How Not to Create Private-Company GAAP

A favored approach to establishing "little GAAP" for private U.S. companies is way off target.

Dissatisfaction with generally accepted accounting principles is increasing among stakeholders of private U.S. companies. A blue-ribbon panel has tentatively concluded that a new standard-setting body should create a distinct GAAP for private U.S. companies by specifying extensive exceptions to GAAP as set by the Financial Accounting Standards Board. Unfortunately, due to the panel’s lack of risk awareness, establishing a “little GAAP” for general-purpose financial reporting is unlikely to solve the problems of key stakeholders (see “Private-Company GAAP: Setting the Right Goal”). Beyond that, stakeholders are likely to reject the panel’s solution regardless of how suitable it is for their problems (see “Private-Company GAAP: Another Set of Standards to Ignore?”).

But let’s suspend common sense for a moment and assume the panel’s solution would be both appropriate and widely embraced. Even then, we quickly find there are other risk-blind — and thus failure-prone — aspects of the solution. In this column, I’ll focus on solution-development risk, which the panel hasn’t addressed. I’ll also explain how that risk can be mitigated.

What Is Solution-Development Risk?

Solution-development risk is a type of process risk. Specifically, it’s the risk of employing a solution-development process that is ineffective or otherwise unfit for the purpose of producing a desired solution.

In concluding that a standard-setting body other than FASB should define GAAP for private U.S. companies — by specifying extensive exceptions to GAAP as set by FASB — the blue-ribbon panel has overlooked two significant sources of solution-development risk. First, as envisioned by the panel, the new standard-setting body would employ a stakeholder-engagement model very similar to the one FASB currently uses. That means major dysfunctions of FASB’s current standard-setting process would be replicated, rendering the new body equally ineffective at setting appropriate standards for private U.S. companies.

The other significant source of solution-development risk comes from the strategy of creating “little GAAP” by specifying exceptions to “big GAAP.” Executing such a strategy would increase the complexity of applying GAAP when complexity already makes GAAP difficult to apply. And it would do so for companies that have the least capacity to absorb additional complexity. Worst of all, it would require private-company stakeholders to pay even more attention to the standard-setting process at a time when they’re already overburdened by it.

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Mitigating Solution-Development Risk

The panel believes that the main problem with FASB’s current standard-setting process is the people who execute it. There’s some validity to that belief; it’s not reasonable to expect individuals who have had little meaningful experience as preparers, auditors, or users of private-company financial statements to set appropriate standards for private companies. But the panel has erred by focusing on getting different people to execute the standard-setting process without realizing that the process itself needs to be improved.

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