Background on Private Company Framework Comments, By Andy Thrower
Dec. 5, 2009
NOTE: This document was originally prepared by Andy Thrower to inform members of FEI's Committee on Private Companies - Standards, and represents his personal views and not the views of FEI or CPC-S.
It seems that every December I get into the mood to write. However, I am trying to suppress that mood and hopefully this edition will be short.
I want to clarify why I am harping on a conceptual framework solution for private company constituents. First I want to elaborate a little on the view expressed or felt by many private company constituents that if we could just roll GAAP back to the way it used to be, then we could keep that base set of standards for private company financial reporting. This latter view is expressed in a number of ways by private company constituents. For example, some of us, including me, have stated (not totally with tongue in cheek) that if we could eliminate all FAS standards numbered above 100, we could solve a lot of our problems. Another way that this desired roll back of recent changes to basic GAAP was stated in the SBAC meeting by a fellow SBAC member and the quote was picked up in the BNA Reporter:
I don't think two sets of standards, 'big GAAP/little GAAP,' is the answer. Instead, I'd propose additional disclosure requirements for public companies to satisfy that small group of analysts, investors, that want that, and leave GAAP alone, GAAP should be GAAP; if you need additional information give it in schedules, in footnotes, but don't put undue cost out to 95, 98% of companies in the U.S., that are going to get zero benefit out of it.
So, we private company constituents have made the argument that GAAP be put back to its normative state and then GAAP will be okay for private companies. Then, the FASB can just add, only for public company users, the requested additional disclosures. That way we can also keep a single standard setting body.
My alternative conceptual framework approach is driven by my belief that the above “roll back” approach cannot work. I am old enough to have been educated in the earlier GAAP; i.e., a GAAP that focused, among other things, on measuring periodic income using the matching principle by allocating past incurred historical costs to current and future reporting periods. There was a basis for how and why accountants did this. In other words there was a conceptual framework. This framework was partially written down, and partially accepted by custom and tradition; e.g., we older accountants were all taught the matching concept, the going concern concept, the principle of recognizing a transaction if it was a least probable and could be reasonably measured, etc. This framework was “normative” in nature as opposed to “positive” By normative I refer to that process that attempts to define a framework by observing what is actually happening in accounting practice and then tries to describe it in general terms. On the other hand an attempt to create a positive framework starts with a blank sheet of paper and asks what does the user want, and then accounting standards in support of this positive framework are written.
Here is what has happened. While we older accountants were trained in the “normative” environment, certain users of public company financial statements, primarily public company investors and their representative analysts, became increasing displeased with the measuring of only past transactions through the income statement and pushed for a new and positive framework that would focus on predicting cash flows with a stronger emphasis on using the balance sheet to do these predictions. After some failed attempts by earlier bodies, the FASB managed to create a somewhat, but certainly not complete, positive framework based primarily on public company user needs. As a result the GAAP that we knew begin to change and move toward the investors’ view. Some changes were done with very little pain to us private company preparers; for example, in deferred taxes we all used to do interperiod tax allocation which allocated tax expense among accounting periods. This was changed in FAS 96(?) to the recognition of deferred taxes on the balance sheet based on the expected future cash flow impact of the deferral (albeit undiscounted). Other changes to standards were more bothersome; for example estimating the future cash flow of goodwill instead of just amortizing original cost. Future standards will continue to change the model that we have known; for example revenue recognition will move from a matching principle concept (i.e., putting income in the period that you earned it) to a balance sheet approach. Additionally, other past standards have been a compromise between the old framework and the new; for example the old pension accounting standard allowed some limited recognition of the present value of future cash flows, but only up to an amount that did not significantly impact the measurement of accounting income. While all of these changes came slowly over many years, the trend has been to bring the old standards in line to the FASB’s, investor oriented framework. The process is now accelerating and this is the primary reason for both complexity and lack of relevance in the standards that are felt by private company constituents. (There are, of course, other substantial reasons for complexity such as the legal and regulatory environment that we all live in.)
My point is that we cannot get GAAP back to its former simpler version that many private company constituents believe is all that is needed for them. I have attempted to demonstrate this in this diagram.
The original framework attempted to describe by a normative process the existing financial reporting model. In the top section of the chart (Section I) Point A represents a point along the original GAAP development timeline. While it was never frozen, that GAAP had the characteristic of the old framework. When the conceptual framework was changed at Point B, existing GAAP as we knew it changed directions and began a migration toward the new framework. (The new framework did not mean that old standards would be thrown away and new standards would be created from a blank sheet of paper. Plus, the new conceptual framework was not made “authoritative”.) As the line of development bends upward from Point B, complexity enters the picture, and GAAP changes perceived by many to not have relevance for private company financial statements users were implemented.
Today we are at Line C and we are headed toward Line D which in theory is a complete evolution of GAAP into the intent of the FASB conceptual framework. While there will continue to be give and take between constituencies, the future direction can be somewhat surmised. For example, at the SBAC meeting a FASB board member said that after we fix lease accounting the next logical step would be to capitalize employment contracts.
I do not believe private company constituents can reverse the flow from C back to A. There is no basis (i.e., conceptual framework) on which to support A. An attempt to reverse the flow has been tried in the creation of IFRS for SMEs. As part of the SME development project, a list of “troublesome” standards was compiled by the IASB staffers and advisory groups. Interestingly, the list included all ten standards on the AICPA’s Private Company Task Force Report that survey participants were asked to rate as to level of importance. Virtually none of these standards made the cut to be excluded from IFRS for SMEs. The reason is that there is really no other basis than “horse trading" to use in such a process of rolling back from Point C to Point A; i.e., “I will give you deferred taxes if you will give me stock options”. (Note: One thing that IFRS for SMEs absolutely proved is that you can write a simple to understand accounting standard; my highest compliments to the IASB staffers.) While we did get simpler to read standards, and countries that never had financial reporting standards can now have them, my opinion as I stated in the SBAC meeting is that in the U.S there will be no significant change (including cost reduction) in the work that preparers will do, and the work that your auditors will do if you decide to go the IFRS for SME route.
Instead of calling on existing standard setters to reverse the flow represented at the top of the chart, my view is that private company constituents should jump to the bottom (Section II) of the chart and create a new private company framework and then develop Point E. Note two things: First, the new private company framework is labeled positive instead of normative. It describes what private company users want first and locks that in so that standard setters don’t “drift” off mission over time. Second, note that Point E is likely to be very similar in structure to point A; i.e., we get back to the old GAAP that we knew before. So we actually achieve what private company constituents like the above quoted SBAC member really want; we just have to get there through a different mechanism.
My public comments at the SBAC meeting were an attempt to get the ball moved down the field. Now while I don’t know yet who the players on offence should be, I think I have called for a long passing play instead of continuing to try to gain three yards by running the ball into the line.
I welcome your thoughts, criticisms (am I crazy?), etc. on all of this. (However, that does not mean that I am going to write another December missive.)
NOTE: This document was prepared by Andy Thrower to inform members of FEI's Committee on Private Companies-Standards, and represents his personal views and not the views of FEI or CPC-S.