By Jeffrey S. Zanzig and Dale L. Flesher
MAY 2006 - The accounting profession has long struggled with the idea that the financial reporting needs of small, closely held businesses often differ from those required by large, publicly traded companies. In formulating generally accepted accounting principles (GAAP), the profession has primarily addressed the needs of a public corporation. This is partly attributable to the importance of ensuring the integrity of U.S. capital markets. Smaller, private organizations have generally been subject to the same reporting requirements as the public corporation. This article addresses the AICPA study regarding the subject of “Big GAAP” versus “Little GAAP,” issued by the Private Company Financial Reporting Task Force in February 2005.
The task force report points out that deficiencies exist in current GAAP’s ability to meet the financial reporting needs of nonpublic companies. A resolution subsequently passed by the governing Council of the AICPA on May 23, 2005, directs “AICPA management to work with the Financial Accounting Foundation (FAF) and the Financial Accounting Standards Board (FASB) to identify and implement a process that would evaluate, where appropriate, potential changes in recognition, measurement, and disclosure from current GAAP as applied by public companies.”
The profession recognizes that GAAP reporting must provide relevant information that is useful for the decision-making needs of those groups for whom the information is provided. For example, in 1974 the standards division of the AICPA performed a study of the application of GAAP for small or closely held businesses. In 2004, the AICPA’s Private Company Financial Reporting Task Force conducted a nationwide survey to determine how to address the continuing concern over differences in the reporting requirements of public and private companies. This article presents findings of the study regarding GAAP and its relevance in the reporting environment of private organizations.
Background
There are diverse perspectives on the subject of GAAP as applied to public and private companies.
Separate GAAP requirements. For many years, it has been proposed that the same accounting standards do not have to be required for both public and private companies. In the December 1972 Journal of Accountancy, two CPAs expressed frustration with GAAP requirements’ being applied to smaller organizations. Betty McGill, a small-firm practitioner, pointed out that local practitioners are aware that requiring smaller organizations to name a long list of noncompliance with GAAP can be so confusing to clients that the statements become meaningless and sometimes intolerable to the client. Peter Arnstein, a partner of a large regional firm, suggested that clients are reluctant to pay for services that they see as providing no value to them or to the public. Arnstein suggested that certain closely held companies should be exempt from GAAP requirements that primarily serve the readers of publicly held companies’ financial statements.
In a 1974 article discussing the necessity of duality in accounting standards for public and private organizations, CPA Journal editor Max Block stated that “the accounting standards should not have been made mandatory to public and private companies without exception. In some instances, later exemplified, they should have been made optional to private companies.” Later, in a 1977 article, Block makes use of the words of John C. (Sandy) Burton, SEC chief accountant from June 1972 to September 1976, to point out that public accounting is actually two professions. In one, where the primary relationship is between the accountant and the client, attestation is less important, because it really exists only with parties that have a direct relationship with the client, such as its bankers. The other profession also has a relationship with the client, but it primarily serves the interests of outsiders. Burton suggested that although a basic accounting model is appropriate for all preparers of financial statements, this is different from the need for specific detailed disclosures and comparability between financial statements. In referring to Burton’s statements, Block clarified his perspective that public corporations and nonpublic companies are actually more like two types of clients that should be sharply distinguished.
In 1976, Haim Falk, Bruce C. Gobdel, and James H. Naus published “Disclosure for Closely Held Corporations” (Journal of Accountancy, October 1976). They had surveyed commercial lending officers regarding their process of evaluating closely held companies and found the following factors to be of importance:
- Disclosures regarding balance sheet items tend to be important in evaluating a closely held company. This is in contrast to research indicating that analysts evaluating public companies find income-statement items such as earnings per share to be most important.
- Information regarding obligations such as contingent liabilities and commitments, leases, and long-term debt is important.
- The statement of changes in financial position is an important financial statement.
- The disclosure of accounting policies is important, particularly with regard to changes in accounting methods.
- Information such as earnings per share, price-level adjustments, and product-line reporting was found to be relatively unimportant.
- Commercial lending officers often encourage their customers to have audited financial statements.
- The lenders strongly believe that the accountant’s report for unaudited financial statements should disclose known departures from GAAP.
Although much time has elapsed—and GAAP and the business environment have changed—since this research was conducted, it does provide the background necessary to appreciate the driving force behind the AICPA’s 2004 study.
Common GAAP requirements. In contrast to the preceding opinions supporting a separate GAAP for closely held businesses, James Naus, in “Practitioners Forum: Unaudited Financial Statements Revisited” (Journal of Accountancy, January 1974), took a position contrary to his coauthors, Betsy McGill and Peter Arnstein, and presented reasons for not allowing separate rules for public and private companies. First, Naus pointed out that allowing alternative treatments may weaken a CPA’s position in achieving fair presentation and full disclosure. Second, a private company may still interact with the public environment. For example, an organization may wish to compare itself with larger competitors or later become a public corporation. Naus implied that CPAs associated with nonpublic organizations would do better to influence GAAP in a way that would meet the reporting needs of all entities.
