By Daniel M. Ivancevich, Susan H. Ivancevich, Anthony Cocco, and Roger H. HermansonIn Brief

What's More Important?

What's more important for the small business, the balance sheet or the income statement? Some FASB pronouncements permit alternative accounting choices that impact the balance sheet and income statement differently.

In exploring the answer to this question, the authors survey how lending officers assess the credit worthiness of two sets of companies. At issue is the adoption of SFAS No. 106 and whether the companies took the full one-time catch up charge or accrued for it ratably over some future period. The first group of financials that lending officers were asked to assess were those of companies that chose to record the one-time full provision and liability. The second group was of financial statements of companies that chose to defer and spread the liability.

The lending officers reported different conclusions depending on the approach the companies chose. And yet there is no real difference between the two groups of financials.

When the FASB issues accounting standards, very often the affected companies have some choices regarding implementation. SFAS No. 123, Accounting for Stock-Based Compensation, allows adopters to choose between financial statement recognition and footnote disclosure of a new method of accounting for the cost of employee stock options. SFAS No. 118, Accounting by Creditors for Impairment of a Loan--Income Recognition and Disclosures, was issued as an addendum to a prior standard for the express purpose of allowing creditors to select among adoption alternatives pertaining to the method of interest income recognition. SFAS No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions, permitted firms to choose between two methods of recognizing the previously unreported accrued cost for benefits earned by employees up to the adoption date.

The objectives of financial reporting may differ for small versus large businesses, especially large public companies. Accordingly, when confronted with alternatives for adopting new accounting standards, the financial reporting strategy considerations may be different for smaller businesses.

Consideration Differences of Small and Large Businesses

For a larger public company faced with adoption choices regarding a new accounting standard, attention is normally directed toward the effects the standard will have on the income statement. The alternative selected often is the one with the most favorable or least unfavorable effect on earnings and earnings per share (EPS). Public companies attract investment capital from investors who often use earnings and EPS as a basis for their investment decisions.

For nonpublic companies, attracting fresh investment capital is often not an important consideration. A sole proprietor, partners in a partnership, or owners of a closely-held corporation have already committed capital to the enterprise, and the impact on earnings of various adoption choices is not likely to change their commitment. To obtain additional funds, attracting creditor capital is usually of primary importance for these smaller nonpublic companies. A sufficiently large line of credit is the lifeblood of many small businesses. Creditors often require periodic submissions of audited financial statements prepared in accordance with generally accepted accounting principles (GAAP). This demand by creditors for audits is the primary reason that new GAAP accounting standards must be adopted by small businesses.

When evaluating a company that has applied for a business loan or line of credit, a creditor will typically focus on the company's ability to meet its debt obligations. Much of the key information used by creditors to evaluate a company's ability to meet its debt obligations, such as leverage and liquidity ratios, are based on balance sheet accounts. Accordingly, it could be argued that the potential balance sheet impact of the standard alternatives should be more heavily considered by small businesses than the potential income statement impact.

Do the choices made by small businesses regarding the accounting standard alternatives selected have economic consequences for the decisions of creditors and potential creditors? Specifically, if one alternative has a more favorable income statement impact, and a second alternative has a more favorable balance sheet impact, will a small business be better served by selecting the first or second alternative if its main goal is to obtain credit capital? To explore this question, we examined the effect that adoption alternatives of a particular accounting standard had on the decisions of loan officers. SFAS No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions, was used as the basis for this inquiry.

The Adoption Alternatives Available Under SFAS No. 106

SFAS No. 106 requires companies to use accrual accounting and expense the cost of these benefits as they are earned by employees. SFAS No. 106 granted firms a choice of adoption alternatives regarding how to account for the previously unreported accrued cost for benefits earned by employees up to the adoption date. This one-time accrual was referred to as the transition obligation. Companies were required to choose between two adoption alternatives:

One-time charge: Recognize the entire amount of the liability on the balance sheet in the adoption year, with an offsetting charge to net income as a cumulative effect of a change in accounting principle.

Deferred recognition: Amortize the transition obligation to compensation expense over future periods, and record a portion of the liability each year over the same time period.

The new recognition of this liability results in a decrease in equity and increase in debt.

Financial Statement Considerations For Adopting SFAS No. 106

Many large public companies elected to take the one-time charge against net income and book the entire liability in the year of adoption. For instance, General Motors recorded a $20.72 billion expense of this item in 1992. As a result, its net worth declined by nearly 80%. The motivating factor for this financial reporting decision was to temper the income statement effect. Although the one-time charge dramatically lowered EPS, the classification of this decrease as a cumulative effect of a change in accounting principle was appealing to many companies. First, operating income was not affected. Further, this classification made the charge "standout" as a one-time-only event. The negative impact on EPS was mitigated by the disclosure of the different components of the EPS in the financial statements and because investment analysts tend to discount such one-time charges in projecting future income and determining firm value.

Large public companies realized that deferred recognition would result in a drag against earnings well into the future. Even worse, this earnings decrease would be buried in compensation expense. Thus, not only net income, but the important subtotal, operating income, would be lowered each year by the amortization expense. The advantages provided by the one-time charge--coupled with the disadvantages of deferring the charge--spurred many large, public companies to select immediate recognition.

