GAAP for private companies is a hot topic that can be looked at from varying perspectives. With that in mind, we offer this second entry of a two part blog series presenting both sides of the issue.

There is a lot of talk these days about the “need” for custom-tailored accounting standards for private companies (some arguments in favor were put forth last week by my colleague, Michael Piessens, in his post Separate Private Company GAAP - an argument in favor). This has been taken up by the Financial Accounting Standards Board and the International Accounting Standards Board. Other countries, such as Canada, have already put forth their own private company accounting standards as an alternative to IFRS. Most arguments for such standards revolve around the idea that GAAP has become too complex and, thus, irrelevant for private company reporting needs.

While I admit that I am not a fan of certain recent trends in accounting these days – like the increasingly pervasive use of fair value accounting – I do not believe that the markets are better served by a second set of accounting standards. Financial reporting was never built around the capital structure of the entity; financial reporting is about comparability and consistency. It is about a user of financial statements and their ability to measure financial performance. If we create divergent standards for private companies, what does that say about our own financial reporting environment? If financial reporting is broken, it is broken for all, regardless of whether it is a public or private entity.

The inherent premise behind the call for private company GAAP is that the financial reports of public companies need to reflect the complexities of transactions that such companies enter into, while private company financial statements do not. But I challenge you to ask, “why?”

Financial complexity is not just in the purview of companies that have registered their stock with the SEC. Read the rest of this entry »

GAAP for private companies is a hot issue that can be looked at from varying perspectives. With that in mind, we offer this first entry of a two part blog series presenting both sides of the issue; be sure to check back next week for “the argument against!”

The Blue Ribbon Panel of the Financial Accounting Foundation (FAF) met on July 19^th to encapsulate the problems that private companies have with U.S. GAAP, how accounting standards are set, and to shorten the list of viable proposed accounting model choices. Also in July, the International Accounting Standards Board (IASB) released a condensed (230 pages, from 2,500 pages originally) International Financial Reporting Standards (IFRS) for small and medium entities (SMEs). This set of rules could in theory become the standard for private companies in the U.S.

Most would agree that a fundamental goal of GAAP reporting is to provide relevant information useful for the decision-making needs of its users; it is encouraging to see some effort to distinguish the needs of private companies from publics. Financial reporting for private companies should be driven by the need for them to have access to capital and key information for their banks and creditors. On the other hand, that drive for public companies is influenced by needs of investors and stockholders and the general legal and regulatory environment.

Because GAAP is not truly geared to the private company model, under current accounting standards such companies encounter issues surrounding relevance, consistency, and perceived unnecessary complexity in presenting financial statement information.

With this in mind, it is not fair to penalize and burden private companies with excessive and sometimes irrelevant accounting and financial reporting requirements, given that their banks and creditors in reality are concerned with a much narrower scope of matters. Keeping apprised of and in compliance with these additional requirements unnecessarily divert private company resources and capital, robbing them of the ability to deploy them in other areas of opportunity.

On top of these issues, private companies are often forced to circumvent the requirements by issuing GAAP exceptions with audit opinions and blaming noncompliance on “unnecessary” GAAP requirements. These frequent actions can result in confusion, consternation and dissatisfaction on behalf of the private company financial statement users – for whom it was the original intent to provide relevant information for decision-making!

FASB Chairman Robert Herz once commented the following, which remains true today: “Private companies are a vital force in the nation’s economy and it is, therefore, critical that their financial reporting be conceptually sound, cost effective, and provide relevant, reliable and useful information.”

To stay on course with that sentiment – I say let’s take the GAPs out of GAAP for private companies!

Buried within the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is the requirement for public companies to develop and implement a mandatory policy to recoup excess incentive-based compensation from current and former executive officers after a material financial restatement.

While compensation recovery policies (or “clawback” policies) are not new, these latest requirements are more stringent and are designed to force companies to tighten up the provisions within their clawback policies and get tough on actual enforcement. As evidence of this “get tough” stance, the Dodd-Frank Reform Act goes so far as to require the national exchanges to delist any company that fails to comply with its own clawback policy.

The new clawback policy requirements

As many know, the concept of clawback policies originally came onto the scene back in 2002 as a result of the Sarbanes-Oxley Act (specifically, Section 304). At the time, the clawback provisions only applied to the chief executive officer and chief financial officer. Furthermore, the provisions were only applicable if the noncompliance resulted from misconduct and was only relevant for compensation events during the year following the misstatement.

Fast forward to July 2010 and we find new and more stringent clawback provisions that require any company listed on a national securities exchange to develop and implement a mandatory recoupment policy stating that following an accounting restatement due to material noncompliance with financial reporting requirements under securities laws, the company will recover certain incentive-based compensation (including stock options) from current or former executive officers for amounts received during the three-year period preceding the date on which the company is required to prepare the accounting restatement. The amount of compensation to be recovered is calculated as the excess amount paid on the basis of the restated results.

In contrast to Section 304 of the Sarbanes-Oxley Act of 2002, the new clawback provisions are broader and cover more individuals. They now apply to all current and former “executive officers” which includes not only the CEO and CFO but also a company’s president, any vice president in charge of a principal business unit, division or function and any other officer who performs a policy making function or person who performs similar policy making functions for the company. In addition, the new requirement to recoup compensation is not dependent on the restatement being a result of executive misconduct. Furthermore, the look back period has been extended from one year to three years and companies must now disclose their clawback policy.

While further clarification is needed, companies would be wise to get ahead of the curve

Some aspects of the Dodd-Frank Act clawback provision are ambiguous and it is clear that further guidance will be required. For starters, the Reform Act does not specify an effective date for implementing the clawback provisions nor does it clearly define what constitutes “material noncompliance” or “incentive-based compensation.”

Until the SEC issues more detailed rules (perhaps in time for 2011 proxy statements?), it will be difficult to ensure complete compliance, however, from a corporate governance perspective, it is recommended that companies not wait — review current policies and consult with an attorney to determine whether or not your policy aligns with the new legislation and subsequent guidance.