Private companies and GAAP
September 22, 2011
There have been discussions about separate private company accounting standards for years. Now standard-setters may actually do something about it. The Financial Accounting Foundation (FAF) — parent organization to the Financial Accounting Standards Board (FASB) — will soon decide whether to adopt recommendations made earlier this year by a blue-ribbon panel on standard setting for private companies.
The panel recommended that the FAF establish a separate, private company standards board to develop appropriate exceptions and modifications to U.S. Generally Accepted Accounting Principles (GAAP) that would “better respond to the needs of the private company sector.” The new board would work closely with FASB, and its standards would be incorporated into FASB’s Accounting Standards Codification (ASC).
However, the board would have final authority over all exceptions and modifications. The panel also recommended the creation of a “differential framework” to guide the new board’s standard-setting activities.
Public vs. private
In the United States, public and private companies, for the most part, are subject to the same set of accounting standards — GAAP. Public companies are required under SEC rules to prepare audited, GAAP-compliant financial statements. Generally, private companies aren’t legally obligated to follow GAAP, but they may need to do so to satisfy lenders, sureties, venture capitalists or other stakeholders.
Preparing GAAP financial statements can be a challenge for private companies, particularly in the current environment. During the last several years, FASB has been shifting toward a fair-value-based accounting approach. In other words, GAAP increasingly requires companies to report assets and liabilities at fair value rather than historical cost. This trend is increasing the complexity and cost of complying with GAAP, which now demands periodic valuations and impairment testing for many financial statement items.
This type of information is valuable to public company investors, who use it to evaluate the price of securities traded in the stock exchanges or other public markets. But lenders and other users of private company financial statements tend to be less interested in fair value and more interested in free cash flow and a company’s ability to pay its debts. In some cases, GAAP can make it more difficult for these users to get the information they need.
Consider, for example, employee stock options. Historically, these options were reported at their “intrinsic value” — that is, the amount (usually zero) by which the underlying stock’s market value on the grant date exceeded the option exercise price. Several years ago, however, FASB modified its standards to require companies to expense employee stock options based on their grant-date fair value, using one of several option-pricing models.
Valuing options can be complex — especially for private companies with limited trading data. Plus, many lenders view stock options as a noncash expense that has little effect on a company’s ability to pay its debts. So, from their perspective, reporting options at grant-date fair value actually distorts the company’s income. For that reason, they add the expense back into net income when evaluating a company’s financial statements.
Proponents of separate private company accounting standards point to fair value reporting as well as other GAAP provisions that may be irrelevant at best and counterproductive at worst in a nonpublic setting. They include:
Reporting of uncertain tax positions
Consolidation of variable interest entities, and
Accounting for derivatives.
As a result, many private companies prepare non-GAAP financial statements — on a cash or income tax basis, for example — while others opt to receive “qualified” opinions from their auditors. Many lenders accept these financial statements or waive certain GAAP requirements because they recognize that compliance can be burdensome and that many GAAP standards lack relevance for private companies.
The concept of separate standards for private companies isn’t without its critics, however. Some opponents argue that financial statements are either correct or they aren’t, and that separate standards will lead to inconsistency and lack of comparability.
They advocate a single set of standards that can be modified, if appropriate, on a case-by-case basis by agreement between a company and its financial statement users. They also contend that, if GAAP standards are overly complex or burdensome, they should be simplified for all companies, both public and private.
The panel’s recommendations
The blue-ribbon panel considered several models for addressing the needs of private companies, including a standalone GAAP built from the ground up and several versions of International Financial Reporting Standards (IFRS), including IFRS for Small and Medium Entities.
In settling on U.S. GAAP with exceptions and modifications for private companies, the panel explained that a standalone set of standards could take a significant amount of time to create and could be significantly different from current U.S. GAAP. It also rejected the various IFRS options, noting that “U.S. private companies should not be leading the charge, en masse, to an IFRS-based set of standards before the SEC makes a decision on U.S. public companies…”
The panel concluded that a new board with standard-setting power would be the most effective approach. In the panel’s view, FASB is too focused on public company financial reporting to address the needs of private companies.
The panel noted that FASB’s Private Company Financial Reporting Committee (PCFRC) has submitted approximately 40 recommendation letters since it was formed in 2007. Although FASB has modified some standards, generally by changing effective dates or disclosure requirements for private companies, the panel concluded that many private company stakeholders view the PCFRC’s work as “not being wholly successful because the FASB has not also shown a willingness to consider carefully and approve, where appropriate, the possibility of measurement, recognition, or presentation differences.”
It’s not yet certain how the FAF will respond to the blue-ribbon panel’s recommendations. But there’s widespread support for the panel’s approach among accountants and finance executives, as reflected in the vast majority of nearly 2,000 letters the FAF has received. Keep in mind that the FAF’s decision and ultimate approach may be affected by the SEC’s decision, expected later this year, on whether to adopt IFRS for U.S. companies.
If you own a private company and have questions about how the blue-ribbon panel’s proposed recommendations might affect how you prepare your financial statements, please give us a call. We would be happy to answer your questions.