A compromise position. In the 1970s, the AICPA’s accounting standards division studied the application of GAAP to small and closely held businesses. As explained by Charles Chazen and Benjamin Benson in “Fitting GAAP to Smaller Businesses” (Journal of Accountancy, February 1978), in reporting its findings the committee distinguished between two sets of principles. First are principles that are used in the measurement process. The committee believed that this process should not be affected by the nature of the user, because confusion would result from similar transactions’ being reported on an inconsistent basis. Second are principles that regulate disclosure practices. The committee supported the idea that particular disclosures may depend upon the needs of the user or on other factors.
A flickering interest in separate GAAP requirements. In the 1970s, the opposing perspectives described above received significant attention that led to a comprehensive study, supported by FASB, to provide detailed empirical data to consider the possibility of having different accounting principles govern reporting by public and by private companies. The statistics in the study, “Financial Reporting by Private Companies: Analysis and Diagnosis” (completed in 1983; principal researcher A. Rashad Abdel-Khalik), indicated that although accountants believed that a separate GAAP would be beneficial, bankers found GAAP-based statements useful for decision making and favored the continued reliance of all companies on one set of GAAP. No consistent opinion was found among managers. In addition, in 1983 FASB published a special report which found that most lenders and other creditors feel “that their financial information needs and decision making practices are essentially the same for private as for public companies.”
This temporarily settled the issue until 1995, when the AICPA’s Private Companies Practice Executive Committee (PCPEC) concluded that standards overload was one of the most significant concerns of members practicing in small firms. The issue of separate GAAP for private companies was again rejected, however, when it was decided that allowing a new basic accounting method would only contribute to the standards overload problem. Therefore, in 1996 the AICPA’s “Report of the Private Companies Practice Section Special Task Force on Standards Overload” recommended that the best approach would be to have “the Financial Accounting Foundation (FAF) make a concerted effort to recruit and select trustees, FASB board members, and FASB staff persons who have experience with and understanding of the needs of small non-public entities.” In fact, The CPA Journal had reported that in 1989 the Private Companies Practice Section (PCPS) of the AICPA Division for CPA Firms had promoted other comprehensive bases of accounting (OCBOA) as an alternative for small businesses to meet financial reporting needs in certain situations, but not as an alternative form of GAAP. After the turn of the century, the AICPA noted that no in-depth study of the issue had been conducted in recent years. This concern led to the following study.
Private Company Financial Reporting Task Force Study
The AICPA’s Private Company Financial Reporting Task Force began comprehensive research in early 2004 to consider whether the general-purpose financial statements of private companies, prepared in accordance with GAAP, meet the financial reporting needs of constituents of that reporting, as well as whether the cost of providing GAAP financial statements is justified compared with the benefits they provide to private-company constituents.
GAAP requirements. One survey question presented 12 GAAP requirements and asked respondents to rate the requirements in regard to relevance or decision usefulness. The following GAAP requirements were included in the survey:
- Accrual basis accounting
- Cash flow statement
- Classification of liabilities and equity (e.g., mandatory redeemable financial instruments, such as ownership buyout agreements as addressed in SFAS 150)
- Comprehensive income measurement (e.g., items excluded from the income statement)
- Deferred income taxes (e.g., deferred tax assets and liabilities)
- Fair-value basis of measuring assets and liabilities (e.g., as compared with historical-cost measurement)
- Guarantees (e.g., recognizing and measuring their fair value)
- Intangibles (e.g., goodwill accounting)
- Leases (e.g., capitalized versus operating)
- Postretirement and retirement plans (e.g., pensions)
- Share-based payments (FASB’s current proposal allows private companies to use the intrinsic-value method instead of the fair-value method for determining compensation expense related to stock options)
- Variable-interest entities (e.g., the need to consolidate entities if certain conditions exist).
Responses were received from 3,709 individuals. The discussion uses a classification scheme based on the mean response on each GAAP requirement for the respondent categories. Subcategory information for respondents is presented only where there is inconsistency in the mean score rating for the overall respondent group.
Basic measurement principles. The respondents were permitted to rate each of the study’s 12 GAAP requirements on a scale of low (1), medium (2), or high (3). Respondents were also given the option of indicating either that the requirement did not apply to them or that they did not know.
