United States: Who Should Set Financial Reporting Standards For Private Companies?

Introduction

Private company financial reporting continues to be a hot topic in the United States and around the world. In the summer of 2009, the Financial Accounting Foundation (FAF) conducted a listening tour across the United States to gather constituents' views on private company financial reporting. The feedback they received was that the Financial Accounting Standards Board (FASB) needs to improve the way it considers the special circumstances of private companies during the standard-setting process. At the American Institute of Certified Public Accountants Fall 2009 Council meeting, the Council also discussed this issue, with more than 95 percent of those attending supporting differences in U.S. GAAP for private companies. Subsequently, the Private Company Financial Reporting Committee (PCFRC) wrote a letter to FAF in November 2009 urging the consideration of private company financial reporting at the strategic level.

The concerns about private company financial reporting are not unique to the United States. According to the International Accounting Standards Board (IASB), as many as 73 countries have adopted or are considering adopting International Financial Reporting Standards for Small and Medium-sized Entities (IFRS for SMEs) for their private companies. Alternatively, Canada decided in 2009 to go its own direction with Canadian GAAP for Private Enterprises. Other countries, including the United States, are considering similar moves. The question is, would adoption of either IFRS for SMEs or a national GAAP for private companies better meet the needs of private companies in the United States?

Summary of Blue Ribbon Panel on Standard Setting for Private Companies

In response to the November 2009 letter from the PCFRC, the FAF established a Blue Ribbon Panel in partnership with the American Institute of Certified Public Accountants (AICPA) and the National Association of State Boards of Accountancy to address how accounting standards can best meet the needs of users of U.S. private company financial statements. The Panel was asked to provide recommendations to the FAF Board of Trustees on the future of standard setting for private companies. The Panel comprised 18 members from a cross-section of constituencies including private companies, auditors, and the banking and private equity communities.

The Panel recommended that the standard-setting system focus on identifying exceptions and modifications to U.S. GAAP that would better meet the needs of the users of private company financial statements. The goal is to create relevant decision-useful and cost-beneficial private company financial statements. To ensure the appropriate exceptions and modifications are made for private companies, the Panel recommended that the FAF create a new private company standard-setting board. The new board would have the ultimate authority to determine and set exceptions and modifications to U.S. GAAP for application by private companies. The new board would be subject to review after three to five years. To further support this effort, the Panel proposed creating a differential framework or set of decision criteria that would help the standard-setting board make the appropriate exceptions and modifications. The Panel members felt that, under the current system, the FASB did not have a framework that could be used to help identify exceptions and modifications. The FAF is currently considering the recommendations of the Panel.

Short-term actions and the FASB response

The Panel also recommended other short-term actions that the FAF and the FASB should consider to provide relief for private companies and to help ensure a successful transition to a new structure and model. The short-term recommendations included filling the open positions on the recently expanded FASB¹ with individuals with private company perspectives, and considering a transition period for private companies for implementation of new standards.

In response, the FASB has increased its efforts to reach private company constituents with various activities, including roundtables for private companies to discuss reporting issues, field studies on specific FASB projects, and expanded use of plain English webcasts and podcasts to better communicate with all constituents. These efforts have already led to at least one proposed change.²

The FAF and the FASB have taken several other steps to address the concerns identified by the Panel:

• In 2009, the FASB hired an assistant staff director who is responsible for focusing on private company and not-for-profit issues.
• In 2010, Board members began attending PCFRC meetings in order to facilitate better communication.
• In 2011, the FAF filled its two open positions with individuals with private company expertise, one of whom was a Panel member and former PCFRC member.

Preparers' views on separate reporting standards for private companies

In April 2011, Grant Thornton conducted a survey of U.S. CFOs, probing their views on a variety of topics including the CFOs' preferred standard setter for private companies in the United States. We also tried to determine whether there were substantive differences between the financial reporting objectives of private and public companies that could inform a framework for determining exceptions and modifications to U.S. GAAP for private companies.

While we tried to ask the questions in as neutral a fashion as possible, we expected that there would be more support for a separate standard setter among CFOs of private companies than among CFOs of public companies. We also expected to see differences between the financial reporting objectives of CFOs of private companies and CFOs of public companies, with more emphasis on accountability (stewardship) among the former and a greater emphasis on capital allocation (valuation) among the latter. We expected this difference in part because investors in public companies make frequent capital allocation decisions based on public information from active markets, while investors in private companies make infrequent capital allocation decisions, based on private information. We based our expectations in part on the discussions surrounding recent changes to the Conceptual Framework, specifically whether the objective of general-purpose financial reporting should be limited to informing capital allocation decisions or whether it should include stewardship. We were surprised by the results on both counts.

FASB is the standard setter of choice for CFOs

Our hypothesis

Private company CFOs would favor standard setting by a different body from the one setting standards for public companies; and 2) CFOs from public companies would not feel as strongly about this issue.

