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How Not to Create Private-Company GAAP

A favored approach to establishing "little GAAP" for private U.S. companies is way off target.
Bruce Pounder, CFO.com | US
January 6, 2011

Dissatisfaction with generally accepted accounting principles is increasing among stakeholders of private U.S. companies. A blue-ribbon panel has tentatively concluded that a new standard-setting body should create a distinct GAAP for private U.S. companies by specifying extensive exceptions to GAAP as set by the Financial Accounting Standards Board. Unfortunately, due to the panel's lack of risk awareness, establishing a "little GAAP" for general-purpose financial reporting is unlikely to solve the problems of key stakeholders (see "Private-Company GAAP: Setting the Right Goal"). Beyond that, stakeholders are likely to reject the panel's solution regardless of how suitable it is for their problems (see "Private-Company GAAP: Another Set of Standards to Ignore?").

But let's suspend common sense for a moment and assume the panel's solution would be both appropriate and widely embraced. Even then, we quickly find there are other risk-blind — and thus failure-prone — aspects of the solution. In this column, I'll focus on solution-development risk, which the panel hasn't addressed. I'll also explain how that risk can be mitigated.

What Is Solution-Development Risk?
Solution-development risk is a type of process risk. Specifically, it's the risk of employing a solution-development process that is ineffective or otherwise unfit for the purpose of producing a desired solution.

In concluding that a standard-setting body other than FASB should define GAAP for private U.S. companies — by specifying extensive exceptions to GAAP as set by FASB — the blue-ribbon panel has overlooked two significant sources of solution-development risk. First, as envisioned by the panel, the new standard-setting body would employ a stakeholder-engagement model very similar to the one FASB currently uses. That means major dysfunctions of FASB's current standard-setting process would be replicated, rendering the new body equally ineffective at setting appropriate standards for private U.S. companies.

The other significant source of solution-development risk comes from the strategy of creating "little GAAP" by specifying exceptions to "big GAAP." Executing such a strategy would increase the complexity of applying GAAP when complexity already makes GAAP difficult to apply. And it would do so for companies that have the least capacity to absorb additional complexity. Worst of all, it would require private-company stakeholders to pay even more attention to the standard-setting process at a time when they're already overburdened by it.

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Mitigating Solution-Development Risk
The panel believes that the main problem with FASB's current standard-setting process is the people who execute it. There's some validity to that belief; it's not reasonable to expect individuals who have had little meaningful experience as preparers, auditors, or users of private-company financial statements to set appropriate standards for private companies. But the panel has erred by focusing on getting different people to execute the standard-setting process without realizing that the process itself needs to be improved.

There is widespread and growing dissatisfaction with GAAP largely because the current standard-setting process isn't effective at engaging stakeholders. As I've mentioned publicly, the lack of scalability in the current standard-setting process precludes most private-company stakeholders (and many public-company stakeholders) from participating in it.

I advocate a simple change to the current standard-setting process. Instead of presenting marked-up text to stakeholders for inspection, FASB should present stakeholders with relevant operational models that are implied by proposed standards. Why? Because the effort to operationalize proposed standards is the most resource-intensive part of the process for stakeholders — so resource-intensive that nearly all private-company stakeholders avoid engaging in the process.

By making it easier for stakeholders to answer such questions as "How would this work in the real world?" and "What would I need to do differently?" FASB would re-engage key stakeholders in the standard-setting process, which would in turn help ensure that issued standards are both useful and operational in both the private- and public-company realms. There are many additional ways to improve stakeholder engagement, but making operational models the "handoff" to stakeholders is the single best way I know of.

Another stated belief of the panel is that a GAAP-by-exception strategy will be more expedient than alternative strategies. But it is difficult to see how a strategy that maximizes complexity, executed within the context of an ineffective stakeholder-engagement model, would actually save any time. In contrast, there are existing resources that could be refined relatively quickly to produce a high-quality set of standards for private U.S. companies. Such resources include:
• A conceptual framework for private-company accounting standards proposed by the Committee on Private Company Standards of Financial Executives International and
• The International Financial Reporting Standard for Small and Medium-Sized Entities (IFRS for SMEs) issued by the International Accounting Standards Board.


These resources aren't necessarily suitable for private U.S. companies as-is, but they're far closer to being made suitable than existing GAAP is.

Conclusion
A viable solution to the problems associated with private-company financial reporting in the United States must address solution-development risk. This means incorporating an effective stakeholder-engagement model into the solution-development process, as well as effectively managing the complexity of an inherently complex undertaking.

Contributor Bruce Pounder is president of Leveraged Logic and is the immediate past chair of the Small Business Financial and Regulatory Affairs Committee of the Institute of Management Accountants (IMA). He will be a featured speaker at the 18th annual CFO Rising Conference & Expo in March. Bruce is also the lead developer and presenter for the Webcast series "This Week in Accounting."




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