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Private company accounting, simplified

Jim Brendel //August 18, 2011//

Private company accounting, simplified

Jim Brendel //August 18, 2011//

For all of those private companies frustrated with being forced to spend $25,000 on a valuation of intangible property or goodwill, or to spend hours drafting disclosures that users may not read, and be burdened with a myriad of other financial reporting responsibilities of public companies, there may be some relief on the way.

Set aside all you’ve heard about US companies converging with international standards for a minute. Public-private accounting standard setting is a different issue and one that has been debated for decades. The Financial Accounting Foundation (FAF), the parent of accounting’s ruling body, FASB (Financial Accounting Standards Board), is considering adopting a blue-ribbon panel report that recommends a new standard-setting board to establish exceptions and modifications to US GAAP for private companies.

Perhaps the best way to describe what is happening is to answer the question about what the report is, when it might affect accounting for private companies and why it came about, or a look at some problems private companies are experiencing with public company GAAP accounting.

The first thing for companies to keep in mind is that even if a private company board is established, it would not represent a dismantling of GAAP accounting. Think “tweak” rather than a wholesale rewriting of current rules. In fact, FASB has its own private company committee that makes recommendations to the main board but the blue ribbon panel recommendation seems to signal a lack of confidence that the committee’s input is being considered.

Now to the question of when. FAF has not indicated it will appoint a separate board. If it does, it will take some time to begin hard adoptions of new standards. Don’t look for this for a year or even two. Also at issue is how to provide funding for a new board.

Now to the question of why this has come about. US GAAP has many requirements that some believe aren’t relevant to smaller companies. The world has become more complex, especially for large multinational corporations. But requiring smaller companies to provide the same complex information as large companies can be expensive, time-consuming and in many cases produce information that users of this information – acquirers, investors and lenders – don’t value. The movement is about simplifying private company reporting.

Gary Fowler, senior vice president and regional manager of Bank of the West, says he analyzes an average of a dozen financial statements a week. He and his staff often “back out” non-cash items such as mark-to-market assets and value of intangible goodwill.

“Relevancy is the key throughout this. We’re trying to get to an operational cash flow and analyze what the company can afford on payments,” he said. “A non-cash item doesn’t add any value to us.”

The last thing the bank wants to do is terminate the loan because the value of a derivative fluctuated in market value and caused a technical violation of a company’s loan covenant, Fowler said. The bank protects itself by periodic valuations of any assets pledged as collateral but the primary focus of large commercial lenders is free cash flow.

“The fact that private companies are held to a public company standard seems unreasonable, given the cost of keeping up with that information,” Fowler said. “A lot are spending thousands if not tens of thousands on this. We support the formation of a separate private company board because our focus is more on ongoing relationships with our borrowers, not focusing on technical non-cash aspects of loan covenants.”

The evidence of some of the pain companies are feeling is the increase in the number of private companies choosing to issue income tax or cash basis financial statements or take GAAP exceptions in their reports, particularly the requirement to consolidate the books of variable interest entities related to the parent company.

Take for example, a business owner who personally owns and leases a building to his company. Bank of the West’s Fowler said he typically would look at the lease as an expense of the company and the assets separately, not as a consolidated balance sheet.

Ed J. Rand, COO/CFO, for American Exteriors, LLC., a $35 million manufacturer and marketer of custom windows, says even though many of the latest accounting rules seem arcane or irrelevant to his business, his company complies with every latest GAAP change.

“I have a hard time saying private companies should be different than public companies, except for public companies there are more disclosures,” Rand said.

Because his company is private equity-owned, he spends a lot of time explaining esoteric elements of his balance sheet – such as the partial step up in basis resulting from a leveraged buyout transaction – to banks and insurance companies, the primary users of his financial statements.

“We expend an incredible amount of time on accounting standards because that’s GAAP and that’s disclosure. It’s set by the industry and we have to comply if we want to have a clean opinion, but it has no great value to the readers of our statements,” Rand added.

So if an accounting system is expensive and irrelevant to users, it’s not an ideal framework for financial reporting. Here are some areas to watch if and when a private company board gets to tweaking current rules.

Fair value disclosures. Under current rules, companies have to “mark-to-market” an asset to its current value on its balance sheet. Examples might be investments and intangible assets. This involves the cost of having an appraisal done and using valuation models to determine fair value. For an asset that you don’t plan on selling in the near term, some people question whether that is relevant information. Impairment testing of goodwill – the premium over the value of individual assets paid in an acquisition – is particularly vexing. To do it right, you might have to have your company valued every year.

Derivatives. It can be a lot of work and expensive to determine the fair value of derivatives and the value of that information depends on your point of view. Is the value today of a futures contract that won’t settle for two years relevant? You see many futures contracts with oil and gas, agriculture and commodity related businesses. This information is probably more useful if a change in ownership is being contemplated.

Uncertain tax position. A recent rule requires a company to analyze their tax returns and outline things the IRS may challenge and then, potentially, accrue a liability for them. You have to assume the IRS will be aware of all relevant facts and make a judgment. Not only is that complicated but some would say that’s a road map to an IRS audit.

Stock options. Companies must expense the value of stock options. Some believe granting stock options is a non-cash expense that doesn’t affect the bottom line, that it’s more a dilution of equity. Many lenders add that expense back to net income calculations. Also, it takes time and money to put a fair value on the options, and the rules on how to record the expense can be complicated depending on the terms of the option.

Consolidation of businesses. The most common example of this issue is when a business owner owns a building he leases to the company. Current rules often require him to consolidate those two balance sheets. If a manufacturing company activity requires an audit, the owner doesn’t want the expense of a second audit of his company that owns the building.

Making “one shirt fits all” causes difficulties in the financial industry, but so does having two sets of standards. What side of the argument are you on? It should depend on your situation, industry and ultimate goal. If you are a private company going public, you might want to follow the public company model. If you are a closely held company and want to stay that way, some alterations of current accounting rules may be to your advantage.
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About the author
James Brendel, CPA, CFE, is the national director of audit and accounting for Hein & Associates LLP, a full-service public accounting and advisory firm with offices in Denver, Houston, Dallas and Southern California. He specializes in SEC reporting and assists companies with public offerings and complex accounting issues. Brendel can be reached at [email protected] or 303.298.9600.