Private-Company GAAP: Setting the Right Goal

Are efforts to fix private-company financial reporting in the United States focused on the wrong solution?

Stakeholders of private U.S. companies are increasingly dissatisfied with generally accepted accounting principles as set by the Financial Accounting Standards Board. Dissatisfaction with GAAP, coupled with the freedom to ignore it, has led private companies to report financial information in diverse ways. Such diversity has resulted in varying reliability and limited comparability of reported information. At the same time, private companies that adhere to GAAP at the insistence of their stakeholders find themselves bearing increasing costs and complexities. If unsolved, these problems pose significant risks to the competitiveness and overall health of a major sector of the U.S. economy.

Over the past year, a blue-ribbon panel has been exploring potential solutions to the problems of private-company financial reporting in the United States. The panel’s aim is to identify a better way of setting accounting standards for private U.S. companies. In theory, improved standard-setting would enhance the usefulness of financial information reported to stakeholders while reducing the burden on reporting entities. Unfortunately, the “solution” toward which the panel is leaning could make our current problems even worse than they are today.

In my previous column, I briefly summarized four key risks the panel has not addressed. In this column, I’ll drill down on the first risk, solution suitability, which is a type of goal-setting risk. I’ll also explain how solution-suitability risk can be mitigated.

What Is Solution-Suitability Risk?

Solution-suitability risk is the risk of setting a wrong goal — one that if attained would fail to solve the problem it’s meant to solve. In many cases, attainment of an unsuitable goal would actually exacerbate the problem. Consequently, mitigating solution-suitability risk should be a top priority in projects that involve large-scale, transformational change.

There are two significant factors that contribute to solution-suitability risk. One is when change agents have a poor understanding of the problem to be solved. This is likely to be the case when key stakeholders aren’t intimately engaged in the change process.

Another factor that contributes to solution-suitability risk is when change agents adopt a “brainstorm and vote” approach to defining the solution to be pursued. Identifying potential solution candidates through brainstorming typically results in a relatively small set of alternatives that differ only incrementally from the status quo and fail to overcome existing trade-offs. As a result, “breakthrough” solutions are unlikely to be included in the identified alternatives. In addition, consensus may be difficult to achieve, and even if it is achieved, it will not be on an optimal solution.

Risk Factors Present

Through its deliberations, the panel on private-company financial reporting identified several alternative standard-setting models and tentatively concluded that a new standard-setting body should define a “little GAAP” for private U.S. companies by specifying extensive exceptions to “big GAAP”; i.e., GAAP as we know it today. Big GAAP would continue to be maintained by FASB, and public U.S. companies would continue to use it.

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