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Private Company Accounting: The Good, the Bad, and the Ugly

Scott Taub | November 26, 2013

It's been less than a year since the first meeting of the Financial Accounting Standards Board's Private Company Council. The PCC is charged with identifying areas where Generally Accepted Accounting Principles can be simplified for private companies because the users of their financial statements do not need the information imparted by the more difficult or detailed accounting requirements.

I was glad to see the PCC created. I believe there are areas where small changes could make financial reporting much easier with only a minimal effect on quality. Since any alternatives proposed by the PCC must be approved by FASB before taking effect, I figured that the chances of unwarranted differences between private and public company GAAP were low. Besides, users of private company financial statements could always ask for financial statements reflecting a full application of GAAP.

That being said, the operation of the PCC so far has left me extremely concerned. While aspects of the four PCC proposals could make financial reporting easier for private companies while respecting the framework of GAAP, others would allow private companies to ignore fundamental principles that underlie financial reporting in the name of reducing cost. In addition, by allowing multiple options, the proposals, if adopted, would render comparability between private company financial statements an illusion at best.

There's still time to get this right, but an inflexion point is nearing.

The Good

There are some things to like in the PCC's proposals. First, the PCC has asked FASB to finalize a simplified hedge accounting model for certain interest rate swaps that hedge private company debt. This proposal could ease the burden on companies that are simply trying to economically change floating-rate debt to fixed, without significantly burdening financial statement users.

The PCC has also asked FASB to allow private companies to amortize goodwill and test it for impairment only when triggering events occur, instead of carrying it at cost and testing for impairment annually. The same proposal would also allow private companies to evaluate goodwill impairment at the entity level instead of the reporting-unit level and allow a shortcut to calculating goodwill impairment, rather than requiring a “hypothetical purchase price allocation.”

While the combined effect would divorce goodwill accounting from economics, there are still a couple good ideas in the proposal. Allowing private companies to evaluate impairment at the entity level makes sense because the “reporting unit” concept in GAAP today relies upon concepts in the segment reporting topic of the Accounting Standards Codification, a topic that has never applied to private companies. Eliminating the step two “hypothetical purchase price” exercise is also a reasonable trade-off since it results in a minimal loss of precision in return for the substantial savings of not requiring a private company facing an impairment (and therefore likely in some financial distress) to go through a valuation exercise that is useful only for accounting purposes.

The Bad

The rest of the goodwill proposal should be scrapped. Switching to amortizing goodwill over an arbitrary short period is a bad idea, as is eliminating the annual impairment test. If these alternatives are allowed, goodwill accounting will be meaningless because the chance of an impairment ever happening would be near zero and the financial statements would include an amortization figure that even the exposure draft admits is meaningless. The recent addition (for all companies) of a qualitative evaluation to the goodwill impairment test that can obviate the need to estimate fair value should be sufficient to reduce the unnecessary costs of an annual impairment test.

More concerning, though, is that the PCC appears to be in a rush to create significant differences. The proposals that are nearing finalization were issued before we even had a definition of a private company. Even now, the PCC and its staff have not finalized the PCC's decision-making framework, which is intended to serve as a guide to what factors might justify differences in reporting between public and private companies.

It is disrespectful to give users only 60 days to consider proposals that would allow controlled entities and purchased intangible assets to stay off the books.

All four PCC proposals thus far have carried 60-day comment periods. Redeliberation of the hedge accounting and goodwill proposals after the comment period lasted only one meeting. No recent FASB project has resulted in proposed changes as fundamental as those in the PCC's goodwill proposal with such a short comment period or such minimal discussion.

On another note, I'm aware that many corporate lending officers at major banks are unaware of these potentially significant changes to the financial statements they use to make lending decisions. As lending officers are (as identified by the PCC itself) amongst the most important users of private company financial statements, their surprise at the existence of these proposals suggests that the PCC's outreach to its key stakeholders has not been effective.

The Ugly

Two other proposals from the PCC are even more concerning. First is a proposal that would allow private companies to ignore, when allocating purchase price in a business combination, intangible assets that don't stem from legal or contractual rights.  This would allow valuable assets like research and development rights, information in databases that could be licensed, and others to be left off the balance sheet. Many of these assets significantly affect the cash flows of acquirers.

The Basis for Conclusions of this proposal asserts that private company users can generally request additional information from management. But that particular justification was removed from the list of factors that could support a difference in reporting for private companies in the latest draft of the decision-making framework. In addition, the PCC learned through the comment letter process that the cost savings from this proposed change would be minimal at best. Undaunted, the PCC plans to continue to discuss this project, including considering the possibility of allowing private companies to recognize no intangible assets other than goodwill, the accounting for which the PCC has already proposed to render useless.

Another troubling proposal would allow private companies to not consolidate certain variable interest entities that they are considered to control under GAAP. It's hard to imagine a more fundamental change to accounting than deviating from the principle of consolidating controlled entities.

These changes have been proposed despite the promise in drafts of the private-company decision-making framework that: “This guide is not intended to be an entirely new conceptual framework that would lead to a basis for preparing financial statements of private companies that is fundamentally different from the basis for preparing financial statements of public companies.” That statement is pretty meaningless if FASB approves either of these last two proposals.

The only justification for a 60-day comment period on these proposals is that supporting the proposals is obvious for private companies as the proposals wouldn't mandate a change and would provide an option for easier accounting—what's not to like? But users of financial statements, who will be the ones dealing with the effects of the reduced requirements, cannot take solace in that fact the way preparers can. It is disrespectful to give users only 60 days to consider proposals that would allow controlled entities and purchased intangible assets to stay off the books.

The Next Steps

The stated goal of the PCC is still one to strive for, but the execution is lacking. The question is how to ensure that the PCC can contribute to private company financial reporting, while avoiding the pitfalls that its operations to date have shown are possible.

FASB is in an awkward position, as the rules by which the PCC operates require its chairman to explain to the PCC, if FASB does not ratify a PCC proposal or standard, what changes could be made that would potentially allow for ratification. Although this certainly sends a message that ratification of the proposals should be the normal outcome, it's time for FASB to pull back from allowing differences in private company standards that would dilute the meaning of “in accordance with GAAP.”

FASB should also mandate longer comment periods for significant PCC proposals, which is essential to allowing for high-quality feedback. In addition, FASB should consider whether to propose similar changes to public company GAAP before the PCC proposal is published for comment. For example, if the variable interest entity accounting literature is causing consolidation of entities that aren't really controlled, it is doing so for both private and public companies.

The PCC has gotten off to a fast start and has shown it won't be shy about proposing differences, even if they are significant. It's time now for FASB to show that it will slow things down and deny PCC requests when necessary to protect the integrity of GAAP and the standard-setting process.

One more thing should be considered if alternative treatments as significant as those in some of the proposals are accepted. At some point, it will no longer be fair to use the same name for financial statements prepared under the full set of standards and those prepared taking advantage of significant exceptions. Perhaps the accounting community needs to start thinking about what to call the “GAAP-light” set of standards that could come to pass, before the lack of clarity results in lending failures that will, like the last crisis, be blamed on poor accounting standards.