What about small, nonpublic companies? There appears to be little data available regarding the percentage of small companies that selected the one-time charge versus those that chose to defer recognition. Is it possible that small, nonpublic companies may have been better off by selecting deferred recognition? Certainly, that question is impossible to answer without knowing all of the facts and circumstances unique to each company. It is possible, however, to make some general observations. As discussed previously, the balance sheet impact of a new accounting standard, in all likelihood, is more important than the income statement impact for smaller companies seeking to obtain creditor capital.

To test this theory, we conducted a survey to explore the differential impact of the two adoption alternatives available under SFAS No. 106 on the decisions of creditors. The description and the results of the survey are discussed in the next section.

Description of the Survey

We sent questionnaire packets to two groups of loan officers. Loan officers were selected randomly from the Thompson Bank Directory (Thompson Financial Services, Skokie, IL, 1993). Each packet contained a set of financial statements for a small, fictitious plastics manufacturer and a two-page questionnaire. The financial statements consisted of comparative balance sheets, income statements, and notes to the financial statements.

The financial statements mailed to each group were identical, except for the manner in which the transition obligation was handled. One group of loan officers received financial statements that reflected immediate recognition (Group IR); the other group received financial statements that reflected amortization over 20 years (Group DEFER). The financial statements contained footnote disclosures on: 1) inventories; 2) property, plant, and equipment; 3) accrued and other current liabilities; and 4) noncurrent liabilities. The footnotes were identical for both groups, except for noncurrent liabilities. The only distinction in this footnote pertained to the account titled "deferred compensation," which differed in the way the transition obligation was handled.

Each questionnaire asked the respondent to examine the company's financial statements, and to assess the riskiness of the company and to determine the loan amount that he or she would be willing to lend the company. The exact questions asked were as follows:

Question 1 (Q-Risk): Based on your review of the information provided, what is your assessment of the riskiness of XYZ company. Please rate your response on a scale of one to five, where one represents very low lending risk and five represents very high lending risk.

Question 2 (Q-Loan): Assume XYZ company has unpledged assets to meet your collateral needs and there are no restrictions on the amount you may loan or the availability of bank funds to loan, what amount would you loan XYZ company?

No special attention was given to the handling of the transition obligation, and neither group was aware of the existence of the other group. We did not want to bias the respondents by making them aware of the purposes of the survey.

Results of Survey

We received 27 responses, of which 24 were usable for Group IR, and 35 responses, of which 31 were usable for Group DEFER. The mean responses to the questions Q-Risk and Q-Loan are presented in Table 1. The results of Table 1 show that Group IR, which received financial statements based on immediate recognition, perceived the company to be a higher lending risk (although not significantly higher) than Group DEFER. Further, they would make the Group IR company eligible to borrow a significantly lesser amount than the Group DEFER company.

Was it primarily the difference in the balance sheets (debt-to-equity) analyzed by loan officers for Group IR and Group DEFER, or was it the difference in the income statements (EPS) presented for the two groups that propelled these results? The answer to this question is critical, because it may provide small businesses with some insight as to how they should focus their financial reporting strategies to obtain credit capital when adopting new accounting standards.

We also collected data pertaining to which components of the financial statements were employed by loan officers in making their loan decisions. The loan officers were requested to list any components of the financial statements, ratios, and other information used to answer Q-Risk and Q-Loan. These results are presented in Table 2.

Although various elements were noted by the respondents, we were primarily interested in what percentage of loan officers used the basic balance sheet ratios that measure leverage and liquidity and how many respondents focused on income statement elements/ratios such as earnings and EPS. As displayed in Table 2, many more respondents in both categories listed debt-to-equity (leverage) and the current ratio (liquidity), as opposed to earnings, as elements that were used in the decision making process regarding Q-Risk and Q-Loan.

It is interesting that these differences were discovered at all, since SFAS No. 106 merely recognized a previously unrecorded existing liability and did not establish a new liability. The failure to detect the content of SFAS No. 106's disclosures causes negative economic consequences for small companies choosing the one-time charge.

Look to Balance Sheet Effect

When alternatives are available regarding the adoption of a new accounting standard, it is of the utmost importance that a financial reporting strategy be adopted for the small business that best suits the needs of the business. For many small businesses, the relevant financial statement users are creditors and potential creditors, and these "users" tend to focus more heavily on a company's ability to meet its debt obligations than on earnings because of the short-term nature of money loans. This information may be found on the balance sheet and the results of this study support this assertion. Thus, when assessing the implementation alternatives of new accounting standards available, small business financial reporting strategy may need to assign more importance to the balance sheet impact of the various alternatives. *

Daniel M. Ivancevich, PhD, and Anthony Cocco, PhD, CPA, are assistant professors of accounting, and Susan H. Ivancevich, PhD, CPA, an assistant professor of hospitality finance and accounting, all at the University of Nevada, Las Vegas. Roger H. Hermanson, PhD, CPA, is regents professor of accounting and Ernst & Young JW Holloway Memorial Professor, Georgia State University, Atlanta.