When you open a box of Cheerios you know what to expect. For those Cheerios that come in different flavors, it’s clear on the box which flavor you’re getting. This consistency is part of what makes the Cheerios brand valuable.

Edward W. Trott

Edward W. Trott

Financial statements that comply with generally accepted accounting principles also provide users with what they expect, even if there are some differences based on accounting policy options. The consistency of financial information provided by GAAP helps to reduce the cost of capital for companies (both public and private) by reducing uncertainties. It also reduces the cost incurred by financial statement users, who have access to information that helps them compare the financials of different companies. Both those elements help make the GAAP brand valuable.

But now the consistency that has helped establish that brand is being threatened. The Trustees of the Financial Accounting Foundation, the group that appoints the board members of the Financial Accounting Standards Board (FASB), set up the Private Company Council (PCC) in 2012 to advise FASB about accounting considerations that are unique to private companies. The PCC has been allowed to propose specific accounting provisions regarding private companies to FASB for its consideration.

Opinion_Bug7At PCC’s request, in 2014 FASB began providing authorized exceptions for private companies to regular GAAP. These authorized regular-GAAP exceptions have been declared part of GAAP. Thus, when financial statement users pick up a set of GAAP statements, they might be getting something they do not expect because the authorized exceptions differ from regular GAAP recognition and measurement standards.

Private companies can now choose (or not) to have different requirements concerning whether to recognize certain assets or liabilities and different ways of measuring some assets and liabilities. FASB has always provided some disclosure and effective-date differences for private companies based on cost/benefit considerations. But providing recognition and measurement differences is new.

Most worrisome about the creation of these authorized regular-GAAP exceptions to recognition and measurement is that their use is called GAAP. There’s no clear warning to users that the financial statements have employed one or more of these authorized regular-GAAP exceptions — they are labeled the same as GAAP-based statements that do not use any of these exceptions. The situation is not like the International Accounting Standard Board’s standards for small and medium sized entities. In the IASB’s case, the financial statements that use those standards are labeled as following the standards for small and medium sized entities. It’s also clear that all of a reporting company’s accounting guidance comes from this second source of accounting guidance.

In contrast, under the FASB approach private companies can choose authorized regular-GAAP exceptions or not on an individual basis. This will produce ever-increasing choices of recognition and measurement standards for reporting by individual companies as more authorized exceptions are created. All these financial statements using different recognition and measurement standards are called GAAP. In my view, this dilution of GAAP creates the opportunity for users to be confused and the cost of capital to increase for all users of GAAP. These provisions spawn new uncertainties about what is included or excluded in the financial statements.

What’s frustrating about all this is that the creation of authorized regular-GAAP exceptions is unnecessary for solving the problem they are intended to solve: providing private companies a way to avoid complying with regular GAAP standards that they feel are unnecessary by agreement with their primary financial statement users.

The most significant unique factor for private companies versus public companies is that unlike public companies, private companies have significant control over who has access to their financial statements. Private companies can negotiate with their primary financial statement users to prepare GAAP-exception (non-GAAP) financial statements to avoid those standards that the company and primary users agree are not necessary. Usually, that’s because the users already have the missing information or can get the information in another way.

Unlike the situation with authorized regular-GAAP-exception financial statements, non-GAAP exceptions aren’t written into GAAP. These exceptions are required to be labeled as non-GAAP, and the primary users get what they expect. Any other user of those financial statements is put on notice that they are different from GAAP statements.

Also, since authorized regular-GAAP exceptions will not cover all the areas some private companies will object to (for example, reporting almost all leases on the lessee’s balance sheet) GAAP-exception (non-GAAP) financial statements will continue to exist.

The FAF, which is currently seeking input for a three-year assessment of the PCC, needs to grasp that the creation of authorized regular-GAAP exceptions is contrary to any effort to simplify financial standards or financial reporting. It should be stopped, and existing authorized regular-GAAP recognition and measurement exceptions should be eliminated.

Edward W. Trott was a member of the Financial Accounting Standards Board from October 1999 to June 2007.

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3 responses to “Exceptions for Private Companies Are Damaging the GAAP Brand”

  1. I agree. The latest attempt by the FASB to be all things to all people has created a wider gap to the organizations intended mission which is to provide a consistent basis by which a company’s performance can be measured and a value derived. By creating different standards for differently-sized organizations, which are largely ignored for professional valuation purposes anyway, you end up a situation where the standards themselves have no value.

  2. I don’t think it’s the exceptions to GAAP that have hurt GAAP. It’s GAAP itself. If Cheerios put a bad tasting product in the box, the brand would not be worth much. It’s only the quality of the product on a consistent basis that is important for the brand to be valuable. GAAP has strayed from reporting that is meaningful to the users of financial statements. The measurement of success avoids the actual purpose of a business operation, having more CASH at the end of the operation than at the beginning. That’s it plain and simple. Take the example of a lease. The reason I lease the property is NOT to avoid having an asset on my balance sheet, it’s because that provides me with the most certain cost for using that asset for the time that I will have a use for it. The asset in it’s total is an EXPENSE, NOT extra cash in my pocket, even if I still have the asset at the end of operations, or it is no longer serviceable in the operation, it is not of value, in fact it may cost more cash to dispose of it. GAAP has over time leaned more toward recognizing revenue before it is received (which is the only time you actually have it), and deferring recognizing expenditures (despite the fact that the CASH is gone, gone, gone). So the GAAP compliant statements don’t really recognize success or failure in terms of CASH growth or decline in a simple straight forward way. It isn’t the brand that is the problem, it is the product!!!

  3. Regular GAAP exceptions are not a new invention of the FASB. There have been a myriad of such exceptions over the years, accounting for stock options being one. The issue now is that generally accepted accounting principles as not “generally accepted.” The FASB has created, issued, and revised and reissued, numerous standards that just don’t have broad applicability to public and private companies alike. Accounting standards for variable interest entities, uncertainties in income taxes, and fair value measurements are complex and difficult to apply and understand. Certain of those standards (some of which bear Mr. Trott’s fingerprints) are not useful to the users of private company financial statements. Plus, such standards require a cost to comply that is out of balance with the related benefit of compliance. Mr. Trott may argue that the solution to such problems is for private companies to issue GAAP-basis financial statements with GAAP exceptions. However, how many exceptions does it take for GAAP-basis financial statements to be perceived as no longer being in compliance with GAAP? Private companies and their constituents have long asked the FASB to produce standards that are not only responsive to the needs of large public companies, investors, and analysts, but to the smaller, more numerous private companies and the users of private company financial statements. The FASB is just giving those constituents what they need and have been asking for. If Mr. Trott seeks to understand why the GAAP brand is damaged, he only needs to look in the mirror and honestly assess the quality, applicability, and complexity of standards for which he was partly responsible.

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