Trustees of the Financial Accounting Foundation received a report early this year from the blue-ribbon Panel on Standard Setting for Private Companies on how best to meet the needs of users of private-company financial statements. The report recommends that the FAF set up a separate standard-setting board to evaluate both old and new standards published by the Financial Accounting Standards Board, to determine whether private companies need different standards for recognition, measurement, presentation, and disclosure of financial information. If differences are warranted, the new board would have the authority to adopt them.

Predictably, the panel asserted that the different needs of private-company users warrant a separate standard-setter, because FASB is incapable of doing an appropriate job itself. By framing the explanation of its recommendations on the needs of users, the panel seems to place its focus in the right place. In reality, however, this recommendation isn't focused primarily on user needs; it's a play to reduce costs for private-company issuers with an outside seal of approval on more business-friendly (and less robust) accounting standards. The FAF would be wise to reject the recommendation. If some accountants and others want to create a set of watered-down accounting standards, let them do so on their own. The FAF shouldn't lend its resources and reputation to such an effort.

We've Been Down This Road Before

Easier accounting and reporting standards for private companies have repeatedly come up for consideration. While I'm not a long-time veteran to accounting policy debate, I've been in meetings on four separate occasions to consider what is often called “Big GAAP, Little GAAP.” They always start the same: with talk about the differing needs of users, and the suggestion that “Big GAAP” fails to meet the needs of users of the financial statements of small companies. But the discussions quickly turn to the cost and effort that goes into preparing financial statements. Lowering costs is a legitimate concern for preparers of financial statements, but it has little to do with Big GAAP failing to meet the needs of users.

The blue-ribbon panel report covers the same ground. It provides no evidence that statements prepared under current Generally Accepted Accounting Principles don't meet the needs of users of private company reporting. Nonetheless, the report suggests that user need is what drives its recommendation that private companies be permitted to prepare financial statements under a set of standards that would result in less disclosure, less cost, and fewer requirements that are hard to obey. As in the past, I fail to see how reduced disclosure and less robust accounting standards could benefit anyone who uses financial data.

The Needs of Different Users

As the report notes, many countries outside the United States have significantly different accounting standards for private companies, including Canada and many European countries. In most of the countries with separate reporting standards, private companies have a legal requirement to prepare financial statements whether they use outside capital or not; that means that many of those companies prepare financial statements only to satisfy the regulation, and no non-governmental users of those statements really exist.

In the United States, a capital provider (say, a bank or private equity fund) imposes the requirement for private companies to prepare financial statements, not the government. The users of those financial statements are far more likely to have needs similar to the needs of users of public company financial statements.

If a group without a reputation for acting in the public interest created Little GAAP on its own, the alternative set of standards might lack credibility.

Nonetheless, it's true that some users of private company financial statements can have their needs met with financial statements prepared under an easier set of accounting standards. FASB implicitly notes this in the conceptual framework, as it describes the objectives of financial reporting:

“Many existing and potential investors, lenders, and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed.”

Now, figuring out which users might have these reduced needs is important. Here, the report seems to skip the question. It concludes that all users of private-company financial statements have reduced needs, although it acknowledges later that some users might see fit to ask for full GAAP statements if they so choose. The report cites this as a strength of its primary recommendation, as it would allow the market to determine whether the financial statements are prepared under Big GAAP or Little GAAP.

But the market already does this. Users of private-company financial statements often will accept financial statements with departures from GAAP, or those prepared on an “Other Comprehensive Basis of Accounting” (such as a tax or cash basis).  While the report correctly notes that fact, oddly, the panel doesn't see this as evidence that the market is already determining when GAAP financial statements are unnecessary. Instead, it is cited as an indication that GAAP is unsuitable for private-company financial statements.

Follow the Money

Critical anlysis of the report indicates that this is a cost-driven initiative. For example, the panel recommends that private companies receive a two-year delayed adoption schedule for new standards, rather than the more common one-year delay. How can that possibly be user driven?

In describing the problem the panel intends to solve, the report provides no evidence that financial statements prepared under GAAP are insufficient for private-company user needs. Rather, it argues that financial statements prepared under a less robust system of standards might well also be sufficient. In that regard, the panel may be correct, but if so, the changes are being made not to meet user needs (since they are already being met), but instead to reduce costs while still (hopefully) meeting those needs. There may be nothing wrong with that logic, but the panel should be more forthright about its motives.

Lenders and private-equity investors typically require financial statements prepared in accordance with GAAP. Rather than simply accepting this as evidence that GAAP-based financial statements meet the needs of private-company users, the report cites this as a reason that a separate board is needed. The panel seems to believe that if an easier set of accounting standards were available, capital providers might be more willing to accept them, while they may be reluctant to accept the same accounting that would have to be described as a departure from GAAP. The theory seems to be that we should allow companies to say they complied with an easier set of standards, instead of making them say they didn't comply with GAAP.

So What's Really Going On?

Of course, nothing is stopping proponents of Little GAAP from creating a set of standards and trying to convince capital providers that it should be good enough. Some jurisdictions have done something similar when they modified International Financial Reporting Standards for use in their country: they aren't the same standards set by the International Accounting Standards Board, but they're good enough. Of course, that works because governments are the ones creating the altered standards, which gives them credibility.

And that leads to the recommendation by the panel that the FAF create a second standard-setting board. If a group without a reputation for acting in the public interest created Little GAAP on its own, the alternative set of standards might lack credibility. While one might argue that keeping a board charged with creating different standards for private companies under the FAF would ensure that private-company standards don't get out of hand, the real benefit to those pushing for the second set of standards is credibility. With the FAF's imprimatur on them, capital providers would be much more likely to accept private company-standards.

But why should the FAF be interested in putting its name on a less robust set of standards? In continuing to emphasize that GAAP should be “Generally Accepted,” the panel seems to think that wide use is the goal, so the FAF should be interested in having a second set of standards available, so that more companies will use FAF-sponsored standards. But popularity isn't the goal. Quality and transparency are the goals, and the Conceptual Framework makes that clear.

The FAF should not lend its name to a set of standards whose primary goal is reduced costs, rather than meeting the needs of users.

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