Private company financial reporting strategies for small and midsize companies.

James, Marianne L.

INTRODUCTION

At a recent national conference, Leslie F. Seidman, current chair of the Financial Accounting Standards Board (FASB) noted that there were "two elephants in the room" (Seidman, 2011). She was referring to International Financial Reporting Standards (IFRS) and private company financial reporting, which she identified as the two most significant issues affecting the accounting profession, companies, and capital markets (Seidman, 2011). These two issues while targeting different types of companies--public and private--are related. Specifically, the likely future implementation of IFRS in the U.S. has lent momentum to a longstanding movement toward the creation of private company financial reporting standards.

For decades, private companies have called for the creation of financial accounting and reporting standards tailored specifically to the needs of their financial statement users. Recent developments in financial reporting have significantly increased the chances of this finally becoming reality. The advent of private company accounting standards, likely will provide companies with the opportunity to choose between private company accounting standards and accounting standards required to be used by public companies.

Especially small and midsize private companies will benefit from the development of private company standards. However, prior to adopting a new set of accounting standards, private companies should carefully consider a number of factors relating to their short-term and long-term strategic plans and assess the advantages and challenges of each choice. This study provides information about the current status of financial reporting for private companies in the U.S. and explores key factors that private companies should consider.

The paper is organized as follows. The first section presents background information regarding accounting standard setting in the U.S., explains the challenges that current accounting standards entail for private entities and their financial statement users, and informs about the current status of the quest for private company financial reporting standards. The second section presents a discussion of factors that private companies may want to consider and the potential effect of their choice on their strategic short term and especially long-term goals.

BACKGROUND

By law, private companies are not required to issue annual or quarterly financial statements. Thus, private companies can choose to apply U.S. Generally Accepted Accounting Principles (U.S. GAAP), or another set of standards, such as cash basis. In fact, since the American Institute of Certified Public Accountants (AICPA) recognized the International Accounting Standards Board (IASB) as a "designated standard setter" in May of 2008 (AICPA, 2008), private companies can utilize IFRS as an alternative to U.S. GAAP. However, many private entities, including small and midsize private companies, utilize accrual accounting, apply current U.S. GAAP, and issue financial statements to outside users. The reasons for choosing to apply U.S. GAAP vary, but tend to include specific lender requirements and desired comparability with public companies, which are required to issue annual reports consistent with U.S. GAAP.

Since its creation in 1973, the Financial Accounting Standards Board (FASB) has become the primary source of U.S. GAAP. In its mission statement, FASB states that its mission is "to establish and improve standards of financial accounting and reporting that foster financial reporting by nongovernmental entities that provides decision-useful information to investors and other users of financial reports" (FASB, n.d., Facts about FASB). Thus, the standards issued by FASB are meant to serve as financial accounting and reporting rules for both public and private companies. FASB derives its standard setting authority from the U.S. Securities and Exchange Commission (SEC), which has the legal authority to set accounting standards for public companies in the U.S. The Financial Accounting Foundation's Board of Trustees appoints FASB members and oversees funding and other aspects of FASB.

Public companies that report to the SEC must comply with U.S. GAAP, which consists of standards, pronouncements, and interpretations issued by the FASB and its predecessors, as well as regulation issued by the SEC. Approximately 14,000 public companies report to the SEC (BRP, 2011). However, there are approximately 28 million private companies (BRP, 2011) with financial statements users whose needs may not be optimally served by accounting information generated through an application of current U.S. GAAP.

Concerns about Current U.S. GAAP

Concerns about current GAAP and its applicability to private companies and their financial statement users typically focus on the complexity of current U.S. GAAP, a lack of relevance of some of the most complex accounting standards to private companies, and the ensuing cost burden for private and especially small and midsize entities (BRP, 2011).

Prior to the codification of U.S. GAAP (FASB Accounting Standards Codification[TM]), which became effective for fiscal periods ending after September 15, 2009, FASB issued 168 Statements of Financial Accounting Standards (SFAS), 40 FASB Interpretations, and a series of FASB Bulletins and Staff Positions. In addition, its predecessors--the Accounting Principles Boards (APB) and the Committee on Accounting Principles (CAP)--had issued a number of APB Opinions and Accounting Research Bulletins, some of which still provided authoritative GAAP and are now part of the FASB Accounting Standards Codification[TM].

While most of the early standards and pronouncements issued by FASB and its predecessors were brief, typically less than 20 pages, during the past two decades, FASB standards have become quite long, with extensive detail and implementation guidance. For example, in December 2007, FASB issued SFAS 141R, a 358 page long revised standard on business combinations (FASB, 2007). The in 2009 originally issued amendment to FASB Interpretation 46R on variable interest entities was 202 pages long. In light of this continually increasing volume of GAAP, business entities have voiced concern about what has been coined as a "standards overload."

