Will Private Company Financial Reporting Add Complexity for Investors, Public Companies?

The Financial Accounting Standards Board (FASB) has a project to create separate private company accounting standards, based on the theory that private companies have unique characteristics that require different financial reporting requirements than public companies. The FASB, for example, contends that private companies have fewer resources than public companies, fewer financial statement users, and that these users have greater access to management to obtain information they need for their financial analyses. Because of these differences, the FASB has deemed it necessary to reduce the cost and complexity of preparing private company financial statements by identifying areas within existing U.S. generally accepted accounting principles (GAAP) to adjust reporting requirements for private companies.

Financial Reporting Shouldn’t be based on Nature of Reporting Entity

We have argued before that financial reporting should not be based on the nature of the entity. Transactions and economic activities that are similar should be reported similarly, regardless of the nature of the entity.

However, this is not how the FASB sees it. As noted in a recent Wall Street Journal article, Jeffrey Mechanick of the FASB said at an accounting roundtable hosted by the NYU Stern School of Business, “As we seek to bring a better cost-benefit balance within GAAP for private companies, we’re initiating at least potential simplification for all entities from yet another direction …. We’ve often looked at public companies first and here we’re looking at private companies first.”

Below we demonstrate how trying to tailor financial reporting to different types of entities may create greater complexity for some reporting entities, greater confusion for investors, and call into question what U.S. GAAP really means.

Greater Complexity for Public Companies

We contend that separate private company financial reporting standards may in some instances create greater complexity for public companies. Consider the following two examples:

• Public Company Acquiring Interest in Private Company: When a public company acquires an interest in a private company, it needs to disclose this to the U.S. Securities and Exchange Commission (SEC) through a filing with the SEC that includes the financial statements of the private company. In such a case, the private entity may have to eliminate any previously elected private company accounting alternatives from its historical financial statements before including them in the public entity’s SEC filing.

• Private Company that Turns Public: Private companies that consider accessing the public markets in the future would have to decide whether to adopt the accounting and reporting private company alternatives available to them; when they turn public they would have to apply public company accounting policies in all historical financial statements presented in a registration statement filed with the SEC.

Separate Private Company Reporting Raises Important Questions

Separate private company reporting raises a number of questions for a private company that is a subsidiary of a public company. Is it appropriate to permit a private company that is a subsidiary of a public company to apply accounting and reporting alternatives for private companies given that the existence of potentially conflicting accounting information (where the financial statements of a private subsidiary may not reconcile to information about the subsidiary included in the consolidated financial statements of the public company parent) may cause confusion for investors? Would it be appropriate to apply private company accounting when the private subsidiary’s operations are a substantial portion of the public company’s financial results?

Is it appropriate to permit a private company that controls a public subsidiary to apply private company accounting specifically when that controlling private company has a significant number of public subsidiaries, or when its primary operations consist of holding an investment in one or more public subsidiaries?

The FASB needs to provide answers to questions like these before forging ahead with the creation of private company standards.

Furthermore, it is being suggested that different accounting and disclosure requirements should be applied to different types of entities:

• Small to Medium Sized Entities – American Institute of Certified Public Accountants’  other comprehensive basis of accounting (OCBOA)
• Emerging Growth Companies – Limited disclosures under the Jumpstart Our Business Startups (JOBS) Act.
• Private Companies – Private company U.S. GAAP.
• Public Companies – Compliance with full U.S. GAAP and SEC requirements.

We believe that such proliferation of accounting and disclosure requirements will increase complexity in financial reporting and create confusion for investors.

In addition it raises the question of what is U.S GAAP. In the case of emerging growth companies, private companies, and public companies, their financial statements would all be considered to be in accordance with U.S. GAAP, thus leaving it to investors to discern the differences within U.S. GAAP.

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