The Big Risks of Little GAAP

Private U.S. companies and their stakeholders may soon get the "little GAAP" they have long sought. Could this dream-come-true turn into a nightmare?

Over the past year, a blue-ribbon panel has been exploring potential changes to the process by which financial accounting and reporting standards are set for private U.S. companies. The panel’s mission reflects private-company stakeholders’ growing dissatisfaction with generally accepted accounting principles as set by the Financial Accounting Standards Board. Unfortunately, the panel is leaning toward a “solution” that would likely make current problems worse rather than better.

One Size Doesn’t Fit All

In theory, GAAP applies equally to all U.S. companies, public as well as private. In practice, FASB sets GAAP primarily for public companies while exempting private companies from certain provisions. In addition, the Securities and Exchange Commission supplements GAAP with certain financial reporting requirements that apply only to public companies. Thus, the financial accounting and reporting standards that are applicable to private U.S. companies are somewhat different from standards that are applicable to public U.S. companies. But many private-company stakeholders have come to believe the standards aren’t different enough.

For decades, the advantages and disadvantages of having a greater distinction between public-company GAAP and private-company GAAP have been debated. Because public companies are commonly presumed to be “big” entities and private companies are generally said to be “little” entities, the debate has traditionally been known as the “big GAAP-little GAAP” debate. Over time, the less-presumptive adjective “differential” has come into use, such that the debate is now often referred to as being about “differential standards.” Regardless of the terminology, the dream of a distinct “little GAAP” has grown within the private-company community as a result of increasingly widespread — and increasingly intense — dissatisfaction with “one size fits all” GAAP.

Pounder-Dec

Why are private U.S. companies and their stakeholders increasingly dissatisfied with GAAP? There are two main reasons, both of which stem from the continual stream of significant changes to GAAP in recent years. First, alignment between the information contained in GAAP-compliant financial statements and the information needs of private-company financial-statement users is poor and getting worse. Second, the cost and complexity of preparing GAAP-compliant financial statements are growing disproportionately in relation to the benefits of providing such financial statements to private-company users. Both of these conditions are perceived to be far more severe in the private-company realm than in the public-company realm.

Diversity in Practice

Public U.S. companies are legally required to use GAAP for statutory financial-reporting purposes. In contrast, private U.S. companies aren’t subject to statutory financial-reporting requirements and may use any accounting standards they choose when preparing financial statements for use by lenders, venture capitalists, surety companies, and so forth. Dissatisfaction with GAAP, coupled with the freedom to choose which accounting standards to use, has resulted in decreasing use of GAAP by private U.S. companies.

Some private U.S. companies adhere strictly to GAAP, but many follow GAAP only up to a point, explicitly disclosing departures from GAAP in their financial statements. Still other private U.S. companies avoid GAAP altogether by doing cash-basis accounting, tax-basis accounting, or some “other comprehensive basis of accounting” (OCBOA).

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