounting Principles for Smaller and/or Closely Held Businesses concluded that measurement rules must be applied across the board but that disclosure standards may be unnecessarily burdensome to small businesses [14]. In recent years the Financial Accounting Standards Board has shown a willingness to reduce some of the disclosure requirements for non-public companies. This is exemplified by no longer requiring earnings per share or segmental disclosures for privately held companies. According to Williams and Thompson there are nine topical areas that currently cause reporting and disclosure problems for small business clients of CPA firms. They are: 1. Irregular Income Items 2. Reporting Changes in Financial Position 3. Interperiod Income Tax Allocation 4. Leases by Lessees 5. Commitments and Contingencies 6. Marketable Securities 7. Related Party Transactions 8. Subsequent Events 9. Problems of Continued Existence [221 The above list consists of topics covered in professional development courses for CPAs that are common to small businesses; therefore, it is unlikely disclosure requirements relating to them will be suspended or reduced. ALTERNATIVES In view of standards overload and the reporting and disclosure problems confronting small businesses, what options are available? The Standards Overload Committee identified five possible alternatives as reported by Nair and Rittenberg [20]. They are: (1) retain the status quo, (2) develop a separate set of GAAP for small, private businesses, (3) simplify GAAP, (4) change the auditor's reporting standards, thus, encouraging special reports with fewer required disclosures, and (5) use a comprehensive basis of accounting (OCBOA) other than GAAP. It is highly unlikely the FASB will consider either numbers two or three above; it has, in fact, indicated a preference for retaining GAAP as is and allowing some suspensions of disclosure requirements. Alternative 5 is already in use. Given the current reporting options available to small businesses, it does seem that no new alternatives are actually needed. Following is a range of reports that are available to small public and/or private companies relating to reporting and disclosure requirements: (1) an audit that meets SEC requirements (public companies), (2) an audit for non-public companies, (3) a review, (4) a compilation with disclosures, (5) a compilation without disclosures, (6) other comprehensive basis of accounting, and (7) financial forecasts. Users of financial reports will likely request statements with full disclosures as long as they don't have to pay for them. Management of small businesses should, therefore,
    • become aware of accounting services such as reviews, compilations, and other comprehensive basis of accounting and be prepared to negotiate a lower level, less costly report with users. REPORT OPTIONS Three reporting options are generally available to small businesses; audits, reviews, and compilations. A look at the definitions of these options, will better allow us to understand the differences between the options. Auditing is the process by which a competent, independent person accumulates and evaluates evidence about quantifiable information related to a specific economic entity for the purpose of determining and reporting on the degree of correspondence between the quantifiable information and established criteria [5]. The established criteria is better known as generally accepted accounting principles (GAAP) or in a few cases some other comprehensive basis of accounting. The outcome of an audit is the expression of an opinion or disclaimer of opinion regarding the fairness of presentation of the financial statements in conformity with GAAP. A review of financial statements involves performing inquiry and analytical procedures that provide the accountant with a reasonable basis for expressing limited assurance that there are no material modifications that should be made to the statements in order for them to be in conformity with generally accepted accounting principles or if applicable, with another comprehensive basis of accounting [1]. A compilation of financial statements is limited to presenting in the form of financial statements, information that is the representation of management (owners) without undertaking to express any assurance on the statements [2]. From these definitions we can determine the primary purpose of each of the reporting options: (1) audits, to determine if the financial statements are fairly presented in conformity with GAAP or in a relatively few cases some other comprehensive basis of accounting, (2) reviews, to determine if modifications are needed to conform with GAAP, and (3) compilation, to generate financial statements. REPORT POSSIBILITIES What are the different report possibilities under the three reporting options? Under the audit three different opinions are possible; unqualified, qualified, and adverse, along with the possibility of issuing a disclaimer of opinion. An unqualified opinion will be used when the auditor was able to conduct the audit in accordance with generally accepted auditing standards and found the financial statements fairly presented in conformity with GAAP and consistently applied with prior years. A qualified opinion is used when the financial statements as a whole are fairly presented but there is a problem somewhere within the statements; this problem may be caused by GAAP departures, GAAP disclosures, consistencies, and uncertainties. An adverse opinion will be issued when the financial statements are not fairly presented. Adverse opinions are caused by GAAP problems, some of which could be the same as those which cause a qualified opinion, except that to be adverse the GAAP problem must be more material. There are only two situations which lead to a disclaimer of opinion. Causes of a disclaimer are when the auditor is unable to determine if the financial statements are fairly presented or materially misstated and if the auditors independence is impaired. The standard review report will be used if no material adjustments are needed for the reports to be