A GAAP of Their Own

Private companies seeking a wholesale exemption from FASB's accounting rules are likely to be disappointed.
Alix StuartJuly 1, 2005

Oh, to be a private company, with no need to file Securities and Exchange Commission reports and able to grow your business unfettered by the Financial Accounting Standards Board or interrogations from auditors.

Think again. Private company CFOs say they are getting the short end of the stick when it comes to financial reporting. Although not subject to SEC rules, about 70 percent of private companies end up preparing GAAP financial statements to satisfy lenders and investors, according to the American Institute of Certified Public Accountants (AICPA). That exercise is getting increasingly expensive and irrelevant, say executives at such companies, as public-company reforms push up both the cost of auditors’ time and the complexity of GAAP.

“We’re getting caught in rules and regulations that were designed for Enron, not for us. As the costs start to go up, you question whether the benefit of reporting is worth the cost,” says Jeanne Henry, CFO of Waltham, Massachusetts-based Atlas Venture. A survey of private-company executives by law firm Foley & Lardner LLP shows a 34 percent increase in compliance fees over the past year.

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As a result, a growing number of private firms are beginning to call for an alternative version of GAAP tailored to the typical structure and resources of a private company. Leading the charge is the AICPA’s Private Company Financial Reporting Taskforce, which includes Henry, along with other private-company CFOs, venture capitalists, bankers, and auditors. “There needs to be a dedicated process to focus on the needs of accounting for private companies,” says Dan Noll, director of accounting standards for the AICPA and staff leader for the task force. Some members even advocate a separate standards-setting board.

What are the chances of success? FASB is currently disinclined to go as far as the task force wants. And, of course, the SEC has nothing to say about the question, since private companies don’t raise capital from the public. Not everyone, for that matter, is convinced that GAAP has serious gaps for private companies. Many bankers, auditors, and watchdogs like the accounting setup as is, or prefer only ad-hoc exceptions. “The financial statements should reflect the worth of the assets and liabilities,” says Jack Ciesielski, publisher of the Analyst’s Accounting Observer newsletter. “If it’s a good idea for a public company, it’s a good idea for a private company.”

Other users of financial statements share that view. A survey commissioned by the AICPA last year of about 1,000 private-company executives, auditors, and financial-statement users found that bank lenders, venture capitalists, and surety lenders rated GAAP high — 2.5 on a scale of 1 to 3 — for its utility in making credit or investment decisions. When respondents were asked why they required GAAP, the highest ranking answers were the standardized language it provides and the fact that it permits easy comparison among many companies. Sixty-eight percent of lenders said GAAP provides useful information; 77 percent of investors and surety/bonding firms agreed.

“The financial industry needs some type of standard comparative basis, so that a machine shop in Massachusetts looks the same as one in California,” says task-force member David Maraman, who is also chief credit officer and a senior vice president at First Indiana Bank.

Nevertheless, the task force concluded that the survey found a need for change, based on the number of survey respondents who stated that certain parts of GAAP were not useful for them. “The results clearly showed the need in some instances for different accounting standards for private companies than for public companies,” says task-force member Arthur Neis, vice president, treasurer, and CFO of Life Care Services LLC, in Des Moines.

What’s Antithetical

While the survey did not address the specifics of what needs to change for private companies, a number of ideas are percolating in the marketplace. For one, critics say the level of disclosure should generally be lower, given the overlap between private-company managers and shareholders, and close relationships with accountants and bankers.

In addition, a report by the AICPA task force found a number of standards to be antithetical to private-company structures. These include FIN 46, which covers accounting for variable-interest (aka special-purpose) entities; lease accounting; goodwill accounting; buy-sell agreements; and a variety of pronouncements that call for marking assets to market value.

FIN 46 is a prime example of overkill for private companies, says Mark Ellis, a member of the AICPA’s private-company task force, and CFO of private luxury-goods retailer Michael C. Fina, based in New York. The rule requires him to consolidate reporting for Michael C. Fina’s real-estate arm with its main retail businesses, since one entity helps guarantee loans for another. While Ellis sees the logic, he says FIN 46 causes more harm than it is worth for his company’s four segments, because neither his lenders nor his stockholders view the businesses as one. “The bankers know what we own,” he says, so “combining the businesses is not something our owners or our banks need or want us to do, and it is costing us money.” Most of the cost involved in conforming to FIN 46 involves paying for their CPA firm to combine everything.

