A Move toward Separate Accounting Standards for Private Companies Begins
For all those private companies frustrated with being forced to spend $25,000 on a valuation of intangible property or goodwill, or spending hours drafting disclosures that users may not read, or being burdened with a myriad of other financial reporting responsibilities, there may be some relief on the way.
Set aside all you've heard about U.S. companies converging with international standards for a minute. Setting public-private accounting standards is a different issue and one that's been debated for decades. The Financial Accounting Foundation (FAF), the parent of accounting's ruling body, the Financial Accounting Standards Board (FASB), is considering the adoption of a recommendation made by the Blue-Ribbon Panel in its report to the FAF Board of Trustees. In its report, the panel recommended that, under the FAF's oversight, a separate private company standards board be established to help ensure that appropriate and sufficient exceptions and modifications are made to U.S. GAAP for private companies.
Perhaps the best way to understand what's transpiring is to get answers to the following questions: What exactly is the blue-ribbon report? When might its recommendations affect accounting for private companies? Why did it come about? What are some of the problems private companies are experiencing with public company GAAP accounting?
The first thing to know is that even if a private company standards board is established, as was recommended, it wouldn't represent a dismantling of GAAP accounting. Think "tweak" rather than a wholesale rewriting of current rules. In fact, the FASB has its own private company committee that makes recommendations to the main board, but the blue-ribbon panel recommendation seems to signal a lack of confidence that the committee's input is being considered.
Now to the question of when. The FAF has not indicated it will appoint a separate board. If it does, it will take some time to begin hard adoptions of new standards. Don't look for this to happen for a year or even two. Also at issue is how to provide funding for a new board.
Next is the question as to why the report came about. U.S. GAAP has many requirements that some believe aren't relevant to smaller companies. The world has become more complex, especially for large multinational corporations. But requiring small companies to provide the same complex information as large companies can be expensive, time consuming, and, in many cases, can produce information that users of the information – acquirers, investors, and lenders – don't value. The movement is about simplifying private company reporting.
Gary Fowler, the senior vice president and regional manager of Bank of the West, says he analyzes an average of a dozen financial statements a week. He and his staff often "back out" non-cash items, such as mark-to-market assets and value of intangible goodwill.
"Relevancy is the key throughout this. We're trying to get to an operational cash flow and analyze what the company can afford on payments," Fowler said. "A non-cash item doesn't add any value to us."
According to Fowler, the last thing the bank wants to do is terminate a loan because the value of a derivative fluctuated in market value and caused a technical violation of a company's loan covenant. The bank protects itself by periodic valuations of any assets pledged as collateral, but the primary focus of large commercial lenders is free cash flow.
"The fact that private companies are held to a public company standard seems unreasonable, given the cost of keeping up with that information," Fowler said. "A lot are spending thousands if not tens of thousands on this. We support the formation of a separate private company board because our focus is more on ongoing relationships with our borrowers, not on technical non-cash aspects of loan covenants."
Finally, let’s look at issues that rankle private company owners. The evidence of some of the pain companies are feeling is the increase in the number of private companies choosing to issue income tax or cash basis financial statements or take GAAP exceptions in their reports, particularly the requirement to consolidate the books of variable interest entities related to the parent company.
Take, for example, a business owner who personally owns and leases a building to his or her company. Bank of the West's Fowler said he typically would look at the lease as an expense of the company and the assets separately, not as a consolidated balance sheet.
Ed J. Rand, COO/CFO of American Exteriors, LLC (a $35-million manufacturer and marketer of custom windows), says that even though many of the latest accounting rules seem arcane or irrelevant to his business, his company complies with every new GAAP change. "I have a hard time saying private companies should be different from public companies, except for public companies, there are more disclosures," said Rand.
Because his is a private equity-owned company, he spends a lot of time explaining esoteric elements of his balance sheet – such as the partial step-up in basis resulting from a leveraged buyout transaction – to banks and insurance companies, the primary users of his financial statements. "We expend an incredible amount of time on accounting standards because that's GAAP and that's disclosure. It's set by the industry and we have to comply if we want to have a clean opinion, but it has no great value for the readers of our statements," Rand added.
So, if an accounting system is expensive and irrelevant to users, it's not an ideal framework for financial reporting. Following are some areas to keep an eye on if and when a private company board gets to tweaking current rules.
Fair value disclosures. Under current rules, a company has to mark-to-market an asset to the asset's current value on the balance sheet. Examples might be investments and intangible assets. This involves the cost of having an appraisal done and using valuation models to determine fair value. For an asset you don't plan on selling in the near term, you might question whether it's relevant information. Impairment testing of goodwill – the premium over the value of individual assets paid in an acquisition – is particularly vexing. To do it right, you might have to have your company valued every year.
Derivatives. It can be a lot of work and expensive to determine the fair value of derivatives, and the value of that information depends on your point of view. Is today’s value of a futures contract that won't settle for two years relevant? You see many futures contracts with oil and gas, agriculture, and commodity-related businesses. This information is probably more useful if a change in ownership is being contemplated.
Uncertain tax position. A recent rule requires a company to analyze its tax returns and to outline things the IRS may challenge and then, potentially, accrue a liability for them. You have to assume the IRS will be aware of all relevant facts and make a judgment. Not only is that complicated, but some would say it's a road map to an IRS audit.
Stock options. Companies must expense the value of stock options. Some believe that granting stock options is a non-cash expense that doesn't affect the bottom line; rather, it's more a dilution of equity. Many lenders add that expense back to net income calculations. Also, it takes time and money to put a fair value on the options, and the rules on how to record the expense can be complicated, depending on the terms of the option.
Consolidation of businesses. The most common example of this is when a business owner owns a building that he or she leases to the company. Current rules often require the business owner to consolidate those two balance sheets. If a manufacturing company activity requires an audit, the owner doesn't want the expense of a second audit of his or her company that owns the building.
One-size-fits-all standards cause difficulties in the financial industry, but so do two sets of standards. What side of the argument are you on? Your position on the issue will depend on your situation, industry, and ultimate goal. If you're a private company going public, you might want to follow the public company model. If you're a closely held company and want to stay that way, some alterations of current accounting rules may be to your advantage.