In the mid-1980s, CPAs in private industry, government and non-profit organizations, and in public practice were served a huge plate full of professional standards. The term "standards overload" was coined to describe this phenomenon. CPAs that worked for small entities and small CPA firms soon began to realize huge time expenditures to comply with these new standards, most of which were more appropriate for larger entities. Amid much table pounding and foot stomping by CPAs that worked for or served small entities, we heard the cry, Give us Little GAAP!
25 years later, we still have no Little GAAP! This may, however, be about to change! Yes, you heard me correctly. Little GAAP may be on the way. In fact, it may already be here in one form! In 2009, the International Accounting Standards Board introduced International Financial Reporting Standards for Small and Medium-Sized Entities. Including about 10% of full IFRS, IFRS for SMEs includes principles-based standards that reduces the disclosure requrements for many small for-profit and non-profit enties. You'll probably find this hard to believe. Almost immediately after these standards were published, both the AICPA and the FASB pronounced them to be GAAP! Has Little GAAP arrived? As user acceptance grows, financial statement and footnotes preparation using this principles-based, simplified version of IFRS may shrink the long lists of rules-based disclosures that are required by U.S. GAAP!
But wait! There's more! The AICPA, the Financial Accounting Foundation (FAF), FASB’s parent organization, and the National Association of State Boards of Accountancy (NASBA) are sponsoring a blue–ribbon panel that is charged with making recommendations on the future of standard setting for private companies. They will take on the issue of whether separate accounting standards are needed for private companies! In the past other groups have wrestled with questions about accounting standards for U.S. private companies, but they mostly focused on technical issues. This panel is unique in that it has support from standard setters, the CPA profession, and state regulators.
What can we do to breath life into Little GAAP? We can begin to learn more about IFRS for SMEs and how it can meet the accounting and reporting needs of small entities. We can keep our ears to the ground and watch for publications of findings by this joint panel of standard setters. Finally, we can respond to the panel when their findings are made available. We can utter the cry of nearly the last three decades, "We want Little GAAP!"
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It's time for Little GAAP
I'm all in favor of Little GAAP. Many of the “improvements” in GAAP that have taken place over the past decade have not served the interests of the primary users of audited financial statements for private companies. Many of the interested readers of private-company, audited-financial-statements are banks or absentee owners. Their information needs are significantly different than public companies, as such it makes sense that private companies have their own set of GAAP. Having a separate Little GAAP might also lower the expense related to unnecessary reporting and examinations that were designed to meet the needs of readers of public company financial statements.
The existing reporting standards for financial statements have strayed very far from what lenders are concerned about. Lenders will tell you that their chief concern with the companies they lend money to is strictly the value of the collateral. Absentee owners, for their part, tend to want a conservative view reported concerning the company financial position and performance. Between the two groups of typical readers of private company financials, it’s generally a loan covenant imposed by the lender, rather than a request by an absentee owner, that prompts an audit.
Lenders tend not to be terribly concerned about internal controls or risk management. This may be a short-sighted view for someone who is holding stock in a company, because lax internal controls and risk management have just as much a chance as diminishing shareholder value to private companies as public companies. However, lenders believe that as long as there are sufficient assets to satisfy loan balances in the event of liquidation, the bank’s funds are secure.
Given the liquidation-value approach to lender valuation of private companies, it’s clear that auditors should provide audited financial statement with that in mind. Of course, internal controls and risk management would have to be evaluated, just as they are in public companies, but only to the extent that losses from fraud or contingent liabilities would impair the banks ability to recover their funds. Additionally, the auditor’s approach to balance sheet valuation would have to be tweaked to better serve the liquidation-value mindset of lenders.
The estimates used for inventory obsolescence and collectibility of receivables have long been the subject of debate between auditors and management. In many audits, the auditors come up with a different estimate than management, with the estimate calculated by the auditors generally coming up higher (i.e., more of a write-off) than management’s. Most of the time, a negotiation ensues between the auditors and management, with both sides giving in a little, though usually more accommodations are made by the auditors than management. The difference between the auditor’s initial estimate and management’s adjusted estimate are generally tolerated as long as the difference remains within prescribed limits of materiality and tolerable misstatements. Since these estimates for inventory and receivables reserves are netted against their respective balance sheet line items, the end result is that the balance sheets amounts reported for inventory and receivables tend to be overstated, though not so overstated as to cause distortion in a general sense. In forming Little GAAP, it may be appropriate to modify how different materiality limits are set, at least for inventory and receivables, so that amounts reported more closely align with liquidation valuation.
