Public Companies Beware of Private Company Standards
By Edward Bechold, Assurance Services Director
In May 2012, the Private Company Counsel (“PCC”) was established by the Financial Accounting Foundation Board of Trustees to provide relief to nonpublic entities (“NonPub”) under United States Generally Accepted Accounting Principles (“GAAP”). The framework and intent of the PCC is to refine “Big” GAAP, but still maintain the relevancy and usefulness of financial reporting for stakeholders of Nonpubs.
In order to adopt pronouncements of the PCC, you must be considered a NonPub.A NonPub is anything that does not meet the definition of a public business entity (“PubCo”). Accounting Standards Update (“ASU”) 2013-12, Definition of a Public Business Entity, lists five criteria that result in a Company being classified as a PubCo. Obvious inclusions in the definition of a PubCo, consist of a Company making a filing under the Securities Exchange Act of 1934 and a Company issuing publicly traded debt.
In addition, there is a catch-all provision practitioners should be aware of as follows:
“An entity may meet the definition of a public business entity solely because its financial statements or financial information is included in another entity’s filing with the SEC [Securities and Exchange Commission]. In that case, the entity is only a public business entity for purposes of financial statements that are filed or furnished with the SEC.”
The catch-all provision will result in additional complexities for an entity that is included in an SEC filing, which could include any of the following:
- Acquisition audits as part of Regulation 3-05 or real estate under Regulation 3-14
- Equity method investees under Regulation 3-09 or 4-08(g), etc.
- Significant Lessees under Regulation 3-01 and 3-02
- Guarantor financial statements required by Regulation 8-02 or 8-03
If a NonPub is required to include its financial statements in a SEC filing, the financial statements would be need to be presented using Big GAAP. For example, if a PubCo owns 25% of your stock, your financial statements would be required to be prepared using Big GAAP. However, you would not be required to apply Big GAAP as it relates to financial statements you provide to your lender in accordance with a financial covenant.
It is important to understand your financial reporting obligations as a PubCo or a NonPub.
A PubCo is required to present financial statements in accordance with Big GAAP, unless there is a specific SEC exemption. However, a NonPub target acquisition has no such requirement and could create a problem if an acquisition is contemplated. For example, Regulation 3-05 requires Big GAAP to be utilized to determine the significance of an acquisition as it relates to the PubCo. If the NonPub adopted the principles of the PCC, this could have major timing ramifications as the accounting on the NonPub will need to be re-addressed, financial statements redrafted and restated and the new presentation re-audited. Based on a review of the issues addressed by the PCC, it is very easy to see the complexity and mobilization efforts that will need to be addressed in order to remediate the matter. Variable interest entities, derivatives and hedging, intangible assets, acquisition accounting and share based compensation are some of the more complex areas in accounting the PCC has addressed.
If a NonPub were to adopt all or some of the PCC's refinements, it will take considerable effort to readdress the accounting. Depending on the size and significance of the PubCo, if the materiality levels require the presentation of three years of financial data, you would have to go back four years to have a good starting point plus the interim period, if necessary. Smaller reporting companies typically exceed the 20% significance thresholds in their acquisitions, which can cause additional issues when the acquisition does not have a sophisticated finance department to deal with the more complex financial reporting issues.
In most instances it will be necessary to restate previously issued financial statements, which can take considerable time and effort when there is only a 74 day window from the date of acquisition. Best practices would be to identify and remediate the accounting issues prior to the acquisition being consummated.
Before a NonPub considers adopting any of the PCC's refinements, it should consider its exit strategy and timeline with its investors. If you are contemplating sale to a PubCo (strategic buyer), reverse merger or IPO in the next 3 to 5 years, adoption might be complex and costly down the line.
As mentioned previously converting from the PCC pronouncements to Big GAAP will result in a re-statement of previously issued financial statements and additional costs associated with a re-audit. Materiality threshold levels will also be impacted, because until such time as the adjustments to Big GAAP is performed, it will be impossible to determine whether or not the differences between applying Big GAAP and the PCC's refinements are quantitatively material.
For example, the goodwill and intangible asset PCC pronouncements can have a material impact on financial statements and will require a re-assessment of purchase price accounting to address intangible assets ignored under PCC standards (i.e. customer relationships and non-competes) and an assessment of goodwill impairment that could be triggered based on different materiality thresholds.
In addition, the variable interest entity guidance could impact financial covenants if the loan agreements were not appropriately structured.This could result in additional disclosures on liquidity, failure of covenants resulting in default interest and acceleration of required debt payments, etc.
The exercise of converting from PCC principles to Big GAAP could very quickly evaporate upfront savings upon adoption and therefore it is critical that NonPub’s are sure about their disclosures.
If you are a NonPub, family owned business and have no future aspirations of going public or plans to sell within the next 5-7 years, it might be more beneficial to present your financial statements using the income tax method. You will get similar treatment of the complex accounting issues as the PCC is offering and a review or audit is typically much easier.
The following is a listing of Accounting Standards Updates based on a consensus of the Private Company Council:
- Update No 2014-07 – Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements
- Update No. 2014-03 – Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps-Simplified Hedge Accounting Approach
- Update No. 2014-02 – Intangibles-Goodwill and Other (Topic 350): Accounting for Goodwill
- Finalized, not issued – Alternative to non-competition agreements and customer related intangible assets
In the future, the PCC plans to address ways to improve accounting for stock-based compensation and they are considering their views on the FASB Lease project.
Greg Giugliano, Firm Wide Partner-In-Charge, Assurance Services contributed to this article.