Over the past year, a blue-ribbon panel has been exploring potential changes to the process by which financial accounting and reporting standards are set for private U.S. companies. The panel’s mission reflects private-company stakeholders’ growing dissatisfaction with generally accepted accounting principles as set by the Financial Accounting Standards Board. Unfortunately, the panel is leaning toward a “solution” that would likely make current problems worse rather than better.

One Size Doesn’t Fit All

In theory, GAAP applies equally to all U.S. companies, public as well as private. In practice, FASB sets GAAP primarily for public companies while exempting private companies from certain provisions. In addition, the Securities and Exchange Commission supplements GAAP with certain financial reporting requirements that apply only to public companies. Thus, the financial accounting and reporting standards that are applicable to private U.S. companies are somewhat different from standards that are applicable to public U.S. companies. But many private-company stakeholders have come to believe the standards aren’t different enough.

For decades, the advantages and disadvantages of having a greater distinction between public-company GAAP and private-company GAAP have been debated. Because public companies are commonly presumed to be “big” entities and private companies are generally said to be “little” entities, the debate has traditionally been known as the “big GAAP-little GAAP” debate. Over time, the less-presumptive adjective “differential” has come into use, such that the debate is now often referred to as being about “differential standards.” Regardless of the terminology, the dream of a distinct “little GAAP” has grown within the private-company community as a result of increasingly widespread — and increasingly intense — dissatisfaction with “one size fits all” GAAP.

Why are private U.S. companies and their stakeholders increasingly dissatisfied with GAAP? There are two main reasons, both of which stem from the continual stream of significant changes to GAAP in recent years. First, alignment between the information contained in GAAP-compliant financial statements and the information needs of private-company financial-statement users is poor and getting worse. Second, the cost and complexity of preparing GAAP-compliant financial statements are growing disproportionately in relation to the benefits of providing such financial statements to private-company users. Both of these conditions are perceived to be far more severe in the private-company realm than in the public-company realm.

Diversity in Practice

Public U.S. companies are legally required to use GAAP for statutory financial-reporting purposes. In contrast, private U.S. companies aren’t subject to statutory financial-reporting requirements and may use any accounting standards they choose when preparing financial statements for use by lenders, venture capitalists, surety companies, and so forth. Dissatisfaction with GAAP, coupled with the freedom to choose which accounting standards to use, has resulted in decreasing use of GAAP by private U.S. companies.

Some private U.S. companies adhere strictly to GAAP, but many follow GAAP only up to a point, explicitly disclosing departures from GAAP in their financial statements. Still other private U.S. companies avoid GAAP altogether by doing cash-basis accounting, tax-basis accounting, or some “other comprehensive basis of accounting” (OCBOA).

The use of diverse accounting standards by private U.S. companies creates several problems for users of their statements. Under diverse standards, the reliability of reported information can and does vary greatly from company to company. Furthermore, it is difficult for users to compare financial statements across companies and over time.

Fixing the Problem

In the private-company realm, unfavorable trends in GAAP and the disadvantages of using diverse alternatives are matters of pervasive and deep concern to those who must bear the consequences first-hand. But these realities also raise public-policy issues; aligning private-company reporting with the information needs of financial-statement users and aligning its costs with its benefits would reduce capital costs and operating costs for companies that make up a large sector of the U.S. economy. As a result, economic recovery and growth could be enhanced by improving the way private-company financial accounting and reporting standards are set and used.

In December 2009, three prominent accounting organizations announced the formation of a blue-ribbon panel to investigate and recommend potential improvements to the standard-setting process for private companies in the United States. The panel’s sponsoring organizations are:
• The Financial Accounting Foundation (FAF), FASB’s parent organization;
• The American Institute of Certified Public Accountants (AICPA), a voluntary membership organization for certified public accountants; and
• The National Association of State Boards of Accountancy (NASBA), a voluntary membership organization for state-level governmental agencies that regulate the practice of public accountancy.

The panel has met publicly on four occasions. Through its consideration of input from interested parties and its own deliberations, the group has tentatively identified the following elements of a new approach to setting GAAP for private U.S. companies:
• Private U.S. companies would get a distinct little GAAP; that is, a set of standards significantly different from full or “big” GAAP, which public U.S. companies would be expected to continue using.
• Little GAAP would be defined by specifying extensive exceptions to big GAAP.
• The identification of appropriate little-GAAP exceptions would be done by a new standard-setting body separate from FASB, which would continue to set big GAAP.

Unfortunately, the path forward that the blue-ribbon panel has tentatively defined leads directly into a dense thicket of significant risks. If unmitigated, those risks are likely to thwart the panel’s best efforts. And the failure of the approach the panel is contemplating would make things worse than they are now for private companies, their stakeholders, and the U.S. economy. How? Introducing an additional set of standards without attaining pervasive acceptance and successful implementation would increase the diversity of standards used by private U.S. companies. In turn, this would further reduce comparability across reporting entities while increasing the complexity and cost of financial-statement preparation, auditing, and analysis. And the flow of capital to private companies could be disrupted at a time when our economy cannot bear such a disruption.

What Are the Risks?

There are two kinds of risks associated with the solution being contemplated by the panel: goal-setting risks and process risks. Furthermore, there are two specific risks of each kind, for a total of four key risks. In my next several columns, I’ll explore each of the risks in turn and explain how each can be mitigated. But for now, here’s a brief summary of the risks.

The first goal-setting risk is solution-suitability risk. That is the risk of defining a target solution that inherently cannot solve the problem it is intended to solve. In essence, this is a risk of setting the wrong goal — one that is ineffective or otherwise unfit for the purpose of solving a particular problem. For example, in rejecting the “one-size-fits-all” GAAP, the panel has ironically embraced the concept of “one-size-fits-all-private-companies” GAAP, despite the vast diversity of users’ information needs and preparers’ capabilities in the private-company realm. Such a solution could be at least as onerous as the problem it is intended to solve.

The second goal-setting risk is solution-acceptance risk — the risk of defining a target solution that will be rejected by stakeholders whose voluntary acceptance of the solution is necessary for success. So far, the panel has received input from very few of the key stakeholders in this matter; namely, users of private-company financial statements. And what input the panel has received has been largely anecdotal and rife with contradictions. As explained above, private U.S. companies can easily ignore standards that they don’t have a say in, don’t understand, or simply don’t like.

The first process risk is solution-development risk. In this case, it’s the risk of employing a solution-development process that inherently cannot produce the defined solution. In other words, it’s the risk of using a development process that is ineffective or otherwise unfit for its purpose. As contemplated by the panel, a separate standard-setting body would likely employ a standard-setting process similar to FASB’s current process and thus replicate the existing dysfunctions of that process, which are particularly notable with regard to setting standards for private U.S. companies.

The second process risk is solution-implementation risk, which is the danger of employing an implementation process that inherently cannot succeed at deploying the developed solution. Because the millions of individual and corporate users of private-company financial statements are far removed from the influence of the panel’s sponsoring organizations, implementation challenges of any solution loom large.

Conclusion

Without risk management, a move toward little GAAP for private U.S. companies is likely to turn into a fiasco. Fortunately, there are several specific steps that can be taken to foster success and avoid failure. And if you’re a private-company CFO, you can play an important role — be sure to watch for my upcoming columns.

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 is also the lead developer and presenter of the Webcast series

“This Week in Accounting.”