The Art of Accounting
Our FAQ section briefly describes possible approaches to account for loans received under the Paycheck Protection Program (“PPP”). This article will go into a bit more depth.
To address the economic issues caused by the COVID-19 pandemic, the CARES Act, signed into law on March 27, 2020, established the PPP to provide loans to qualifying businesses to pay up to 8 weeks of certain qualifying expenses. The PPP Flexibility Act, signed June 5, 2020, extended the pay period to 24 weeks. Qualifying expenses include payroll costs, including benefits, mortgage interest, rent, and utilities. The SBA administers the program. Under the program’s provisions, the loan and interest may be forgiven, provided the business meets the eligibility criteria for forgiveness.
The program intends to keep employees employed, and the doors open for business. And, by doing so, the loan and interest are subject to forgiveness by the SBA. So how does a for-profit business entity account for the loan? And when and how do you recognized the income if the loan is subsequently forgiven?
Most CPAs who have practiced accounting for some time realize that financial accounting is more art than science. Math is a science, but accounting is not math. Generally accepted accounting principles (“GAAP”), certainly for the last several years, are not a list of specific rules, per se. To a large degree, it is broad principles applied to the facts and circumstances fairly and consistently. When we say consistently applied, it means the same company consistently uses the accounting principle from period to period. It does not mean that GAAP is applied consistently across all companies. Therefore, it’s possible and acceptable for one company to account for a transaction one way, and another company to account for a similar transaction another way with different results. Because of numerous accounting elections available to account for a PPP loan, companies may present a similar transaction differently and still comply with GAAP.
The Financial Accounting Standards Board (“FASB”) is the organization responsible for establishing accounting and financial reporting standards in the United States. In other words, it determines GAAP. It has issued numerous authoritative pronouncements over the decades. Yet, none of the pronouncements seem to adequately address the accounting for a non-governmental business entity that receives an SBA forgivable loan if specific requirements are satisfied. That leaves us to look to other sources for guidance.
The AICPA, in its Q&A Section 3200.18, notes that while the legal form of a PPP loan is debt, in substance, it could be construed as a governmental grant. Q&A Section 3200.18 outlines the following nonauthoritative approaches to account for a PPP loan:
- Debt. The legal form of the funds is that of a debt. So, it is always permissible to account for the PPP loan under FASB ASC 470 – Debt. Our impression is that most companies will account for the PPP loan as a debt, even if it expects the debt and interest to be forgiven. If the stated interest rate is below market, interest will not be imputed because government-guaranteed obligations are excluded from this requirement. Under further guidance in FASB ASC 405-20-40-1, the loan remains recorded as a liability until it is paid off or forgiven, either in whole or in part. If forgiven, the debt liability is reduced by the amount forgiven, and gain on extinguishment of debt would be recorded.
This approach’s appeal is twofold: a) The legal form of the funds received is debt; it is an SBA loan. b) It removes the requirement of estimating if it is probable the SBA requirements for the forgiveness of debt will be met. (See #2 below). Under the debt method, gain recognition and debt derecognition are postponed until the accounting period the loan is forgiven (i.e., legally released).
- Deferred Income Liability. If the company estimates that it is probable it will meet the PPP’s eligibility criteria for loan forgiveness, it may conclude that the loan is, in substance, a government grant. Therefore, it may account for the PPP loan as a grant by analogy to the provisions of International Accounting Standard 20, Accounting for Government Grants and Disclosure of Government Assistance (“IAS 20”). Bear in mind, though, that the likelihood of forgiveness must meet the probable threshold under GAAP, a high bar to reach. The standards define “probable” as a future event or events that are likely to occur. While no percentage threshold is given in authoritative accounting standards, in practice, many CPAs consider a 75% or greater likelihood of occurrence as necessary to meet the probable requirement.
Under the IAS 20 model, the PPP loan funds are initially recorded as a deferred income liability. The liability is reduced as income is recognized “on a systematic basis over the periods in which the entity recognizes as expenses the related costs for which the grants are intended to compensate.” In other words, as qualifying expenses are incurred during the 8 or 24-week period, an equal amount of income is recognized.Under IAS 20, the PPP income is presented in the statement of income as either:
- A separate caption or under a general caption such as Other Income, or
- As a reduction to the related expenses.
Many companies present income from operations on its statement of income. Under option #1 above, the company’s accounting policies determine if PPP income is included in operating income. However, if the company elects to net the income against the related expense, as described in option #2 above, then the PPP income would necessarily be included in operating income.
We expect that most companies who choose the IAS 20 model would elect to present PPP income as either a separate caption or under a general caption such as Other Income, as described in #1.If all or a portion of the previously recognized income is deemed repayable in a subsequent accounting period, it will be accounted for prospectively as a change in estimate.
- Refundable Advance. Suppose a business entity anticipates complying with the eligibility criteria and expects the loan to be forgiven. Another acceptable approach would be, by analogy, to follow the not-for-profit model (“NFP model”) described in FASB ASC 958-605-25-13. Under the NFP model, a conditional contribution is “…accounted for as a refundable advance until the conditions have been substantially met or explicitly waived by the donor.” Therefore, the SBA loan would be carried on the balance sheet as a refundable advance until the criteria for forgiveness are substantially met or explicitly waived. At that time, recognize the refundable advance as income.
When are the criteria for forgiveness substantially met? Is it:
- When the qualifying expenses are incurred?
- When the company submits all required documentation to the lender for forgiveness?
- When the lender submits approval of the application to the SBA?
- Or, when the SBA remits payment to the lender?
The point in which the criteria for forgiveness are substantially met is not entirely clear, and there will probably be diversity in practice. For this reason, we believe few business entities will follow the NFP model to account for PPP loans.
- Gain Contingency. Another method a business entity may elect, if it expects the loan to be forgiven, is by analogy to the gain contingency recognition model presented in FASB ASC 450-30. Under this model, the loan proceeds are recorded as a deferred income liability. Grant income will not be recognized until the period when the grant proceeds are realized or realizable. This will probably not be until the lender approves the company’s application for loan forgiveness.
We think few businesses will use this model. If management is inclined to wait until forgiveness to recognize the grant income, they will use the debt model instead.
Regardless of the approach taken to account for the PPP loan, all companies must adequately disclose its accounting policy and its implications to the financial statements.