Earlier this year a panel of diverse representatives including CPAs, lenders, venture capitalists and private company financial leaders overwhelmingly recommended that the overseers of the Financial Accounting Standards Board in Norwalk, Conn., create a new board for private company accounting standards. The panel was a joint project of American Institute of Certified Public Accountants, the National Association of State Boards of Accountancy and the Financial Accounting Foundation, which oversees the FASB.
The panel concluded that U.S. generally accepted accounting principles aren't sufficiently relevant for private companies. In January, after a year of deliberation, the panel made two key recommendations.
First, the FAF should create a separate board under the FAF's oversight to make modifications to GAAP for private companies. The new board would consist of five to seven members with private company experience and would work closely with the FASB, which would continue to set accounting standards for public companies.
Second, the board would have the authority to make changes and modifications to existing GAAP where appropriate to reflect private company user needs. Any changes would be reflected in one GAAP codification that preserves GAAP's foundation on a set of core principles.
Now, the Financial Accounting Foundation is responding with due diligence to the panel's key recommendation that the U.S. needs a separate standard-setting board for private companies. Bankers should support formation of a new board because it will produce more useful and better financial reporting by our private company commercial customers.
As a banker and a CPA, I bring a unique perspective to this issue. The truth is the majority of commercial borrowers in the U.S. are private companies. When you take a look at their loan files, their financial statements often no longer contain independently verified financial statements. Oftentimes, bankers are accepting tax returns as an alternative to full financial statements. As a result, the quality of financial reporting has diminished.
This problem has been developing for decades, primarily because the FASB has produced ever more complex rules aimed at responding to public company investor needs. Many of these new rules are designed to promote disclosure for institutional and individual investors in public markets. But for users of private company financial statements, much of that same information is simply irrelevant.
While the panel addressed the broader systemic issue of how these standards are set and wasn't charged with dealing with specific standards, here are some examples of how GAAP doesn't work for private companies:
FIN 46(R), a FASB standard on "Consolidation of Variable Interest Entities," requires aggregation by a parent company of operating units in a consolidated statement. Private company lending decisions are made on a disaggregated basis and lenders often ask private companies to deconsolidate what GAAP forced as consolidation. In fact, strong anecdotal evidence suggests many lenders take GAAP-exception audit reports so their private customers don't have to follow 46(R) in the first place. Growing use of such exceptions weakens the relevancy of GAAP.
FIN 48, a standard on "Accounting for Uncertainty in Income Taxes," requires excessive calculations be made in order to present a company's deferred income tax liability. This is wholly unnecessary. Private company owners already know what their tax situation is and lenders often don't find the additional information useful. And if a lender wants more information from a company, the lender can call up the loan client and find out.
FASB standards require that goodwill — assets created by business combinations — be assessed for impairment annually. This requires involved calculations that include extensive "fair value" estimates. Users of private company financial statements often say they ignore goodwill. For bankers, it's totally irrelevant to cash flow and the company's ability to repay their loan. If so, why does a private company need to spend the time and expense on an annual evaluation of goodwill?
Proponents of a new board contend there are 10 to 15 GAAP standards that are similarly problematic for private companies and need to be changed and simplified. Lenders' financial information needs are generally centered on short-term cash flows, liquidity, and core earnings. For decades, these problems have been identified and detailed by a series of different working groups within the accounting profession.
Creation of a new standards board for private company accounting is an eminently reasonable solution, but one that because it represents change appears to threaten the status quo in some quarters. To be clear, the panel did not recommend a whole new GAAP for private companies. Instead, what the new board would do is peel the onion and make changes in a few layers to simplify and improve the relevance and utility of specific standards. This is a commonsense solution and one that will reduce complexity in our financial system.
We need a new and separate board under the FAF. Members of the FASB are predominantly from a public company background. For all the good work they do, they can hardly be expected to exercise the independent thinking and self-critiquing it would take to undo or revise the standards they themselves have written. To do that properly, we need a group of people who are laser-focused on the needs of the 29 million private businesses that account for more than half the U.S. economy.
We are at an important crossroads now. Bankers need to educate themselves about this issue and communicate to the FAF in support of the formation of a new board for better private company accounting standards. This is a problem that has been building for 30 years. Now is the time for real systemic change for better U.S. accounting standards.