In the past, we have discussed the differences between the cash and accrual bases of accounting. While these differences can be hard to grasp, the overall concepts of the two methods are fairly straightforward. The accrual basis of accounting does not, however, address all the complexities in what we accountants call the Generally Accepted Accounting Principles, or GAAP. That's why a decades-long debate has raged over whether there should be two sets of accounting standards in the United States: one for publicly reporting entities and one for private companies. With the appointment in December 2009 of an 18-member panel to investigate developing separate standards for public and private companies, the American Institute of Certified Public Accountants is attempting to address the issue.
A Short History of GAAP
In the 15th century, a monk named Luca Pacioli codified what we now call double-entry bookkeeping. While we accountants can be an imaginative lot, we still haven't found a better way of setting up a general ledger than what Luca documented in 1494, and indications are that he wasn't the first to use the concept.
Until now, the basics of the double-entry system have remained unchanged, but our global economy has altered considerably. As technology has progressed, so has the need for banks, investors, companies and governments to be able to understand one another's economic activities in a consistent manner. As the world continues to shrink due to technology, so has humanity's ability to think of new ways to make money and spend it. The result is a complex financial system that sometimes defies logic.
To make sense of this, the accounting profession is constantly developing new standards to keep the financial statements of public and private companies relevant to their users, including creditors, investors and taxing authorities. The problem it that there is a divergence between the needs of large public companies (with stocks traded by numerous shareholders) and the needs of privately held companies, which are owned by only a few shareholders. Because accounting standards have historically addressed the needs of the public companies, private companies have been subjected to complex standards with little relevance to their situation. Hence, the new AICPA committee was established to address this issue.
What's Happening Now
In another article this month, we talked about the complexity of changing the nation's financial system. Addressing what is referred to as the Big GAAP vs. Little-GAAP issue is also highly complex. As a small business owner, you might not think it's a big deal to read a headline like that in a recent issue of the Journal of Accountancy, which reads: "Panel on Private Company Financial Reporting Narrows Down Alternative Models." CPAs recognize that this is a huge step for an AICPA panel to take and that this bodes well for any future discussion.
If you are wondering why you should care, the fact is that if you run a small shop that requires no financing and the only users of your financial statements are you and the taxing authorities, you might not care. However, if you want to grow and need capital, you might need to go to the bank. The bank could require audited financial statements and if your CPA can't get the loan committee to accept anything other than GAAP financial statements, you might be in for a surprise when you receive the draft of statements and/or the bill for the audit. The statements that were adequate to help you manage the business up to now might not measure up to the requirements of GAAP.
For example, in years past the basic requirement for consolidating the financial statements of two or more entities was that one had a controlling interest in the other or some upstream parent held the controlling interest. The common definition of controlling interest was ownership of a greater than 50 percent voting interest in another entity. In late 2003, the Financial Accounting Standards Board issued guidance that required some companies to provide consolidated financial statements even if the greater than 50 percent voting interest test was not met. While there is theoretical justification to the treatment required by the new standards, the cost to comply with them can be onerous and the results can be misleading to the users of private company financial statements.
If you have never sought to issue GAAP financial statements and you own companies that might fall under the new rules, chances are you have not been consolidating the financial statements of those companies. If you are required to provide audited GAAP basis statements for Company A, expect to have Company B audited as well.
This is only one of the issues that our profession faces that will have a big impact on how you report your financial results.
One prime consideration is whether to require all private companies to follow whatever standards are eventually crafted or whether to allow them the option to use public company GAAP. Requiring all private companies to use private company GAAP could cause problems for those intending to go public at some point.
Nobody Has a Crystal Ball
Private vs. public company accounting standards is an issue that has befuddled policymakers for decades. It's not likely to be one that will be resolved easily or quickly, but at least the profession is working toward a resolution. It benefits all of us to keep an eye on what is happening and offer input to ensure your needs as a small business are met.
Have a great August.