In addition, private companies and especially small and midsize companies do not routinely encounter some of the transactions and financial reporting issues pertinent to public companies. For example, goodwill and the required complex impairment testing of goodwill tend to be less important to private and especially small companies, than to public companies. Complex equity transactions, contingent considerations in mergers and acquisitions also tend to be less pertinent to those entities. However, when FASB issues a new standard (now referred to as Accounting Standards Update) or existing standards are revised, the accounting staff of a company utilizing U.S. GAAP must disseminate the information, evaluate the impact of the change on the company's accounting information system, and implement and report on the change.

Even with the FASB Accounting Standards Codification[TM] (codification), which consolidated multiple standards on related topics into one source and superseded all original pronouncements issued by FASB and its predecessors, the 2010 print version of the codification still exceeds 7,000 pages.

In the past, FASB occasionally allowed non-public companies to adopt a new accounting standard at a later date than that required by public companies. For example, small private companies were allowed to delay adoption of SFAS 106, "Employers' Accounting for Postretirement Benefits other than Pensions" (FASB, 1990) until fiscal years beginning after December 15, 1994, while public companies were required to implement the standard two years earlier.

Movement toward Private Company GAAP

The call for private company GAAP is long-standing. Even as early as 1974, an article in the CPA Journal discussed the need for two different sets of accounting standards for private and public companies (recited in Zanzig & Flesher, 2006). While the call for private company GAAP is long-standing, recent regulatory and accounting standard setting events have provided new momentum to the movement. During the past ten years, the FASB and the IASB have worked together on what is called their "Convergence Project." Their efforts have eliminated many key differences between U.S. GAAP and IFRS. Since issuing its "Roadmap" in 2008 (SEC, 2008) and its "Work Plan" in 2010 (SEC, 2010), the SEC is formally considering implementing IFRS in the U.S. The SEC's decision is imminent and is expected to require at least some level of mandatory IFRS implementation by U.S. public companies.

While global public companies likely will benefit in the long-run, the benefits of using IFRS tend to be much less certain for private and particularly small private entities. Thus, the creation of private company GAAP has become even more important.

The Blue Ribbon Panel

In 2009, the Financial Accounting Foundation (FAF) together with the AICPA and the National Association of State Boards of Accountancy (NASBA) sponsored a Blue Ribbon Panel (BRP) whose ultimate mission was to consider the needs of private company financial statement users and prepares and to recommend a course of action regarding private company financial reporting (BRP, 2011). The BRP's activities included a request for public input on the issues from interested parties. The comments they received were largely from CPA practitioners and private company financial statement preparers and confirmed previously voiced concern about the often lack of relevance of private company financial statements prepared under current U.S. GAAP and the high cost and complexity of compliance with the current standards. Some of the comments also pointed to the recent increase in qualified audit opinions for private companies, which may have been prompted by non-compliance with some of the most complex requirements of U.S. GAAP (BRP, 2011).

In January 2011, the BRP issued its report. The BRP's two key recommendations related to the type of standards that should be used by private companies and the organization that should be in charge of standard setting for private entities. The BRP recommended the development of a specific "GAAP with exceptions and modifications for private companies (with process enhancements)" (BRP, 2011, 3) and the establishment of a "separate private company accounting standards board" (BRP, 2011, 3).

The FAF's Response to the BRP Recommendations

The FASB initiated a research project with the express objective to "develop a framework ... for making decisions about whether and when to adjust the requirements for recognition, measurement, presentation, disclosure, effective dates, and transition methods for financial accounting standards that apply to private companies" (FASB, 2011).

After considering the BRP's recommendations, on October 4, 2011, the FAF issued a proposal entitled "Request for Comment. Plan to Establish the Private Company Standards Improvement Council" (FAF, 2011) and proposed that instead of a separate independent board, a separate council should be responsible for setting accounting standards for private companies. Contrary to the BRP's recommendation, the council would be part of FASB and FASB would maintain the ultimate authority to approve accounting standards for private entities.

The FAF received 299 formal comment letters by the January 14, 2012 comment deadline. According to analysis by the AICPA, many of those who commented on the issue urged the FAF to comply with the recommendation of the BRP and establish an independent board to set private company financial reporting standards (AICPA, 2011a). The AICPA also strongly urges the FAF to comply with the BRP's recommendation and supports the creation of a separate independent board in charge of developing GAAP modifications for private companies (AICPA, 2011b).

STRATEGIES FOR PRIVATE COMPANIES--KEY FACTORS TO CONSIDER

Currently, private companies can choose to apply U.S. GAAP or another set of accounting standards, such as IFRS, which also is based on accrual accounting, or even a cash or tax basis of accounting. Assuming that a new set of standards that is modified to address the special needs of private company financial statement users becomes available, private companies may have an additional financial reporting choice. Prior to making a choice, private companies should consider the short-term and long-term consequences and the advantages and disadvantages associated with applying specially tailored private company GAAP. These advantages and disadvantages will be directly influenced by a company's short-term and long-term strategic plans.

