Over the past decade, rapid and substantive changes to generally accepted accounting principles (GAAP) in the U.S. have generated a fierce debate regarding the accounting practices for public and private businesses alike. In particular, a growing consensus argued that the financial reporting needs of private companies are sufficiently different from those of public companies, warranting an accounting alternative for private companies. This debate ultimately resulted in the formation of a new group, the Private Company Council (PCC), which, in collaboration with the Financial Accounting Standards Board (FASB), is charged with developing, deliberating, and voting on proposed exceptions or modifications to U.S. GAAP. Upon the FASB’s endorsement, the exceptions or modifications became incorporated in U.S. GAAP.
This article highlights amendments to U.S. GAAP resulting from PCC consensus opinions and resulting FASB endorsements, including accounting for goodwill and accounting for identifiable intangible assets in a business combination, as well as implications to preparers and users of financial statements.
What Is a Private Company?
For the purposes of the PCC’s activities and resulting modifications to GAAP, a private company is defined as any entity other than a public business entity, a not-for-profit entity, or employee benefit plans. A public business entity is a business entity meeting any one of the following criteria.
An entity may meet the definition of a public business entity solely because its financial statements or financial information are included in another entity’s filing with the SEC. In that case, the entity is only a public business entity for purposes of financial statements that are filed with the SEC.
Of note, a company may currently be defined as a private company, but may become a public business entity in the future through an initial public offering, capital raise, an investment or acquisition by a public company, or other events. The current accounting alternatives do not provide clear transition guidance for entities that use the accounting alternatives and later become public business entities. All current signs indicate that these companies would need to retroactively “undo” application of the accounting alternatives, which can be burdensome and costly. Accordingly, companies that are currently eligible to apply the accounting alternatives should carefully weigh the current and future costs and benefits.
Overview of the PCC
Formed in 2012 by the Financial Accounting Foundation (FAF) Board of Trustees, the PCC has two principal responsibilities. First, the PCC determines whether exceptions or modifications to existing nongovernmental U.S. GAAP are required to address the needs of users of private company financial statements. Second, the PCC serves as the primary advisory body to the FASB on the appropriate treatment for private companies for items under active consideration on the FASB’s technical agenda.
The PCC is the product of prior working groups, committees, roundtables, and solicitations of input dating back to 2006. In connection with the formation of the PCC, the FAF’s outreach included the receipt of 7,367 comment letters, four nationwide roundtable discussions with 60 stakeholders, and a webcast that included 316 participants.
Accounting for Goodwill
The first PCC consensus opinion and resulting FASB endorsement was completed in January 2014, culminating in Accounting Standards Update (ASU) 2014-02, which amends Accounting Standards Codification (ASC) Topic 350, Intangibles — Goodwill and Other (ASC 350”) (the “Goodwill Accounting Alternative”). During its research and outreach efforts, the PCC obtained feedback from private company stakeholders that the benefits of the current accounting for goodwill after initial recognition do not justify the related costs as it pertains to the usefulness of the carrying amount and potential impairment losses, as well as the cost and complexity in performing the current goodwill impairment test.
The PCC and FASB noted in ASU 2014-02 that many users of private company financial statements disregard goodwill impairment charges from their quantitative analysis of a private company’s operating performance. Moreover, because the underlying events and conditions leading to goodwill impairment generally manifest themselves long before the impairment is reported, users that provided the PCC feedback indicated that they use other, more real-time information (including information obtained through their access to management). Some users acknowledged that an impairment loss (or lack of an impairment loss) can be an indicator of the failure (or success) of an acquisition; however, they noted that the usefulness of goodwill impairment accounting is diminished because most private companies do not issue GAAP interim financial statements, and they generally issue their year-end financial statements later than public business entities. Users further stated that the amount of the impairment is less relevant than the existence of impairment because the calculation of the impairment loss is not well understood.
The main provisions of the Goodwill Accounting Alternative, if elected by a nonpublic entity, are outlined below and contrasted against the “general” accounting guidance in the following table.
Accounting for Identifiable Intangible Assets in a Business Combination
In December 2014, another PCC consensus opinion and FASB endorsement was completed, resulting in ASU 2014-18, which amends ASC Topic 805, Business Combinations (“ASC 805”) (the “Intangibles Accounting Alternative”). Similar to the Goodwill Accounting Alternative, the Intangibles Accounting Alternative was adopted in response to private company stakeholder responses that the benefits of the current accounting for identifiable intangible assets acquired in a business combination may not justify the related costs.
In the course of its outreach, the PCC noted that the Fair Value of some identifiable intangible assets is relevant to some users of private company financial statements. Intangible assets that are legally protected and that can be sold or generate discrete cash flows, such as technology, were characterized as most relevant. Some users, particularly lenders, indicated that intangible assets are most relevant when their cash flows can be reliably estimated or they can be sold in liquidation. Because customer-related intangible assets and noncompetition agreements are typically not capable of being sold or licensed independently from the other assets of a business, and because these assets are often the most subjective and difficult intangible assets to measure, stakeholders stated that the alternative should focus on those intangible assets.
The main provisions of the Intangibles Accounting Alternative, if elected by a nonpublic entity, are outlined below and contrasted against the “general” accounting guidance in the following table. For entities that adopt the Intangibles Accounting Alternative, the amendments to ASC 805 will generally result in those entities separately recognizing fewer intangible assets in a business combination compared to entities that do not elect or are not eligible for this option.
Customer-based intangible assets often represent the primary identifiable intangible asset in a business combination, and accordingly this asset is frequently valued using the multi-period excess earnings method (MPEEM), whereby contributory asset charges attributable to supporting assets are applied to a stream of overall company economic benefits to derive the remaining cash flows attributed to the customer-based intangible. In the instance that another identifiable intangible asset constitutes the primary asset of an acquired business (e.g., trademarks or technology), customer-based intangibles would be valued via an alternative methodology, with the MPEEM applied to the primary asset of the business. As a consequence, while the Intangibles Accounting Alternative may not require recognition of customer-based intangible assets or noncompetition agreements, the Fair Value of these assets may still need to be measured in certain circumstances.
We would also note that in a taxable (asset) transaction, the value attributed to noncompetition agreements typically maintains different tax treatment for the seller than other intangible assets and goodwill (i.e., noncompetition agreements are often taxed at ordinary income tax rates whereas the gain on other intangible assets and goodwill is taxed at capital gains tax rates). Accordingly, noncompetition agreements may still require measurement in certain circumstances regardless of the nonrecognition alternative for reporting purposes.
In January 2015, the CFA Institute — whose membership is comprised of investment professionals — published the results of a survey of its members in May 2014 titled “Addressing Financial Reporting Complexity: Investor Perspectives” (the “2014 Private Company Survey”). In the view of the CFA Institute, outreach by the FAF to private company stakeholders was undertaken largely at the behest of the preparer community as it argued for changes in reporting requirements aimed at reducing preparer compliance costs. The CFA Institute contended that the perspectives of investors were missing from the discourse. The 2014 Private Company Survey sought investor insights on the impact of separate nonpublic company reporting requirements on investors’ financial analyses, how investors view extending such reduced requirements to public companies, and their perspectives on efforts related to changes in public company requirements.
Weighing Costs and Benefits
New accounting and reporting options are now available to nonpublic business entities. While these alternatives may serve to decrease compliance costs and simplify reporting requirements, businesses that meet the criteria required to apply these accounting alternatives must carefully weigh the current and future costs and benefits of these amendments to U.S. GAAP, including the costs of compliance, a future transition to a public business entity, and the perspectives of its various stakeholders.
A previous version of this article was published in September 2015.