Private-Company GAAP: Setting the Right Goal

Are efforts to fix private-company financial reporting in the United States focused on the wrong solution?
Bruce PounderDecember 10, 2010

Stakeholders of private U.S. companies are increasingly dissatisfied with generally accepted accounting principles as set by the Financial Accounting Standards Board. Dissatisfaction with GAAP, coupled with the freedom to ignore it, has led private companies to report financial information in diverse ways. Such diversity has resulted in varying reliability and limited comparability of reported information. At the same time, private companies that adhere to GAAP at the insistence of their stakeholders find themselves bearing increasing costs and complexities. If unsolved, these problems pose significant risks to the competitiveness and overall health of a major sector of the U.S. economy.

Over the past year, a blue-ribbon panel has been exploring potential solutions to the problems of private-company financial reporting in the United States. The panel’s aim is to identify a better way of setting accounting standards for private U.S. companies. In theory, improved standard-setting would enhance the usefulness of financial information reported to stakeholders while reducing the burden on reporting entities. Unfortunately, the “solution” toward which the panel is leaning could make our current problems even worse than they are today.

In my previous column, I briefly summarized four key risks the panel has not addressed. In this column, I’ll drill down on the first risk, solution suitability, which is a type of goal-setting risk. I’ll also explain how solution-suitability risk can be mitigated.

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What Is Solution-Suitability Risk?
Solution-suitability risk is the risk of setting a wrong goal — one that if attained would fail to solve the problem it’s meant to solve. In many cases, attainment of an unsuitable goal would actually exacerbate the problem. Consequently, mitigating solution-suitability risk should be a top priority in projects that involve large-scale, transformational change.

There are two significant factors that contribute to solution-suitability risk. One is when change agents have a poor understanding of the problem to be solved. This is likely to be the case when key stakeholders aren’t intimately engaged in the change process.

Another factor that contributes to solution-suitability risk is when change agents adopt a “brainstorm and vote” approach to defining the solution to be pursued. Identifying potential solution candidates through brainstorming typically results in a relatively small set of alternatives that differ only incrementally from the status quo and fail to overcome existing trade-offs. As a result, “breakthrough” solutions are unlikely to be included in the identified alternatives. In addition, consensus may be difficult to achieve, and even if it is achieved, it will not be on an optimal solution.

Risk Factors Present
Through its deliberations, the panel on private-company financial reporting identified several alternative standard-setting models and tentatively concluded that a new standard-setting body should define a “little GAAP” for private U.S. companies by specifying extensive exceptions to “big GAAP”; i.e., GAAP as we know it today. Big GAAP would continue to be maintained by FASB, and public U.S. companies would continue to use it.

With regard to the suitability of this solution for solving the problems of private-company financial reporting, both of the risk factors described above are present, yet the panel has not formally acknowledged or addressed them. As a result, the panel is at significant risk of ultimately recommending an unsuitable solution.

To date, certain key stakeholders have not been intimately engaged in the panel’s activities. Specifically, the panel’s sponsors do not include any organizations of the primary users of private-company financial information: lenders, owners (typically venture capitalists or other investors), and surety companies. Furthermore, such users are clearly a minority of the panel’s membership. And in response to the panel’s solicitation of written input from interested parties, only 4 responses came from lenders and owners, and none came from sureties. In contrast, 103 responses came from certified public accountant firms and state CPA societies.

The pitfalls of the panel’s brainstorm and vote approach are also apparent in the candidate solutions considered by the panel. In every case, private-company GAAP would, like current GAAP, focus on general-purpose financial reporting. In other words, financial reporting would be geared toward stakeholders who are not in a position to demand specific information from the reporting entity. But unlike most users of public-company financial information, most users of private-company financial information are in a position to demand information tailored to their own subjective needs. Those needs also vary significantly among users, and in most cases users in the private-company realm have the bargaining power to get exactly the information they want. Thus, in the private-company realm, there is little need for general-purpose financial reporting relative to the need for:
• General-purpose financial reporting in the public-company realm; and
• Specific-purpose financial reporting in the private-company realm.

Another concern with the suitability of the panel’s tentative solution is that private-company GAAP would be derived by making incremental exceptions to public-company GAAP. The result: reporting entities and stakeholders would face an even-more-complex standards environment than the current one. Essentially, one would always have to “go through big GAAP to get to little GAAP.”

Mitigating Solution-Suitability Risk
How can change agents mitigate the risk of setting a wrong goal and instead maximize the suitability of any solution they may come up with? There are three critical tactics.

First, change agents must develop a profound understanding of stakeholders’ needs and capabilities, in all their diversity. This starts with active, deep engagement of all key stakeholders. It is subsequently enhanced by systematic, rigorous research.

Second, optimal solutions are best identified by a design approach rather than the more common brainstorm and vote approach. Design starts with defining what an optimal solution should look like, and then proceeds to systematically investigating how such a solution could be realized.

Third, never assume that you can “set it and forget it.” Any solution that is suitable today can quickly become obsolete in our increasingly volatile business environment.

Setting the right goal with regard to improving the process by which accounting standards are set for private U.S. companies will require mitigation of solution-suitability and other risks. Ignoring risk management in such a significant undertaking is nothing short of irresponsible.

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 2011. Bruce is also the lead developer and presenter of the Webcast series “This Week in Accounting.”