Companies that anticipate change and adapt their short-term and long-term strategies accordingly, typically enjoy competitive advantages and potentially long-term cost savings. The key factors that may influence a company's short-term and long-term strategic plans are: (1) the company's anticipated future organizational structure, (2) expected and targeted sources of future growth, (3) future sources of financing, (4) potential for globalization and financial statement comparability, and (5) staffing considerations. Costs and benefits should be considered for each of these five key areas of consideration.

Organizational Structure

Most companies begin their life as private entities; as sole-proprietorships, traditional partnerships, limited liability partnerships (LLPs), or S Corporations. Highly successful companies may, at some point, decide to convert their organizational structure to a public corporation to help finance rapid growth and gain access to large amounts of capital. Public companies must comply with U.S. GAAP and, in the future, likely will have to implement IFRS.

If a company anticipates that it will eventually "go public," it should consider continuing applying current U.S. GAAP and probably (in the future) IFRS, once the SEC issues a formal decision on IFRS. Implementing a modified standard for private companies will entail some initial cost and likely create more divergence with public companies. If such an organization decides to become public, the costs associated with converting the accounting information system and restating its prior years' financial statements will be quite significant. For this reason, companies should consider carefully, whether a change in organizational structure is likely in the future and whether it would be truly beneficial in the long-run to apply private company GAAP, once it becomes available.

Sources Of Growth And Expansion

Companies can grow through internal expansion and through external acquisitions. A company should carefully evaluate its short-term and long-term growth plans. Internal growth tends to result from successful operations and the company's ability to raise additional capital through ownership participation and/or lending from financial institutions.

On the other hand, external sources of growth typically involve the acquisition of outside entities, such as competitors, suppliers, or distributers. The acquired companies may be private or public. Evaluating acquisition targets is not easy. If a company that is considered for acquisition utilizes a different set of accounting standards, the evaluation will become even more difficult. In addition, once an acquisition is completed, the acquiring company will need to consolidate the financial results of the acquired company with its own results. Differing sets of accounting standards will make this process more complex and costly.

Furthermore, some successful private entities may not only seek acquisitions, but may wish to become a target for a friendly acquisition. If this describes a company's potential long-term strategic plans, use of public company accounting standards may facilitate future acquisitions of public companies, and perhaps may help the company become a more attractive target for public acquirers. Thus, in deciding what type of accounting standards to use, private companies should consider their long-term growth strategies and their expected sources of growth.

Future Sources of Financing

A company's strategies for future growth and anticipated future changes in capital structure are closely related to a company's strategies relating to future financing sources. A common reason for converting from a private to a public company is to gain access to large amounts of financing capital. In addition, owners of private companies in need of large amounts of additional capital for expansion or other purposes can minimize a concentration of control by publicly selling stocks or bonds to a large number of diverse investors. Compliance with SEC regulations for public offerings includes filing financial statements consistent with U.S. GAAP.

Many companies that started out private subsequently become public entities. Thus, private companies that anticipate a future initial public offering (IPO) may want to consider using public company financial reporting standards (currently, U.S. GAAP) instead of private company financial reporting standards to support their long-term corporate structure and to build the internal staff and resources needed to comply with the complex public filings required by the SEC. If a company plans to "go public," it may want to consider using U.S. GAAP to avoid the future conversion of the accounting information system from private company GAAP to public company GAAP.

Potential Globalization and Financial Statement Comparability

A company that is currently, or in future plans to compete in a global market, should carefully consider its choice in financial reporting standards and the effect of that choice on financial statement comparability. Maintaining and enhancing comparability between different companies represents an important goal of financial reporting standards. Whenever there are choices, comparability is, to some degree, impaired. The availability of different sets of accounting standards for public companies and private companies will raise some important comparability issues. This will be especially the case if, or rather when, the SEC decides to implement some degree of IFRS in the U.S.

Private companies will have to consider this issue from the perspective of future opportunities and costs. For example, a private company using a different set of accounting standards that wishes to be acquired by a public company may be more difficult to evaluate. This may affect the offering price for the private entity. In addition, comparability issues between public and private companies may make it more difficult and ultimately more costly for private companies to raise capital. This would particularly be the case if private company financial reporting standards were to be perceived as less rigorous than public company standards.

Currently, nearly 130 nations world-wide permit or require the use of IFRS. U.S. companies would likely experience significant disadvantages if the U.S. were to not implement IFRS. This will also apply to private companies that wish to operate and compete in a global market. In fact, some private companies already operate in a global market; others may plan to do so in the future.

