Private Companies Need Modified Standards, Not Separate Rules
Private companies have long argued that U.S. Generally Accepted Accounting Principles (GAAP) are too expensive to apply and that the results are often of marginal benefit to end users.
So the American Institute of Certified Public Accountants and the Financial Accounting Foundation (FAF) created a "Blue Ribbon Panel" to analyze how existing U.S. accounting standards could be leveraged to help improve the usability of private company financial statements.
The panel recently issued a report on its findings, which are summarized below.
There are approximately 28 million private companies in the United States. In contrast, there are approximately 14,000 public companies that have reporting requirements with the U.S. Securities and Exchange Commission (SEC).
Although private companies may not need to prepare GAAP financial statements for the SEC, they might need them for lenders, bonding companies, regulators, and others.
Depending on the size of a public company, the number of shareholders can reach well into the hundreds of thousands. A public company's shareholder population typically includes a broad range of investor types with a wide variety of expectations regarding the information needed from the company's financial statements.
Alternatively, the shareholder population of a private company is generally far smaller with relatively defined needs and expectations for the company's financial statements.
What both public and private shareholders do expect is accurate, reliable, and comparable financial statements that paint a clear picture of the company's financial performance over time.
Applying U.S. GAAP to private companies has resulted in a number of unintended consequences including the following:
- Private companies often incur considerable costs to apply U.S. GAAP. These costs may, or may not, improve the usability of their financial statements. In many cases, it can actually complicate the financial reporting process.
- Since private companies can choose to ignore GAAP, it is often difficult to compare financial statements for private companies with other entities.
- Stakeholders may not be familiar with U.S. GAAP or they may have specific questions that are not easily answered by reviewing the company's financial statements. As a result, stakeholders often request additional information or an ad-hoc analysis in order to make sense of the financial statements.
- Accounting staff members with U.S. GAAP experience can be relatively expensive to hire and retain since they can work with private and public companies.
The Blue Ribbon Panel issued a report earlier this year, which includes the following recommendations:
- The panel concluded there are "urgent and growing systemic issues that need to be addressed in the current system of U.S. accounting standard setting."
- However, the panel did not recommend a wholesale departure for private companies from U.S. GAAP. In the near term, the report stated, "The system should focus on making exceptions and modifications to U.S. GAAP for private companies that better respond to the needs of the private company sector."
- A new board should be created that would be overseen by the Financial Accounting Foundation (FAF). The board would be tasked with developing exceptions and modifications to U.S. GAAP to better suit the needs of private companies.
- A framework should be developed that the newly formed board could use to determine whether a specific exception or modification to U.S. GAAP is appropriate. The framework would take into account costs, complexity of the revisions, and the overall impact on the relevance and accuracy of a private company's financial statement.
The FAF is considering the panel's recommendations. It is likely that the Foundation will release a final recommendation that will be available for public comment. It is possible that the FAF will finalize the changes to private company reporting later this year.
What do the Panel's recommendations mean for companies? Will the users of private company financial statements welcome the exceptions and modifications produced by the newly appointed FAF board? Time will tell. However, consider the following steps that a company can take to prepare for the finalized changes:
- Map out a strategy. Once you have a detailed understanding of how the upcoming changes approved by the FAF will affect your business, develop a timeline of steps and communications that your company needs to undertake prior to implementation. Taking the time to plan for the changes can dramatically increase the probability that your company will be able to quickly and effectively implement them.
- Meet with significant stakeholders. To prepare users of your company's financial statements for possible changes in how your company reports its performance, consider meeting with major stakeholders. Waiting until the changes are in place and your company has produced its next financial statement may not cause undue concern. However, lenders, investors and others typically hate surprises.
- Review lender debt covenants. Changes in the application of U.S. GAAP may result in the "busting" of bank imposed covenants. Once the FAF recommendations are finalized, consider engaging your accounting firm to model the impact on your company's debt covenants. In addition, if your company is subject to government regulation, your accounting firm can implement tests to ensure that the financial metrics that are subject to review by regulators remain within an acceptable range.
- Contact your accounting firm for guidance. Once the FAF recommendations have been approved, companies need to prepare for changes in personnel, processes and technology needed to produce financial statements. Discuss with your accountants how the changes may affect your company. Your accountants will be able to share with you the cost/benefit of adopting the FAF approved changes, as well as help your company model the impact on its financial statements.
Another View of the Panel's Proposal
The Panel's recommendations are not without critics. Some have suggested that the plan is unrealistic because it puts forth solutions without adequately addressing the risks inherent in the solutions. Critics say we need to take another look, this time with a keen awareness of risk management. Successful implementation is not automatic and requires careful development and monitoring. For example, implementation might fail because of real-world resource constraints, or because the costs of implementation could exceed the benefits gained by resolving the issue. A solution with high implementation risk, critics argue, will probably prove useless.
Arguably, U.S. GAAP is most suited to public companies. The changes proposed by the Blue Ribbon Panel may be the first step in a long process that has the potential to dramatically improve the overall quality and consistency of private company financial reporting.
About the Blue Ribbon Panel
- The Blue Ribbon Panel was established in December 2009.
- It was made up of 18 members who are senior leaders representing a cross-section of financial reporting constituencies, including lenders, investors, and owners, as well as preparers and auditors.
- In January 2011, the Panel issued a report with recommendations to the Board of Trustees of the Financial Accounting Foundation.
- The Panel limited its work to private for-profit companies, and did not include private-sector not-for-profit entities.
For more information, please contact us at 408.288.5111.