Another area for consideration in balance sheet valuation for Little GAAP is how to account for fixed assets and goodwill. If lenders are primarily concerned with liquidation value, recording fixed assets at cost net of depreciation doesn’t make much sense. Very different methods for valuing fixed assets would have to be used, most likely resulting in fixed assets being valued at deeply discounted salvage-value amounts. And, what about goodwill, whose very value is determined as the price paid for an acquired entity above and beyond the valuation amounts of tangible assets? Allowing for balance sheet value of goodwill is justified for going concerns because something of value, e.g. a set of customers or brand identity, was acquired along with the purchased company that translates into enhanced shareholder value. Do intangible assets hold value to a lender upon liquidation? Probably not because any many of the “improvements” in GAAP that have taken place over the past decade have not served the interests of the primary users of audited financial statements for private companies. Many of the interested readers of private-company, audited-financial-statements are banks or absentee owners. Their information needs are significantly different than public companies, as such it makes sense that private companies have their own set of GAAP. Having a separate Little GAAP might also lower the expense related to unnecessary reporting and examinations that were designed to meet the needs of readers of public company financial statements.
The existing reporting standards for financial statements have strayed very far from what lenders are concerned about. Lenders will tell you that their chief concern with the companies they lend money to is strictly the value of the collateral. Absentee owners, for their part, tend to want a conservative view reported concerning the company financial position and performance. Between the two groups of typical readers of private company financials, it’s generally a loan covenant imposed by the lender, rather than a request by an absentee owner, that prompts an audit.
Lenders tend not to be terribly concerned about internal controls or risk management. This may be a short-sighted view for someone who is holding stock in a company, because lax internal controls and risk management have just as much a chance as diminishing shareholder value to private companies as public companies. However, lenders believe that as long as there are sufficient assets to satisfy loan balances in the event of liquidation, the bank’s funds are secure.
Given the liquidation-value approach to lender valuation of private companies, it’s clear that auditors should provide audited financial statement with that in mind. Of course, internal controls and risk management would have to be evaluated, just as they are in public companies, but only to the extent that losses from fraud or contingent liabilities would impair the banks ability to recover their funds. Additionally, the auditor’s approach to balance sheet valuation would have to be tweaked to better serve the liquidation-value mindset of lenders.
The estimates used for inventory obsolescence and collectibility of receivables have long been the subject of debate between auditors and management. In many audits, the auditors come up with a different estimate than management, with the estimate calculated by the auditors generally coming up higher that management’s. Most of the time, a negotiation ensues between the auditors and management, with both sides giving in a little bit, though usually more accommodations are made by the auditors than management. The difference between the auditor’s initial estimate and management’s adjusted estimate are generally tolerated as long as the difference remains within prescribed limits of materiality and tolerable misstatements. Since these estimates for inventory and receivables reserves are netted against their respective balance sheet line items, the end result is that the balance sheets amounts reported for inventory and receivables tend to be overstated, though not so overstated as to cause distortion in a general sense. In forming Little GAAP, it may be appropriate to modify how different materiality limits are set, at least for inventory and receivables, so that amounts reported more closely align with liquidation valuation.
Another area for consideration in balance sheet valuation for Little GAAP is how to account for fixed assets and goodwill. If lenders are primarily concerned with liquidation value, recording fixed assets at cost net of depreciation probably doesn’t make much sense. Very different methods for valuing fixed assets would have to be used, most likely resulting in fixed assets being valued at deeply discounted salvage-value amounts. And, what about goodwill, whose very value is determined as the price paid for an acquired entity above and beyond the valuation amounts of tangible assets? Allowing for balance sheet value of goodwill is justified for going concerns because something of value, e.g. a set of customers or brand identity, was acquired along with the purchased company that translates into enhanced shareholder value. Do intangible assets hold value to a lender upon liquidation? Probably not because any goodwill would likely evaporate upon liquidation. It’s unlikely that even if a distressed company can be sold in tact, as a going concern, that it will be sold at a premium justifying the inclusion of goodwill in a company's net worth.
For these reasons and more, the current method of reporting the financial condition does not serve the interests of the primary users of private company audited financial statements and efforts should be made to implement Little GAAP for private companies.