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When Accounting Standards Diverge

Robert Herz | April 29, 2014

One of the bigger questions in accounting is if there should be different standards for different sets of companies.

Last fall, I participated in a roundtable on the topic at New York University called, “Big GAAP vs. Little GAAP: Public Company and Private Company Reporting.” The roundtable focused on the pros and cons of having different accounting standards for private companies from those for public companies and included a discussion of recent private company reporting initiatives by the Financial Accounting Standards Board and the American Institute of Certified Public Accountants.

 Before the roundtable discussion began, I was chatting with one of the accounting professors who remarked, “Remember the good old days when GAAP was GAAP?” He said that nowadays he needs to teach both U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards and did not seem thrilled with the prospect of potentially also having to cover new differences in accounting for private and public companies. I reminded him that the “good old days” were not quite that simple, since there have long been some differences in the reporting requirements for public and private companies.

Private companies, for example, are exempt from the requirements to present earnings per share, segment reporting, and various specific presentation and footnote disclosures mandated by Securities and Exchange Commission regulations. Still, I had to admit that financial reporting is certainly more complex now and that we may be heading toward a more diverse, multi-dimensional financial reporting system in the United States.

Just where might we be heading in terms of the use of different accounting standards? First, in terms of reporting by SEC registrants, there have long been differences in the requirements between domestic registrants and foreign registrants. Until relatively recently, however, the SEC required foreign-based companies raising funds in our public capital markets to either file financial statements prepared under U.S. GAAP or supplement their home country financial statements with detailed reconciliations between earnings and stockholders' equity as reported in those financials with what they would be under U.S. GAAP. Foreign companies filing in the United States must also provide various additional disclosures comparable to those required of domestic registrants.

A Tale of Two Standards

Those requirements were intended to enhance the comparability of financial information across all SEC registrants regardless of where they were domiciled. In late 2007, as part of its long-standing support of the development of a single set of international accounting standards and in light of the progress being made by FASB and the International Accounting Standards Board in their convergence efforts, the SEC decided to allow foreign registrants using “full” IFRS as promulgated by the IASB to file in the United States without having to convert or reconcile their financial statements to U.S. GAAP.

That move by the SEC, which was criticized by some as reducing the comparability of financial information in the U.S. capital markets, was very important to promoting the rapid spread of IFRS around the world.  It effectively provided non U.S. companies with a more cost-effective reporting passport to raising capital across the globe, including in the United States, the world's largest capital market. And so it was not surprising that governments and regulators in many countries quickly decided to require or allow their listed companies to use IFRS.

While the PCC-FASB effort is not intended to create a parallel “Little GAAP,” private companies preparing GAAP financials are allowed to choose any or all of the alternative private company modifications.

As a result, the number of companies around the world using IFRS has mushroomed as has the number of foreign companies listed on U.S. stock exchanges that use IFRS. This led some to call for the SEC to allow U.S. companies, particularly those with significant foreign operations, to also use IFRS instead of U.S. GAAP. Since this has not occurred, we now effectively have two sets of widely used accounting standards in our public capital markets. For those emphasizing the importance of comparability, continued convergence between IFRS and U.S. GAAP would seem to be highly desirable.

What About Private Companies?

Perhaps somewhat paradoxically, as efforts aimed at reducing the number of differences in accounting standards used by listed companies around the world continue, there has been a movement toward differential accounting standards between public and private companies in the United States. I would note that we are not unique is this regard, with many other countries already adopting different accounting standards for private companies in varying degrees.

In the “good old days” of U.S. GAAP, although there were differences in certain presentation and disclosure requirements between public and private companies, by and large it contained the same accounting recognition and measurement principles and practices for public and private companies. This approach was premised on the benefits of comparability to users of financial information resulting from having the same transactions and arrangements accounted for the same way regardless of whether a company was public or private. It also reflected a view that having different standards for public and private companies or what was termed “Big GAAP vs. Little GAAP,” would impose additional costs and complexity across our reporting system. It would create, for example, the need to educate and train accountants, investors, and regulators in two different sets of standards.

On the other hand, there have also been calls for many years from U.S. private company stakeholders to make financial reporting by private companies simpler, more cost effective, and more relevant. They argue that a one-size-fits-all approach to accounting does not properly reflect important differences between private and public companies in terms of their capital structure, user needs, and availability of resources to deal with complex accounting methods.

Two recent initiatives, one from the Financial Accounting Foundation which oversees FASB and one from the AICPA, attempt to address these concerns. In late 2012, the FAF established a new group, the Private Company Council to work closely with FASB to agree on a set of criteria to decide whether and when alternatives within U.S. GAAP are warranted for private companies. Based on those criteria the groups would then develop alternatives within U.S. GAAP to address the needs of users of private company financial statements.

This new structure appears to be off to a fast start, with the PCC and FASB working together on a number of alternatives within U.S. GAAP intended to improve and simplify reporting by private companies in specific areas. To date, this has resulted in the issuance by FASB of modifications to GAAP for private companies relating to accounting for certain interest rate swaps to the treatment of goodwill, and to not having to consolidate certain commonly controlled leasing entities.

The groups also worked together to develop and issue a Private Company Decision-Making Framework that will help guide their decisions on potential modifications to GAAP for private companies. While the PCC-FASB effort is not intended to create a parallel “Little GAAP,” private companies preparing GAAP financials are allowed to choose any or all of the alternative private company modifications. FASB also considers whether these alternatives should also be extended to public companies in order to reduce the complexity of their reporting. That would be a welcome outcome as long as it does not diminish the quality of reporting by U.S. public companies.

At the same time that the FAF announced the new PCC-FASB effort, the AICPA announced that it would develop a new “special purpose framework” aimed at providing owner-managed small- to medium-size private companies that are not required to provide GAAP financial statements with a more useful but still cost-effective alternative to preparing cash basis, modified cash basis, or tax basis financials.

Last year, the AICPA launched the Financial Reporting Framework for SMEs, which emphasizes the use of historical cost accounting and the matching principle and provides for simplified methods in a number of areas, including the accounting for derivatives, stock compensation, and consolidation policy, and for more targeted footnote disclosures. It also allows the use of tax methods in certain areas. While the FRF for SMEs is not GAAP, the AICPA seems to hope that it will become a generally accepted approach to preparing financial statements for a significant portion of the U.S. private company sector. And, by the way, a number of years ago the AICPA also sanctioned the use of yet another set of standards by U.S. private companies, namely IFRS for SMEs which is a slimmed-downed, simplified version of IFRS.

It will be interesting to see how all this develops over time, including which private companies choose to prepare GAAP financials without any of the private company alternatives, which avail themselves of one or more of the private company GAAP alternatives, and whether FASB also extends some of these alternatives to public companies.

It will also be interesting to see which private companies adopt the FRF for SMEs, and which continue to provide cash, modified cash, or tax basis financial information to third parties. With all that and the use of IFRS in our public capital markets, the United States seems to be heading for a more diverse, dynamic, and possibly more complex and less comparable system of accounting.  Yet it is also potentially fostering a richer financial reporting environment than in the “good old days.”