Three GAAP requirements received a mean score greater than 2.0 from each of the three groups: accrual basis of accounting, cash flow statement, and classification of liabilities and equity. The consistently high score for these items indicates that they are perceived as important to relevance/decision usefulness. In accordance with the previously described recommendation of the AICPA’s accounting standards division, the authors propose that these items be included as part of principles used in the measurement process in order for financial statements to comply with GAAP (public or private organizations). In other words, they are not to be considered optional requirements when a GAAP presentation is the intent of the information provider.
Value-added service unrecognized by practitioners. Exhibit 1 identifies the GAAP requirements which all groups of external stakeholders and some owners/managers rated high on relevance/decision usefulness. Practitioners, however, scored these requirements as medium or low. Although the results show that some owners/managers also rated the requirements as low, overall the requirements provide perceived value that should receive further evaluation. Future research is needed to determine the role that organizational size and possibly other factors play in determining the value of specific GAAP requirements for private companies.
It is possible that practitioners view comprehensive income measurement and fair-value measurement of assets and liabilities as unnecessary requirements for private companies. It does appear, however, that this information is often something that external stakeholders desire and that some owners/managers may be willing to pay to have provided.
Demonstrate value or discontinue. The information shown in Exhibit 2 identifies GAAP requirements that external stakeholders and owners/managers scored as medium or low on relevance/decision usefulness. Practitioners’ ratings are somewhat mixed, except for the high value assigned to leases. Some practitioners, however, rated each of the Exhibit 2 requirements at the high end of the scale.
This is not to suggest that these GAAP requirements are of no value in providing appropriate financial reporting for private companies. If the profession wishes to continue these requirements, however, owners/managers and stakeholders should be educated as to their value. With the exception of leases, not even practitioners are in agreement on the value of these requirements, because practitioners in different-sized firms evaluated the relevance/decision usefulness at varying levels.
Educate owners and managers. The information shown in Exhibit 3 identifies GAAP requirements that some external stakeholders and practitioners ranked highly. Owners/managers, however, scored the requirements as medium or low. Although both practitioners and external stakeholders were mixed in their evaluation of these requirements, the external stakeholder groups of creditor/lender and surety/bonding both rated the requirements on the high end of the scale. Also interesting is that firm size was directly correlated with practitioners’ rating assigned to both deferred income taxes and guarantees.
Because the purpose of financial reporting is to satisfy the needs of decision makers with capital, owners/managers should be shown the value that certain external stakeholders place on financial information. Given the mixed results for practitioners, accountants may need to further evaluate the value of the Exhibit 3 requirements to their clients.
Consider discontinuing the requirement. The mean scores for the GAAP requirement shown in Exhibit 4 are medium to low on relevance/decision usefulness for all three groups of respondents. If information about share-based payments is not perceived to add value to private-company financial reporting, then this area might not be relevant for private companies. (Of course, some may argue that it is not relevant for public companies either.)
Confronting the Inadequacy of a Single GAAP
The AICPA task force concluded that most of the constituencies in the 2004 study are of the opinion that it would be useful if the underlying accounting for public versus nonpublic (private) companies were different in certain situations. It found that some of the GAAP requirements for public companies studied lack relevance/decision usefulness for private companies. In addition, the task force found that, although respondents rated certain GAAP requirements as low on decision/relevance usefulness, respondents appear to believe that the benefits of complying with GAAP outweigh the costs. This apparent conflict may be explained by the favorable ratings given the overall value of GAAP.
The task force also concluded that allowing GAAP exceptions and other bases of accounting is not an appropriate response to the unique needs of private-company financial reporting. The task force believes that such an approach would erode the overall recognized value of GAAP, while other bases of accounting may not adequately serve the needs of private companies.
In essence, the task force recommends that a recognized set of standards be established as GAAP for private companies. Although the task force has not attempted to determine the structure of such an arrangement, it has suggested that the framework include the following:
- Changing the composition of FASB and the FAF to be more representative of private-company constituents; or
- Increasing private-company constituents’ representation on the FAF and establishing a new private-company GAAP standards-setting board under the FAF that would address only the needs of these constituents; or
- Creating a new private-company GAAP standards-setting body outside the FAF.
As eloquently stated by FASB Chairman Robert Herz in 2005: “Private companies are a vital force in the nation’s economy and it is, therefore, critical that their financial reporting be conceptually sound, cost effective, and provide relevant, reliable and useful information.” This does not mean that there should be two sets of GAAP requirements that do not share some common components. The information drawn from the task force study provides a good starting place for identifying the beginning principles of GAAP for private companies.
Jeffrey S. Zanzig, PhD, CPA, is an assistant professor of accounting at the College of Commerce and Business Administration of Jacksonville State University, Jacksonville, Ala.
Dale L. Flesher, PhD, CPA, is associate dean of the Patterson School of Accountancy of the University of Mississippi, University, Miss.
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