A private GAAP?

Here’s something not every private equity CFO has been closely tracking but should be: the Financial Accounting Foundation (FAF), the body that oversees US accounting rulemakers, is in the process of creating a council dedicated to the needs of private companies.

For years now CFOs of non-public entities have complained that Generally Accepted Accounting Principles (GAAP) – the common set of financial reporting standards followed by US companies – were too complex and primarily designed with large public companies in mind. Although US GAAP is primarily applicable to public companies, many lenders and insurers require private firms to produce a US GAAP report for evaluation purposes.

That message was made loud and clear to FAF during a “listening tour” back in 2009. However it would not be until late 2011 that FAF revealed the message had not fallen on deaf ears by proposing the formation of a “Private Company Council”.

The council is still in its infancy stage but its mission is clear: to determine whether exceptions or modifications to GAAP are needed for private companies and act as an advisory body to the Financial Accounting Standards Board (FASB). That will provide a stronger voice for CFOs who argue private entities have different needs in how they present financial information, less resources to do it, and need more time to keep pace with changing accounting rules (see below for details).

DE-CLUTTERING

A reduction in the number of disclosure notes CFOs include in their financial statements is arguably where private equity CFOs stand to gain the most in the council’s formation. Already FASB is seeking input on this topic as part of its ongoing disclosure framework project. In July the board released a 75 page consultation paper asking stakeholders how to improve the effectiveness of disclosures by making them more useful and less redundant (with comments due by 16 November). 

David Larsen, a managing director at valuation specialist Duff & Phelps, says many private equity CFOs have questioned the relevance and sheer volume of information that must be contained in note disclosures. For instance, “having to disclose specific inputs used in the fair value estimates of portfolio companies could be an information overload for investors”.

Reducing the volume of notes is not the primary focus of the project, but “the board hopes that a sharper focus on important information will result in reduced volume in most cases”, the consultation paper said.

According to Larsen, a more efficient framework for note disclosures would be a twofold victory for GPs: in reading underlying portfolio company financial statements and in the creation of the funds’ own statements.

FASB began work on its disclosures framework in 2009, having realised that financial reports became bloated with notes as a safeguard against regulatory scrutiny.

The discussion paper encompasses both public and private entities, but FASB said that the PCC may have “some effect” on the consultation. And it is entirely possible that whatever conclusion FASB reaches on the matter, the PCC can make the case that looser disclosure guidelines should be made available for private-sector companies that make themselves more available to inquisitive readers of their financial statements.

WISHFUL THINKING

One thing the PCC will not be however is a saving grace for all the frustrations that come with preparing private company financial statements under US GAAP. For starters the council falls short of what many in the private-sector had hoped for: the creation of a wholly independent standard-setter for private companies. Any PCC recommendations must first pass a FASB endorsement process before making their way into US GAAP.

But is that such a bad thing? Larsen says a completely separate set of standards for private companies would create unneeded bureaucracy for accountants who would likely need to keep track of changes in both public and private standards. Moreover a separate set of rules “doesn’t allow you to build off the good things that FASB has done”. And readers of financial statements would need time to familiarise themselves with the differences between private standards and US GAAP. There is no guarantee the transition would come easy. 

David Larsen

A small minority of private equity CFOs are also hoping the PCC will start a campaign to allow firms to report their investments at cost instead of the more time consuming “fair value” estimates used today. If the PCC were to pursue this path, it would be a mistake, says Larsen. What some forget “is that would create a huge problem for LPs who have their own fiduciary obligations to report investments at fair value”. Fund managers going back to the old way of business (i.e. reporting their investments at the price they paid for them until some other significant change in value occurs) would have on their hands an investor relations nightmare, he says.

But for the most part the PCC should be welcomed by the industry. The council provides a stronger voice for private-sector CFOs hoping for a more bespoke set of accounting rules. At press time the FAF was interviewing candidates for the PCC Chairman role as well as the 9 to 12 members who will make up the council – all of whom will be selected and appointed by the board of trustees, which is currently reviewing more than 100 nominations. 

The council’s first meeting is expected sometime in the fourth quarter, according to a FAF spokesperson. It is something for the industry to track, and more importantly engage.

In late July FASB already published some early ideas on how tailored private company accounting standards could look: including revisions to recognition and measurement, disclosures, and presentation standards for example. Another suggestion is to allow private companies more time to adopt new standard as they are issued. The board is looking for feedback on its proposals, leaving CFOs a grand opportunity to have their GAAP criticisms formally considered.

=====================================================================
THE CASE FOR PRIVATE STANDARDS

Last summer FASB staff identified six factors that justify the need for tailored private company accounting standards:

1. The markets have less need for private company financial statements than they do public company statements (i.e., debt investors, analysts).

2. Readers of private company financial statements have more access to management to ask follow-up questions.

3. Shareholders in public companies are more active buyers and sellers who rely on up to date financial statements to anticipate short-term changes in share price.

4. Ownership structure should play a role in what (and how) financial information is presented. Private companies are usually structured as S-corporations; limited liability companies or limited partnership for tax purposes while public companies are usually formed as a C-corporation.

5. Private companies typically have thinner resources than public companies to manage the accounting function.

6. Due in part to less accounting resources, it takes private companies longer to learn about new financial reporting guidance.