FASB Framework to Guide Development of Separate Private Company Standards
The Financial Accounting Standards Board (FASB) and the Private Company Council (PCC) have issued the Private Company Decision-Making Framework: A Guide for Evaluating Financial Accounting and Reporting for Private Companies. This guide is intended to help the FASB and the PCC determine whether and when to provide alternative financial reporting requirements for private companies. The guide also provides a definition of a public business entity to establish which entities do not fall (and de facto do fall) within the scope of the guide.
CFA Institute on numerous occasions has expressed its concerns over the establishment of a two-tier financial reporting system in the U.S., the inconsistent definitions of public and nonpublic entities contained in accounting literature, and the unease over how far reaching the differences between private and public company reporting standards should be.
In this blog post, we focus on some of the factors that the FASB believes differentiate the financial reporting considerations of private companies, expounded upon in the guide. The CFA Institute position is that the guide does not adequately demonstrate how private companies are different or justify different treatment.
Number of Financial Statement Users
The guide states that most private companies typically have a smaller number of users than those of public companies. The users have direct access to management and, hence, the ability to obtain additional information.
However, private companies vary greatly in size; we believe it would be difficult to say what the typical number of users is since that number differs across private companies. Consequently, access to management will differ across firms. For example, private equity general partners have greater access to management than do the limited partners.
Also, a user can only request additional information. If management is unwilling to provide that information, the user has no recourse other than, for example, to not lend to the company. Furthermore, while in theory it may be the case that private company users can obtain additional information, it may be more difficult to do so in practice. For example, the willingness of management to provide information may depend upon the competitive pressures faced by lenders/banks.
Strategies for Investing in Private Companies
The guide notes that investment strategies, holding periods, and sources of return often vary between private and public company investors. The guide states that public company investors are more likely to hold their equity ownership interests for a shorter period than many private company investors. We contend that those public company investors investing through indexes may have very long expected holding periods. Moreover, while public company investors look to changes in share price and sale of shares in a quoted market as a source of return on their investment, they also seek dividends.
The guide further notes that most users of private company are lenders, other creditors, and equity investors whose focus in the financial statements is on reported amounts of cash, liquidity, and cash flow from operations available to service debt. Since cash is considered so relevant for private companies, we believe this demonstrates the need for a better cash flow statement for private companies — the direct method cash flow. Instead, the guide notes reliance on inadequate proxies such as adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA).
Finally, the guide stresses that private company users focus on cash, unlike public company investors who focus on the value of the company as a whole. We maintain that equity investors in a private company have the need to know the value of the company at key junctures as well.
Another observation in the guide is that private companies have fewer and less specialized accounting staff than public companies. With fewer resources, private companies are less likely to participate in the standard-setting process and to closely monitor and evaluate changes in accounting guidance.
With their limited resources, we question how private companies and their accounting personnel have managed thus far. Furthermore, given that private companies have less qualified resources without the requisite expertise, we ask whether investors should charge a risk premium for admittedly lower quality accounting resources and capabilities.
Of course, private companies differ greatly in size, complexity of activities that they undertake, and the accounting personnel that they retain. We, therefore, propose that private companies that are truly small and have limited resources receive relief in disclosure requirements and deferral of effective dates of new/amended accounting standards. Less disclosure and the extra time needed to adopt new requirements will help private companies with limited resources.
Photo credit: iStockphoto.com/samdiesel