The Financial Accounting Standards Board (FASB) and the Private Company Council (PCC) recently released new guidance that sheds light on how they will determine whether to grant private companies that adhere to Generally Accepted Accounting Principles (GAAP) some exceptions to those standards when preparing financial statements.
The two bodies will use Private Company Decision-Making Framework: A Guide for Evaluating Financial Accounting and Reporting for Private Companies (known informally as “the Guide”) to decide whether to establish alternative standards for private companies in the areas of recognition and measurement, disclosures, display/presentation, effective date and transition method. The Guide lays out specific criteria FASB and the PCC will consider when weighing whether to sanction such alternative standards.
In addition, FASB has published Accounting Standards Update (ASU) 2013-12, Definition of a Public Business Entity: An Addition to the Master Glossary. The ASU provides the definition that FASB and the PCC will apply to determine which entities new accounting and reporting standards will cover, as well as which entities will be excluded from the scope of the Guide and thus subject to GAAP without exception.
The definition of a “public business entity”
The amendments in ASU 2013-12 come in response to stakeholder concerns about the inconsistency and complications created by the multiple definitions of “nonpublic entity” and “public entity” contained within GAAP. The amendments clarify that a business entity will be considered public only if it meets one of the following criteria:
- It files or is required to file or furnish financial statements with the U.S. Securities and Exchange Commission (SEC), including voluntary filers.
- It is required by the Securities Exchange Act of 1934 or related rules or regulations to file financial statements with or furnish them to a foreign or domestic regulatory agency other than the SEC.
- It is required to file financial statements with or furnish them to a foreign or domestic regulatory agency in preparation for the sale of — or for purposes of issuing — securities that aren’t subject to contractual restrictions on transfer.
- It is a conduit bond obligor or its securities are traded, listed or quoted on an exchange or an over-the-counter market.
- Its securities aren’t subject to contractual restrictions on transfer, and it’s required by law, contract or regulation to prepare GAAP financial statements, including footnotes, and make them publicly available on a periodic basis (for example, interim or annual periods).
In good news for affiliated businesses like subsidiaries, ASU 2013-12 specifies that, if an entity meets the definition solely because its financial statements or information is included in another entity’s SEC filing, it’s deemed a public entity only for purposes of the financial statements filed with or furnished to the SEC. Such a business, therefore, would indeed be eligible for potential GAAP alternatives for its standalone financial statements.
But it’s important to realize that, even when an entity falls within the Guide’s scope because it falls outside the definition of a public entity, the entity won’t necessarily be allowed to apply every alternative GAAP standard. FASB and the PCC will review factors such as user needs on a standard-by-standard basis when determining which business entities within the scope of the Guide can actually apply financial accounting and reporting alternatives. Moreover, whether an entity may apply GAAP alternatives may be determined in the end by the entity’s regulators, lenders and other creditors, or other financial statement users that require GAAP financial statements.
The new definition doesn’t apply to existing standards. ASU 2013-12 takes effect when the first new ASUs that use the definition are issued, which are the two PCC alternatives on accounting for goodwill (ASU 2014-02) and the simplified hedge accounting approach for certain interest rate swaps (ASU 2014-03).
Financial statement user needs
The Guide lists five factors that may distinguish the needs of private company and public company financial statement users, along with observations about each factor’s potential implications for financial reporting:
1. Number of primary users and access to management.
The types of primary users of private and public company financial statements are generally similar, but private companies frequently have fewer users. In addition, these users may have greater influence on financial statement preparers than, for example, a single shareholder in a public company. As a result, these users can usually access financial information throughout the year without needing to resort to interim financial statements.
Disclosures in private company financial statements, therefore, may need to provide only the information necessary to enable users to ask management follow-up questions that would satisfy their needs for information. But the Guide observes that access to management should have no effect on whether GAAP regarding recognition and measurement should include private company alternatives. Access can, however, be a factor in evaluating potential alternatives for private companies within GAAP.
2. Investment strategies of primary users.
Users of private company financial statements have little or no access to public markets where they can turn to exit their investments. They may have a greater focus on cash that can be realized, such as dividends and interest, repayment of principal, and business combinations. These users may hone in on cash-adjusted earnings from operations — for example, earnings before interest, taxes, depreciation and amortization (EBITDA) — with some additional noncash adjustments. Private company investors, therefore, may be more interested in accounting guidance that affects cash amounts or probable future cash flows or that produces volatility in reported earnings and asset and liability values.
3. Ownership and capital structure.
In contrast to public companies, private companies often take the form of pass-through entities. They may also have multiple entities under common ownership that result in transactions with related parties and guarantees and cross-collateral arrangements with lenders. Such differences should be considered in evaluating the applicability and consequences of accounting guidance on, for example, income taxes, consolidation and equity. They also could justify requiring different information about related-party transactions — either more or less — from private companies and public companies.
4. Accounting resources.
Most private companies that prepare GAAP financial statements are small and have fewer accounting resources, including less influence on standard setting, than public companies. The Guide indicates that FASB and the PCC should consider these resource limits when developing effective date and transition guidance.
5. Education on new financial guidance.
Preparers of private company financial statements usually don’t receive education updates until the second half of the calendar year, while preparers of public company financial statements commonly learn about new guidance on a regular basis throughout the year. Deferred effective dates help ensure that private company preparers receive appropriate notification and training. They also allow users of private company financial statements additional time to learn about new guidance and better gauge how the change will affect their financial statements.
Interplay with the AICPA SME framework
The American Institute of Certified Public Accountants (AICPA) in 2013 announced a new option for small business financial reporting, referred to as the “Financial Reporting Framework for Small- and Medium-Sized Entities” (SME framework). The SME framework — unlike the Guide — is intended for smaller, privately held, owner-managed businesses whose financial statement users don’t require them to follow GAAP.
The SME framework is designed to help these businesses clearly and concisely report what they own, what they owe, and their cash flow. The AICPA has stated that the SME framework complements the PCC’s efforts to modify GAAP for private companies.
The Guide and the new definition of “public business entity” are encouraging signs for private entities that have felt beleaguered by some of the more onerous financial reporting requirements for companies that follow GAAP. Combined with the upcoming release of new PCC standards, their publication lends credence to the promise by FASB and the PCC to reduce the complexity and costs of preparing financial statements for such companies.
If you have questions regarding how the FASB and PCC guidance affects how you prepare your financial statements, please contact us. We are happy to answer your questions.