in conformity with GAAP. Alterations in the standard review report will be required for such items as inadequate disclosures required by GAAP or departures from GAAP. Compilation reports give no assurance regarding the fairness of the financial statements. The standard compilation report will be issued in most situations. However, modifications to the standard wording may be necessary in the following situations: departures from GAAP, substantially all disclosures are omitted, a comprehensive basis of accounting other than GAAP was used in preparation of the financial statements, and the CPA was not independent. ADVANTAGES AND DISADVANTAGES OF REPORTING OPTIONS The primary advantage of an audit is found in the opinion of the auditor relating to the fair presentation or lack of fair presentation of the financial statements. The assurances provided in the audit report are valuable in communicating with stockholders, bonding agencies, bondholders, and other third party creditors. A disadvantage of the audit is its relative expensiveness in comparison with the other reporting options. Advantages of the review option are its lower cost compared to an audit, and limited assurance that no material modifications are needed for conformity with GAAP, which makes them more desirable to creditors and stockholders, and increases usefulness to management. Compilations provide a very valuable service to the small business sector, which many times does not have the expertise on board to generate adequate financial statements. The cost of a compilation report is the lowest of the three alternatives. One major disadvantage of the compilation is the lack of any assurances on the part of the accountant. OTHER COMPREHENSIVE BASIS OF ACCOUNTING
    • Much attention is given to at least the following three comprehensive basis of accounting: (1) strict cash basis, (2) modified cash basis, and (3) income tax basis. The strict cash basis of accounting recognizes revenue when cash is collected and expenses when cash is disbursed, with no capitalization of fixed assets or recognition of receivables or liabilities. A modified cash basis also recognizes revenue when cash is collected and expenses when cash is disbursed, however, it does capitalize fixed assets and may allow for the recognition of receivables and payables. Probably the most intriguing of the three is the income tax basis. This method allows a business to use the same accounting methods for income tax filing and for financial reporting. The advantages would be reduced accounting costs and elimination of time consuming and difficult adjustments. How would these three comprehensive basis relate to our three reporting services: (1) audits, (2) reviews, and (3) compilations? Statement on Auditing Standards #14 allows a CPA to express an opinion on financial statements prepared under some other comprehensive basis than GAAP. This type of reporting is considered a Special Report and may cause additional risk for the auditor. The review of financial statements does not allow for reporting under a comprehensive basis of accounting other than GAAP, since it only applies to GAAP or statements that require a material modification to be in conformity with GAAP. The compilation does allow for reporting under a comprehensive basis other than GAAP but it does require modification of the wording in the standard report. Remember that our discussion earlier indicated that the CPA does not give any type of assurance when he issues a compilation report, therefore the compilation report may not meet the needs of the business. SUMMARY Much has been written over the years regarding BIG GAAP vs. LITTLE GAAP. These discussions may range from allowing different accounting methods and different accounting principles, to alternative comprehensive basis of accounting for large and small businesses. Although strong arguments can be brought forward for allowing small businesses special concessions in the area of financial reporting, it is our feeling that the controversy will continue in the future with one single GAAP prevailing, due to the benefits of comparability, understanding, and uniformity. REFERENCES 1. AICPA, Statement on Standards for Accounting and Review Services No. 1, Compilation and Review of Financial Statements, December, 1978, p. 3. 2. Ibid. 3. Anderson, Donald T., Dycus, Harold I., and Welker, Robert B., "GAAS and the Small Business Audit," The CPA Journal, April, 1984, P. 10. 4. Ibid., pp. 10, 18. 5. Arens, Alvin A., and Loebbecke, James K., Auditing an Integrated Approach, Prentice-Hall, 3rd Edition, 1984, p. 1. 6. Friedlob, Thomas G., and Plewa, Franklin J., "Small Business - A Practical Solution to Standards Overload," Management Accounting, October, 1984, p. 92 Thompson, Richard 7. Jefcoat, Linda R. and Loudell, Ellis Robinson, "Another Look at GAAP Applied to Small Business," The Woman CPA, July, 1984, p. 14. 8. Ibid., pp. 13-14. 9. Knutson, Dennis L. and Wichmann, Henry Jr., "GAAP Disclosures: Problem for Small Business," Journal of Small Business Management, January, 1984, pp. 39-40. 10. Ibid., p. 41. 11. Korn, Donald H., "Small public companies: Do they have different reporting needs?" Financial Executive, August, 1984, p. 37. 12. Ibid., p. 39.
    • 13. Lippitt, Jeffrey W. and Oliver, Bruce L., "Big GAAP, Little GAAP: Financial Reporting in the Small Business Environment," Journal of Small Business Management, July, 1983, p. 53. 14. Ibid. 15. Ibid., p. 54 16. Ibid., pp. 55-56 17. Nair, R. D. and Rittenberg, Larry E., "Alternative Accounting Principles for Smaller Businesses: Proposals and Analysis," The Journal of Commercial Bank Lending, April, 1983, pp. 4, 7. 18. Ibid., pp. 3-4, 16-17. 19. Ibid., p. 17. 20. Ibid., p. 6. 21. Stanga, Keith G. and Tiller, Mikel G., "Needs of Loan Officers for Accounting Information from Large versus Small Companies," Accounting and Business Research, Winter, 1983, pp. 63- 64, 69. 22. Williams, Jan and Thompson, Richard L., Reporting and Disclosure Problems for Small Businesses, American Institute of Certified Public Accountants, Inc., New York, New York, 1986, p. v.