Companies in emerging industries such as renewable energy probably believe they have enough to worry about without dealing with the convergence of U.S. and international accounting standards. However, as the financial system struggles to keep up with world events and technology, renewable firms need to keep up as well.
The simple reasons behind convergence are to get the players in the world economy on the same page and avoid another financial meltdown akin to 2007-08. Because U.S. GAAP (Generally Accepted Accounting Principles) is significantly different than European accounting, the Financial Accounting Standards Board (FASB) has been working with the International Accounting Standards Board (IASB) to converge. The SEC is seen as the governor who will force the issue.
If you are a small company, you could always ignore what’s happening with world accounting. But if your long-term plan is to obtain financing or investors, sell to or buy another company, or go public, it will benefit you to pay attention.
You may have already heard of some of the concerns; for example, that convergence may cost the average company $1 million or more to implement or that rigorous and expensive “mark-to-market” asset valuations may result in a serious write down of asset values. The sophisticated business person may also be familiar with the more subjective system used by Europe versus the rule-based U.S. system that is filled with bright line standards. Yet there are also some breaks being contemplated by both U.S. and international rule makers that exempt smaller firms from some of the most costly accounting policies.
Will we ever have total convergence of financial systems? That’s very unclear right now as there still is a lot of disagreement, but the eight major areas that they are working on have either already been implemented or will be within a couple years in the United States.
Much of the discussion is currently in the public company realm, including when the SEC will mandate adoption of International Financial Reporting Standards (IFRS) for U.S. issuers. In May of this year, the SEC issued a staff paper in which it outlined a work plan to incorporate IFRS into the financial reporting system for U.S. issuers, and proposed a “condorsement” approach (the SEC created this new terminology to define the approach).
However, IFRS is not only affecting public companies. Because of the FASB’s approach to convergence of international standards, private companies are being affected as well. For renewable energy companies in the United States, the extent to which this transition affects you will be largely driven by the size and complexity of your operations and financings, but regardless, it will affect them. So the question then becomes what is the gist of the changes that are most likely to affect renewable energy companies?
In a joint project with the IASB, the FASB has proposed ? through an exposure draft ? a significant change to the accounting for leases. Under the proposed standard, all leases will be accounted for on the balance sheet, and the concept of an operating lease will go away. As a result, leases for items such as office space will be presented as non-current assets and as liabilities, similar to a note payable with the current portion in current liabilities and the long-term portion in long-term liabilities. This presentation will generally negatively affect a company’s working capital and, potentially, bank covenants.
On the other hand, the change will likely have a positive effect on a company’s income statement due to the classification of the related expenses. The asset will be depreciated and presented in operating expenses. Lease expense, which is generally classified in operations, will go away, and additional interest expense will be recognized on the lease liability. While a company’s net income or loss will likely remain unchanged, the operating income will improve and EBITDA, an important measure for many users of financial statements and analysts, will also improve.
While we expect this standard to have significant effects on all companies, consider a manufacturer of wind turbines or solar panels that leases their manufacturing facilities and the effect that this rule will have on their financial statements.
While U.S. GAAP has many industry-specific revenue recognition rules, the boards are trying to work toward one that would apply basic principles across all industries and also apply to services. This would include a company selling smart grid software and service packages over the Internet or a researcher being paid under contract to develop solar technology for the government. It would also apply to solar installers who likely currently utilize percentage of completion accounting.
The boards are considering using a six-step model: (1) Identify the contract; (2) identify performance obligations; (3) determine transaction price; (4) allocate the transaction price; (5) recognize revenue when performance obligations are satisfied; and (6) account for certain contract costs.
LIFO inventory accounting
Another area of difference between U.S. GAAP and International standards is that International standards do not allow the LIFO (last-in-first-out) method of inventory pricing. While the advantages of this method of inventory pricing are largely tax driven, a significant number of companies in the United States price their inventory using LIFO.
Potential relief is in sight for private companies. Earlier this year, a Blue Ribbon Panel on Standard Setting for Private Companies — which was established by the American Institute of CPAs, the Financial Accounting Foundation, and the National Association of State Board of Accountancy ? submitted a report recommending the establishment of a separate board to set private company accounting standards. The panel has recommended that the new board would focus on making exceptions and modifications to U.S. GAAP for private companies.
Canadian companies were required to switch from Canadian GAAP to IFRS this year, and the results were alarming. Some of the costs were similar to the U.S. adoption of the Sarbanes Oxley Act of 2002. So whether your renewable energy company conducts business internationally or only domestically, is public or private, you should pay attention to and weigh in on the debate related to IFRS adoption.