The results

Contrary to our expectations, most of the CFOs of private companies who responded to this question did not support a separate standard setter for private companies. Given a choice between the FASB, the IASB and a separate standard setter, 59% of private company CFOs preferred the FASB. Adoption of IFRS for SMEs (i.e., the IASB as a standard setter) came in a distant second at 22%. Only 18% of the CFOs of private companies preferred a separate standard setter for private companies. Even more surprising, support for the FASB as a standard setter for private companies was stronger among private company CFOs than among public company CFOs.

CFOs at public companies continue to prefer the FASB over the IASB as the standard setter for public companies by a margin of 2 to 1: half (50%) preferred the FASB, while 24% preferred the IASB, with the remainder preferring other options. Again, support for the FASB was stronger among CFOs at private companies, with 57% preferring the FASB, and 16% opting for the IASB.

Another unanticipated result of the survey was the strong level of support for optional use of IFRS for SMEs. Although only 22% of CFOs at private companies favored adopting IFRS for SMEs, 51% of private company CFOs and 55% of public company CFOs favored allowing private companies to use IFRS for SMEs. Therefore, opposition to a separate board for setting standards for private companies does not imply opposition to separate GAAP for private companies, at least on an optional basis.

Different frameworks for private and public companies

Our survey also probed differences in how private and public companies view the users of their financial statements and what they consider to be the objective of financial reporting.

Our hypothesis

CFOs of private companies would emphasize the needs of current owners and lenders (an accountability objective), while CFOs of public companies would be more likely to consider potential investors (a capital allocation objective) as the primary users of their financial statements.

The results

The responses from CFOs at private companies confirmed our expectations, with 62% indicating either current owners or management were the primary users of their financial statements. Less than a third (30%) considered lenders (creditors) to be the primary users. Only 2% of the respondents considered potential owners to be the primary users. The surprising finding, however, was that 62% of CFOs at public companies also considered current owners or management to be the primary users of the financial statements. For public company CFOs, there was only slightly more emphasis on potential owners/investors (8%) and less emphasis on creditors (20%).

We further explored this area by examining whether there were differences between private and public companies in their financial reporting objectives.

Our hypothesis

CFOs at private companies would be more concerned with reporting information about past transactions and events (performance) consistent with an accountability objective. CFOs at public companies would be more concerned about reporting either information useful for estimating the risk, timing and amount of future cash flows or information about those future cash flows, consistent with the recently revised Conceptual Framework.

The results

To our surprise, there was little or no difference between the responses from CFOs of private companies and CFOs of public companies: 57% of both groups selected the accountability objective relating to information about past transactions and performance.

We approached this issue differently by also asking respondents for the primary reason they prepare audited financial statements.

Our hypothesis

CFOs at private companies would focus on accountability to owners and creditors. CFOs at public companies would be more interested in providing information useful for valuing the equity and debt securities of the firm.

The results

Two-thirds (68%) of private companies said the purpose of preparing audited statements was to demonstrate accountability to owners and creditors or to meet other legal requirements — objectives that are consistent with an accountability/stewardship focus. Only 28% indicated capital allocation goals of obtaining credit or providing information useful for valuing equity and debt. This confirmed our expectations. However, we were surprised that only 18% of the CFOs at public companies considered valuation of their equity and debt or obtaining credit to be their primary objective, which would have been consistent with a capital allocation objective. In fact, fully half (51%) of public company CFOs considered reporting financial position and performance to current owners — an accountability objective — to be the primary reason for preparing audited financial statements.

Finally, we asked respondents to tell us what they considered to be their primary performance measures (they were able to select more than one).

Our hypothesis

Both groups would focus on cash flow from operations, with private companies focusing more on EBITDA, and public companies concentrating more on free cash flow, net income, comprehensive income and forward-looking information.

The results

The results were broadly in line with expectations, although we were surprised that only 16% of public company CFOs considered comprehensive income to be a primary performance measure.

Conclusion

The results of our survey indicate that the financial reporting needs, objectives and target audiences of private and public companies may not be very different. The main difference we found was between the objectives of CFOs as a group and the stated objectives of financial reporting in the Conceptual Framework (see the appendix for a more in-depth discussion of the views espoused in the Conceptual Framework).

The responses from the CFOs indicate that they view the objectives of financial reporting to be accountability to current shareholders and measurement of past performance. This contradicts the views expressed by the FASB in the Conceptual Framework — a view that is reflected in recent exposure drafts — that the focus of financial reporting should be on capital allocation and providing information about the nature, timing and risk of future cash flows.

In the Conceptual Framework, the FASB and the IASB have taken the position that in most cases information useful for making resource allocation decisions would also be helpful in assessing management's performance. Our interpretation of the survey results is that CFOs take the opposite view: that information useful for assessing performance would also be useful for making resource allocation decisions. One could arrive at very different conclusions about the nature and content of financial statements and financial reporting standards (and the nature of auditing), depending on which point of view one considers correct.

The results further indicate that it is not only private companies that are concerned about the issues identified by the Blue Ribbon Panel. CFOs of public companies may view users and their needs differently from the FASB. Whatever the reason, it will be more difficult for preparers to communicate effectively by means of financial reporting if those who prepare financial statements and those who set accounting standards are operating from different premises. This suggests opportunities for additional dialogue between preparers and standard setters, and opportunities for additional research.