Staffing Considerations

Private companies, and especially small and midsize enterprises, typically experience a significant cost burden from the increasing volume of GAAP. Smaller companies do not have the staffing resources to allow for detailed analysis of new GAAP and typically are not able to sponsor in-house continuing education seminars. Engaging outside speakers or sending staff to seminars may cause staffing shortages and incur additional costs.

Switching from current U.S. GAAP to private company GAAP involves additional costs and resources, but in the long-run may yield significant cost savings, and hopefully reports that are more meaningful for financial statement users. However, if a company anticipates a future change in capital structure and public offerings, an additional switch would be warranted that would be even more costly. Companies should consider their long-term as well as their short-term strategic plans and the cost and benefits associate with each choice in the context of their plans.

CONCLUSION

For several decades, private companies and their financial statement users have asked standard setters to address the growing burden and lack of relevance of statements prepared consistent with current U.S. GAAP. This movement has gained momentum during the last few years and accounting standards that better meet the needs of private companies and their financial statement users may, in the near future, finally become a reality.

Private companies, and especially small and midsize organizations, need to be aware of anticipated changes in financial reporting and the challenges and opportunities that may arise. A change or new choice in GAAP for private companies tends to generate advantages and challenges for the companies, their owners, and financial users that need to be considered by management. Management's decisions on accounting standards should support and complement their short-term and especially their long-term strategic plans.

Factors that should be especially considered include the companies' expected future capital structure, planned sources of expansion, future financing needs, globalization and financial statement comparability issues, and staffing needs. Each choice will hold advantages and disadvantages and generate costs and benefits. Private company executives should carefully consider all pertinent factors in unison and not in isolation. In addition, private companies should keep informed about developments in financial reporting for both private and public companies. Continually updated information can be found on the FASB.org and AICPA.org websites.

REFERENCES

American Institute of Certified Public Accountants (2011a). Private Company Financial Reporting. Retrieved on February 19, 2012, from http://www.aicpa.org/INTERESTAREAS/FRC/ ACCOUNTINGFINANCIALREPORTING/PCFR/Pages/PCFR.aspx.

American Institute of Certified Public Accountants (2011b). Statement from Barry Melancon, AICPA President and CEO, and Paul Stalin, AICPA Chair, Addressing FAF's Failure to Create an Independent Standard Setting Board for Private Company Financial Reporting. Retrieved on November 14, 2011, from http://www.aicpa.org/Press/PressReleases/2011/Pages/FAF-Fails-to -Create-Private-Board.aspx

American Institute of Certified Public Accountants (2008). AICPA Council votes to Recognize the International Accounting Standards Board as a Designated Standard Setter. Retrieved on February 20, 2012, from hpt:www.ifrs.com/updates/aicpa/Press_Release_May18.html.

Blue Ribbon Panel Blue-Ribbon Panel (BRP) on Standard Setting for Private Companies (2011). Report to the Board of Trustees of the Financial Accounting Foundation. Retrieved on January 31, 2011, from http://www.aicpa.org/interestareas/frc/accountingfinancialreporting/ pcfr/downloadabledocuments/blue_rib bon_panel_report.pdf

Financial Accounting Foundation Board of Trustees (2011). Request for Comment. Plan to Establish the Private Company Standards Improvement Council. Retrieved on October 21, 2011, from http://www.accountingfoundation.org/cs/ContentServer? site=Foundation &c=Document_C&pagename= Foundation%2FDocument_C%2FFAFDocumentPage&cid=1176158991959

Financial Accounting Standards Board (n.d.). Facts about FASB. Retrieved on February 26, 2012, from http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176154526495

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Financial Accounting Standards Board (2007). Business Combinations. http://www.fasb.org/cs/BlobServer? blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=117582091 9432&blobheader=applicat ion%2Fpdf

Financial Accounting Standards Board (1990). Statement of Financial Accounting Standards No. 106. Employers' Accounting for Postretirement Benefits Other Than Pensions. Norwalk: CT.

Securities and Exchange Commission (2010). Releases Nos. 33-9109; 34-61578 Commission Statement in Support of Convergence and Global Accounting. Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers SEC. " Retrieved on April 21, 2010, from http://www.sec.gov/ rules/other/2010/33-9109.pdf

Securities and Exchange Commission. (2008). Release Nos. 33-8982. Roadmap for the Potential Use of Financial Statements Prepared in Accordance With International Financial Reporting Standards by U.S. Issuers. Retrieved on November 16, 2008, from http://sec.gov/rules/proposed/ 2008/33-8982.pdf.

Seidman, L.F. (2011). Remarks by Leslie F. Seidman Chairman of the Financial Accounting Standards Board To the American Institute of Certified Public Accountants National Conference on Current SEC and PCAOB Developments. December 6, 2011: Washington, D.C. Retrieved on January 15, 2012, from: http://www.fasb.org.

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Marianne L. James, California State University, Los Angeles