Perhaps most worrisome to private-company CFOs is FASB’s increasing interest in fair-market valuation, particularly in mergers and acquisitions. Not only are fair values potentially costly to determine for nonpublicly traded assets, such values are often meaningless to outside investors or lenders. Atlas’s Henry, for example, is concerned that making fair-market value part of GAAP will needlessly detract from her portfolio companies’ focus on their core business efforts. Atlas currently requires all portfolio companies to provide audited GAAP financial statements. However, if a company that Atlas invested in was spending all of its time trying to figure out what its assets were worth, Henry isn’t sure the cost of that time would be worth the benefit. “For a VC, it’s really all about cash,” she explains.

Other types of lenders also say they don’t need the fair-market valuations from private companies, even if GAAP requires it. For a bank, the nature of the asset — and how close it is to being a commodity — is what is most important, according to First Indiana Bank’s Maraman. “Regardless of what type of valuation you receive on a financial statement, a bank is going to do its own assessment of lendable value,” he says. “The idea of getting a mark-to-market value is totally unhelpful,” since a bank is looking “at how liquidatable the assets are,” something an accountant could not “possibly reasonably factor in.” For example, an inventory of paint pigment would be valued more highly than an equally priced stock of mixed paint, he says, because the pigment could be sold on the market, while the mixed paint could not.

Ad Hoc Okays

Still, FASB recognizes that some of its rules aren’t appropriate for private companies. In November 2004, for instance, the board agreed to “indefinitely delay” portions of SFAS 150, which governs buy-sell agreements in response to complaints from Financial Executive International’s (FEI) private-company committee. The rule would have required private companies to record as liabilities the “mandatorily redeemable” shares they agree to buy back from partners or owners upon death or retirement. For private companies, nearly all shares are likely to be mandatorily redeemable because there is no public market for them. Under this treatment, nearly all private companies would appear to be insolvent, says Neis, since the liability is shown at current redemption value but the assets are not. Paradoxically, the only way the liability would decrease would be if the company’s value declined.

While FEI considered that outcome a win, it serves to undermine the argument that sweeping change is necessary, because it shows FASB as reasonably open to requests for specific exemptions. Further short-circuiting the argument is the fact that lenders and investors seem happy with the pro-forma versions of GAAP that they now work out with companies. About 70 percent of banks and 60 percent of VCs and surety lenders surveyed by the AICPA say they accept GAAP statements with exceptions, at least in some cases. “We can use what we have now,” says Maraman, since “banks are still going to do their due diligences,” regardless of the relevancy of the filings. He notes that his bank will also often accept accountant-reviewed financials rather than audited ones to help reduce costs.

What’s more, points out Ciesielski, FASB has long waived segment-reporting requirements for private firms, and offered exceptions for stock compensation or making fair-value disclosures about financial instruments. “Those exemptions are sensible because there isn’t a need for the information; scoping them out of the applicable standards keeps things sane,” he says. But he insists that FASB shouldn’t go further than making such exemptions as the need arises. “Do we really need different revenue-recognition standards or different income-tax accounting standards?” he asks.

In fact, building a separate GAAP for private companies may only make it more difficult for such companies to get financing in the long run. “Most private companies, including family-owned businesses, are likely to be faced with a transition event at some point, whether it’s through an IPO, a private-equity firm investment, or a strategic acquirer,” says Jay Mattie, audit leader for PricewaterhouseCoopers’s Private Company Services practice. “If two standards were in place, it would be a real challenge to manage that conversion process.”

Where the AICPA’s effort will go from here is anybody’s guess. FASB has included private companies on its small-business advisory board, and FEI recently formed a subcommittee within its private company task force to study the issue further. However, the outcome is ultimately contingent on FASB’s approval and enthusiasm.

With no further meetings set between the AICPA’s private-company task force and FASB at press time, it is “impossible” to put a time frame around the project, says Noll. FASB has publicly encouraged the task force’s efforts, and chairman Robert Herz has said he is open to making “some little differences,” but he is clearly not looking for a revolution. “I’m not in favor of a completely different set of GAAP [for private companies],” he said at a recent CFO conference.

And given the potentially monumental changes that GAAP is already slated for in light of the impending convergence with international accounting standards, keeping the status quo may be the sanest approach. Says Ciesielski: “The ‘House of GAAP’ has grown so large that adding another wing to it is ludicrous.”

Alix Nyberg Stuart is a senior writer at CFO.

Exceptions to the Rules

Lenders and investors frequently allow private companies to make exceptions to GAAP in their financial statements, upon request. The table below shows the most common alterations.

How often private companies report exceptions to particular GAAP requirements (in %)
Creditor/Lender Investor/VC Surety/Bonding
Accrual basis of accounting 57.7 54.9 60
Cash-flow statement 53.5 54.8 56.9
Fair-value basis of measuring assets & liabilities 49.3 50 60
Deferred income taxes 43.7 40.3 52.3
Intangibles 40.8 45.2 38.5
Source: AICPA