We doubt that the Blue Ribbon Panel's recommendations will be the last word on the issue of private company financial reporting. Grant Thornton LLP supports research into the issues surrounding financial reporting by both private and public companies and encourages the FASB to continue its outreach activities to all constituents.

Appendix: The Conceptual Framework (revised September 2010)

The FASB and the IASB issued a joint revision to the Conceptual Framework in September 2010. The revision continues a decades-long trend of moving the focus of financial reporting away from an accountability and performance approach focused on the income statement — based on realization and the matching of revenue and expense — toward a capital allocation and comprehensive income approach focused on the balance sheet and information about future cash flows. In essence, the Boards have been gradually narrowing the scope of general purpose financial reporting so that it applies primarily to the needs of investors in capital markets. Early drafts proposed that "the objective of general purpose external financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions." The Boards further stated that:

"To help achieve its objective, financial reporting should provide information to help present and potential investors and creditors and others to assess the amounts, timing, and uncertainty of the entity's future cash inflows and outflows (the entity's future cash flows). That information is essential in assessing an entity's ability to generate net cash inflows and thus to provide returns to investors and creditors."

The traditional objective of stewardship (or accountability) was not included as a separate objective in the early draft of the Conceptual Framework on the basis that there should be a single objective and that information that meets the needs of capital providers would also meet the needs of users interested in stewardship.

After reviewing comments letters, stewardship came and went as an objective. The final text does not make reference to stewardship, but it does soften references to capital allocation and future cash flows:

OB2. The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.

OB3. Decisions by existing and potential investors about buying, selling, or holding equity and debt instruments depend on the returns that they expect from an investment in those instruments; for example, dividends, principal and interest payments, or market price increases. Similarly, decisions by existing and potential lenders and other creditors about providing or settling loans and other forms of credit depend on the principal and interest payments or other returns that they expect. Investors', lenders', and other creditors' expectations about returns depend on their assessment of the amount, timing, and uncertainty of (the prospects for) future net cash inflows to the entity. Consequently, existing and potential investors, lenders, and other creditors need information to help them assess the prospects for future net cash inflows to an entity.

The Boards further decided not to use the term "stewardship" or to describe it as a separate objective of financial reporting. Stewardship and information about future cash flows are both components of the information that investors and creditors will use to make resource allocation decisions.

The Boards included the following description of their reasoning for not specifically including stewardship as an objective.

BC1.24 Both the Board's [the FASB's] and the IASB's previous frameworks focused on providing information that is useful in making economic decisions as the fundamental objective of financial reporting. Those frameworks also state that financial information that is useful in making economic decisions would also be helpful in assessing how management has fulfilled its stewardship responsibility.

BC1.25 The Discussion Paper that led to this chapter stated that the objective of financial reporting should focus on resource allocation decisions. Although most respondents to the Discussion Paper agreed that providing useful information for decision making was the appropriate objective, they said that investors, lenders, and other creditors make other decisions that are aided by financial reporting information in addition to resource allocation decisions. For example, shareholders who vote on whether to retain directors or replace them, and on how members of management should be remunerated for their services, need information on which to base their decisions. Shareholders' decision-making process may include evaluating how management of the entity performed against management in competing entities in similar circumstances.

BC1.26 The Board agreed with these respondents and noted that, in most cases, information designed for resource allocation decisions also would be useful for assessing management's performance. Therefore, in the Exposure Draft leading to this chapter, the Board proposed that the objective of financial reporting is to provide financial information about the reporting entity that is useful to present and potential investors, lenders, and other creditors in making decisions in their capacity as capital providers. The Exposure Draft also described the role financial statements can have in supporting decisions related to the stewardship of an entity's resources.

BC1.27 The Exposure Draft discussed the Objective of Financial Reporting and Decision Usefulness in separate sections. The Board combined those two sections in this chapter because usefulness in making decisions is the objective of financial reporting. Consequently, both sections addressed the same points and provided more detail than was necessary. Combining those two sections resulted in eliminating the separate subsections on usefulness in assessing cash flow prospects and usefulness in assessing stewardship. The Board did not intend to imply that assessing prospects for future cash flow or assessing the quality of management's stewardship is more important than the other. Both are important for making decisions about providing resources to an entity, and information about stewardship also is important for resource providers who have the ability to vote on, or otherwise influence, management's actions.

BC1.28 The Board decided not to use the term stewardship in this chapter because there would be difficulties in translating it into other languages. Instead, the Board described what stewardship encapsulates. Accordingly, the objective of financial reporting acknowledges that users make resource allocation decisions as well as decisions as to whether management has made efficient and effective use of the resources provided.

Footnotes

1. The FASB, which was cut from seven to five members in 2008, was restored to seven members in 2011.

2. Based on issues raised in recent roundtables in regard to goodwill impairment testing, the FASB published, for public comment, a proposed Accounting Standards Update, Intangibles–Goodwill and Other (Topic 350): Testing Goodwill for Impairment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.