Historic Changes in Private Company Financial Reporting

On May 30, 2012, the Financial Accounting Foundation (“FAF”) issued its final report on the “Establishment of the Private Company Council (“PCC”).  The PCC will be comprised of 9 to 12 members, including a chairperson (who will not be affiliated with the FASB), all of whom will be appointed by the FAF.  Terms will generally be for 3 years with possible reappointment for an additional 2 year term.

The PCC and Financial Accounting Standards Board (“FASB”) will work together to determine criteria for whether and when exceptions or modifications to GAAP are needed for private companies.  Exceptions or modifications to GAAP will be exposed for public comment if endorsed by a simple majority of FASB members.  The exceptions or modifications will then be redeliberated by the PCC for final approval by FASB.  If approved, the exceptions or modifications will become GAAP.  All existing GAAP will be reviewed by the PCC to determine if any standards require reconsideration for private companies. In addition, the PCC will be actively involved as the primary advisory board to the FASB regarding current FASB projects and their implications to private companies.

HOW WE GOT TO TODAY
Numerous efforts to improve private company financial reporting have been attempted without success over the years.  The current effort began in January 2011, when a Blue Ribbon Panel on Private Company Financial Reporting issued a set of recommendations on the changes necessary to best meet the needs of the users of private company financial statements.

Noting, among other factors, that exceptions taken in auditor’s reports on private company financial statements can be confusing, the panel recommended creation of a new, autonomous board with private company standard-setting authority.  The Panel also called for utilizing existing Generally Accepted Accounting Principles (GAAP) as the starting point for any modifications to private company financial statements.  The Panel wanted to give the new standard setters the ability to provide near-term relief by granting exceptions or modifications to existing GAAP rather than starting from scratch.

On October 14, 2011, the FAF released its plan to improve the standard-setting process for privately-held businesses based on the Blue Ribbon Panel’s recommendations. It essentially included all of the Panel’s recommendations, except one.  The FAF plan did not include an autonomous board for private company standard setting.  Rather it called for the creation of a new board that is chaired by a member of the FASB with recommendations subject to FASB approval.

While the FAF envisioned a collaborative effort by the new board and the FASB, the plan resulted in strong public opposition for creating a less than autonomous board.  The public comment period on that plan closed on January 14, 2012, and the FAF received more than 6,500 comment letters.  Many expressed concerns that the FAF plan falls significantly short of what is needed to improve private company financial reporting standards. There was hope that the FAF would reconsider because the plan was considered to be a continuation of an ineffective strategy that has been in place for the last 30 years.  Only time will tell if this new council will help solve the financial reporting issues that private companies are challenged with.

WHAT AREAS NEED IMPROVEMENT?
The private company reporting system is likely to consider several areas of concern.  Two issues of particular interest are consolidation of variable interest entities (formerly FIN 46) and derivative accounting for interest rate swaps.

In response to public company scandals related to off-the-books financings, FIN 46 focused on the consolidation of variable interest entities.  FIN 46 changed the accounting rules related to a variable interest entity and these changes often times resulted in the consolidation of related entities in a single set of financial statements, even if their operations were very different.

While this may have made sense for preventing future public company debacles, often times it did not make sense for a private enterprise which, for tax purposes, used a different entity to hold real estate but was now forced to consolidate the properties for financial reporting purposes.  This was especially problematic when the historical cost of the real estate was significantly less than its fair value and the mortgage.

The PCC is also likely to address the way derivatives are treated.  Banks often encourage small, closely held businesses to enter into an interest rate swap to effectively fix the rates on their customer’s borrowing.  Accounting rules sometimes result in the changes in fair value on these swaps being accounted for in the income statement, often significantly impacting the earnings of an entity.  Again, this is an example of a rule established with large public companies in mind, yet significantly impacting the financial reports of a privately owned business.

Other problematic areas in need of improvement include: fair value reporting, financial instruments, income tax accounting, goodwill, and share-based compensation.

WHAT’S NEXT?
We are hopeful that this new system will be more relevant to the users of private company financials.  Earlier this year, the FASB undertook a project to provide a consistent and clear definition of a private company.

In addition, the AICPA has undertaken a project to create an Other Comprehensive Basis of Accounting framework for small and medium sized entities.  The vision is that this framework would be used by small and medium sized owner-managed entities where GAAP financial statements are not required (i.e. for bank financings).

It’s important to note that no one is looking for a reduction in the quality of accounting standards, as is inferred in the reference to the so called “Little GAAP” or “GAAP Lite”, but rather, the changes are designed to offer a set of quality standards that are more “relevant” to company owners, bankers, investors, accountants and bond underwriters.  In an age when we are seeing an explosion of new rules for public companies, having a group that focuses on private company financial reporting would certainly be welcome!

James P. Kenney, CPA is a Member of the Firm at Wolf & Company, P.C. and can be reached at 617- 428-5433 or by email at jkenney@wolfandco.com.

This article discusses recent updates about private company financial reporting.  As changes occur, we will update the content. To receive information of interest to private companies, email us at privateco@wolfandco.com.

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