For decades, privately-owned companies have been forced to comply with many irrelevant public company financial reporting standards, many of which are overly complex, costly to comply with and pose potential litigation risks. Spurred by a desire to create more relevant accounting rules, which avoid unnecessary complexity and costs of compliance, there is growing momentum to create new rules and a new board to oversee private company accounting standards.
On Oct. 14, 2011, the Financial Accounting Foundation (FAF) released its plan to improve the standard-setting process for privately held businesses. The public comment period on that plan closed on Jan. 14, 2012. FAF received more than 6,500 comment letters, many of which expressed concerns that the FAF plan falls significantly short of what is needed to improve private company financial reporting standards. FAF has acknowledged those concerns and anticipates releasing a revised plan in the second quarter of 2012. While there are still structural issues to resolve, including the degree of autonomy of a new private company standard setting board, we anticipate that there will be changes in private company financial reporting, and that this is likely to be beneficial to banks and the companies to which they lend.
Blue Ribbon Panel
Numerous efforts to improve private company financial reporting have been attempted without success over the years. The current and most promising effort began in January 2011, when a Blue Ribbon Panel on Private Company Financial Reporting issued a set of recommendations on the changes necessary to best meet the needs of the users of private company financial statements.
Noting, among other factors, that exceptions taken in auditors’ reports on private company financial statements can be confusing, the panel recommended creation of a new, autonomous board with private company standard-setting authority. The panel also called for utilizing existing Generally Accepted Accounting Principles (GAAP) as the starting point for changes and modifications to private company financial statements.
The panel wanted to give the new standard setters the ability to give near-term relief, granting exceptions or modifications to existing GAAP, rather than starting from scratch.
The FAF plan did not include an autonomous board for private company standard setting, as recommended by the Blue Ribbon panel. Rather, it called for a new board that is chaired by a member of the Financial Accounting Standards Board (FASB) with recommendations subject to FASB approval. Given the strong public opposition to FAF’s plan for creating a board that is less than fully autonomous, there is hope that FAF will reconsider.
Changes Of Importance To Lenders
While there still remain some uncertainties over the structure of the board, the proposed private company reporting system is likely to address several issues of importance to lenders. Two issues of particular interest are: Financial Accounting Interpretation (FIN) 46 and derivative accounting for interest rate swaps.
With its origin in the Enron scandal, FIN 46 focused on the consolidation of variable interest entities. Enron had, among other things, schemed to transfer its debt into special purpose entities, resulting in off-the-books financing. FIN 46 addressed that by changing the definition of and the accounting rules related to a variable interest entity. These changes often resulted in the consolidation of related entities in a single set of financial statements, even if their operations were very different.
While this may have made sense for preventing future public company debacles, often it did not make sense for a private enterprise which, for tax purposes, used a different entity to hold real estate, but was now forced to consolidate the properties for financial reporting purposes. This was especially problematic when the historical cost of the real estate was significantly less than its fair value and the mortgage.
The new private company financial reporting board is also likely to address the way derivatives are treated. Banks often encourage small, closely held businesses to enter into an interest rate swap to effectively fix the rates on their customer’s borrowing. Accounting rules sometimes result in the changes in fair value on these swaps being accounted for in the income statement, often significantly impacting the earnings of an entity. Again, these rules, established with large public companies in mind, and with little relevancy to private companies, can significantly impact the financial reports of privately owned businesses.
What’s Next
While there remains uncertainty as to how far FAF will move in the direction of creating a fully autonomous board, we are hopeful that we will have a new system that is more relevant to the needs of private companies and the lenders that work with them.
It’s important to note that no one is looking for a reduction in the quality of accounting standards, as is inferred in the reference to the so called "Little GAAP" or "GAAP Lite," but rather, the changes are designed to offer a set of quality standards that are more "relevant" to company owners, bankers, investors, accountants and bond underwriters. In an age when we are seeing an explosion of new rules for public companies, having a group that focuses on private company financial reporting would certainly be welcome.
James P. Kenney is a member of the firm at Wolf & Company, PC. Email: jkenney@wolfandco.com.
Editor’s Note: This article has been updated from an original article which appeared in print in the Feb. 20 edition of Banker & Tradesman
