Public and private companies may need to consider recently issued alternative accounting rules. This alert addresses legal, record retention and financial issues facing private companies, as well as issues facing public companies related to acquiring or investing in private companies.
On January 16, 2014, the Financial Accounting Standards Board (“FASB”) issued the first two private company alternatives within Generally Accepted Accounting Principles (“GAAP”). The alternatives, proposed by the recently formed advisory board of the FASB, called the Private Company Council (“PCC”), are part of its effort to focus on the needs of users of private company financial statements. PCC-proposed alternatives must be issued by the FASB to become GAAP.
The recently issued alternatives allow private companies to amortize goodwill acquired in business combinations and to simplify the accounting for interest rate swaps. These PCC alternatives are available for 2013 and will result in recognition and measurement differences between the private companies electing them and public companies, as well as private companies not electing the PCC alternatives.
Is the Company Eligible to Elect the PCC Alternatives?
To be eligible to elect the PCC alternatives, private companies need to make sure they do not fall within the expanded definition of a public business entity (“PBE”), which the FASB recently finalized. The definition goes beyond publicly traded companies to include privately held companies that for various reasons are required to make their financial statements publicly available.
Under the definition, a private company could be classified as a PBE if its financial statements are required to be included in a public company’s SEC filing. Such private companies may include those acquired by a public company (Regulation S-X Rule 3-05) and those in which a public company has a material investment (Regulation S-X Rule 3-09). These private companies would not be allowed to elect the PCC alternatives.
In this alert, we use the term PBE GAAP to refer to GAAP required for PBEs (i.e., public companies) and the term PCC GAAP to refer to the alternatives available to non-PBEs (i.e., private companies).
Will Users of Private Company Financial Statements Accept the PCC Alternatives?
Creditors and equity owners are key users of private company financial statements. Currently, many private companies prepare financial statements in accordance with PBE GAAP. Users may prefer financial statements prepared in accordance with PBE GAAP for consistency with prior years’ financial statements and comparability with other public and private competitors.
Electing the PCC alternatives might complicate the interpretation and use of a private company’s financial information. In particular, with respect to creditors, decisions are often made through an analysis of financial statements of like-sized companies in similar industries. Electing the PCC alternatives creates differences in the financial reports used in these analyses, potentially affecting financial statement comparability. This effect might increase uncertainty with a resultant increase in cost of capital. Conversely, if the company has few equity owners and limited capital requirements, the PCC alternatives may be more worthy of consideration.
How Will the PCC Alternatives Affect Contracts That Are Based on PBE GAAP?
The PCC alternatives change the recognition and measurement of net income and other components of the financial statements, which can impact contracts written based on PBE GAAP. For example, Creditor Z has a credit agreement with Company X. The covenants of that agreement require Company X to maintain certain financial ratios. After executing the credit agreement,
Company X elects the PCC alternative for goodwill accounting and begins amortizing goodwill. This change in goodwill accounting decreases equity and increases the debt-to-equity ratio, which may result in non-compliance with the credit agreement’s covenants. In this example, the non-compliance is not the result of changes in the economics or value of the business, but rather the accounting principle elected by the company. A thorough analysis of existing and contemplated contracts should be performed prior to electing the PCC alternatives.
Will the PCC Alternatives Negatively Impact Future Exit Strategies?
The PCC alternative for goodwill accounting could benefit private companies making acquisitions as it reduces the requirement for impairment testing of goodwill.1 Similarly, the PCC alternative for interest rate swap accounting reduces the requirement for determining the fair value of the swap and reassessing other hedge accounting criteria. However, companies need to consider a number of issues when evaluating the alternatives. A private company that becomes a PBE has to restate its financial statements to retrospectively account for goodwill and interest rate swaps using PBE GAAP. At a minimum, this would entail reversing previously recorded amortization and executing fair value assessments for each period presented.
While many companies predict they will never “go public,” fewer predict they will never be acquired by a public company. Such an acquisition may qualify a private company as a PBE if the filing of its financial statements is required under SEC Rules (e.g., SEC Regulation S-X Rule 3-05 or Rule 3-09). This will require the private company to restate its financial statements and retrospectively analyze goodwill and hedge accounting adjustments, which will be challenging. Moreover, the challenge is greater if prior years’ financial projections were not retained in a form that can be utilized by the valuation and accounting professionals tasked with preparing and auditing the analysis.
Questions to Consider
As PCC alternatives become available, private companies evaluating election and public companies investing in or acquiring private companies have to consider many questions, including:
- Is the company eligible to elect the PCC alternatives?
- Are the current users of the financial statements willing to accept the PCC alternatives?
- Is the company considering exit strategies that might qualify it as a PBE?
- Will the company pursue debt or lease financing with new creditors that may challenge its choice of PCC alternatives?
- How might these challenges impact the company’s cost of capital?
- Will electing the PCC alternatives impact any contracts that have terms based on PBE GAAP?
- Will PCC GAAP interpretation issues subject the company to litigation regarding its contracts?
- Does the company plan to “go public” or issue registered debt securities?
- Could the company be acquired by a public company?
- Are the company’s record retention policies adequate to capture the information necessary to restate its financial statements if it becomes a PBE?
- Will those records hold up to the scrutiny of auditors, SEC reviewers and other regulators?
- Is the company willing to take the risk that the benefits of electing the alternatives will outweigh future costs and complexities?
1.The PCC alternative for goodwill accounting permits the straight-line amortization of goodwill up to 10 years, and goodwill impairment testing is only required upon the occurrence of a triggering event. Thus, the alternative removes the non-amortization of goodwill and the requirement of annual goodwill impairment testing under PBE GAAP.