The Future of Private-Company Financial Reporting

Article excerpt

As I noted last month in my first "Financial Reporting" column for Strategic Finance magazine, most of the changes that are occurring in corporate financial reporting today are the result of a single phenomenon: the global convergence of financial reporting standards. But it's important to recognize that "Convergence" is bringing different kinds of changes to different kinds of companies. In particular, private companies are experiencing the effects of Convergence differently from public companies. In this column, I will focus specifically on private companies and describe a global standards-setting project that is poised to take the lead role in shaping the future of private-company financial reporting in the United States and around the world.

Big GAAP--Little GAAP

In the U.S., there are roughly 1,000 private companies for every public company. Yet the process by which U.S. Generally Accepted Accounting Principles (GAAP) are set has traditionally focused on meeting the needs of users of financial statements issued by public companies. While that focus can be justified from a public-policy standpoint, it has resulted in a widespread perception that U.S. GAAP is "out of sync" with the needs and capabilities of preparers, auditors, and users of financial statements that are issued by private companies.

Stakeholders in the private-company financial reporting process have long argued that "one size does not fit all" with regard to financial reporting standards. Because public companies are commonly presumed to be "big" entities and private companies are commonly presumed to be "little" entities, the debate over whether there should be different standards for different kinds of entities has traditionally been known as the Big GAAP--Little GAAP debate. But so far in the U.S., that debate has resulted in relatively few differences in financial reporting standards based on the size or ownership characteristics of reporting entities.

Convergence Disrupts the Status Quo

In a few years, the U.S. Securities & Exchange Commission (SEC) will almost certainly require public companies in the U.S. to adopt the single set of country-neutral financial reporting standards that U.S. GAAP and International Financial Reporting Standards (IFRS) are converging into. At that time, stakeholders in the private-company financial reporting process will face an unprecedented opportunity to define the future of private-company financial reporting--a future that could be very different from the future of public-company financial reporting. So what might that future be?

An obvious possibility is that private companies could simply choose to adopt the same country-neutral financial reporting standards that public companies will be required to adopt.While that choice would enable private companies to enjoy the economic benefits of globally converged standards, private companies would still suffer disproportionately from the cost and operational complexity associated with standards that are primarily oriented toward the needs and capabilities of public companies.

An alternative scenario in the U.S. is that private-company financial reporting stakeholders could take control of the U.S. standards-setting process since, at that point, the only users of U.S. GAAP would be private companies. U.S. GAAP would then undoubtedly be subject to an "extreme makeover," transforming into a far simpler and more cost-effective set of standards. The smaller the reporting entity, the greater the relief there would be from having such standards. And by creating a "Little GAAP," the U.S. would join the many other countries that have already developed different standards specifically for small and medium-sized entities (SMEs), nearly all of which are private companies.

But that scenario is far from a certainty for two main reasons. First, private U.S. companies would suddenly find themselves having to fund a standards-setting infrastructure that in recent years has been funded mainly by public companies. …