Audit standards for private companies are less stringent than those for publicly listed firms because they face fewer disclosure requirements. For example, small privately owned businesses don't fall under the scrutiny of the Securities and Exchange Commission (SEC), one of several agencies setting standards for public companies. Accounting regulators are beginning to address imbalances between the need for increased disclosure from smaller firms and the increased burdens small business owners would face under stricter reporting rules.
Mind the GAAP
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Both private and public companies are subject to generally accepted accounting principles (GAAP), although for different reasons. The SEC requires publicly traded companies to provide GAAP-compliant audited financial statements. Private companies may be subject to GAAP to satisfy lenders, certain classes of shareholders, or insurance companies. However, many private companies don't issue audited financial statements. Their main concern is minimizing taxes and therefore they often only prepare tax returns and unaudited statements.
Private Council
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Historically, the Financial Accounting Standards Board (FASB) has released GAAP standards for public companies and not-for-profit organizations. The idea was that if private companies needed an accounting framework to follow, they were welcome to comply with the GAAP standard. However, this resulted in higher accounting costs and more complexity for smaller private businesses. In response, FASB created the Private Company Council (PCC). Its purpose was to identify areas where public-company GAAP requirements were irrelevant or counterproductive to private companies and to make modifications as needed.
Accounting Framework
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A new tool, the Financial Reporting Framework for Small and Medium-Sized Entities, is geared toward small businesses that aren't subject to GAAP. Developed with input from the National Association of State Boards of Accountancy and released by the American Institute of Certified Public Accountants, it provides small business owners with a step-by-step process for choosing an accounting framework. The tool is similar to GAAP standards while excluding some hot-button issues the PCC is currently tackling.
More Ideas
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Small businesses having financial statements that don't comply with GAAP are most likely to prepare them on a cash, tax, or modified-cash basis. Some private companies operate in niche industries using specialized accounting disclosures that aren't GAAP-compliant but are more meaningful for industry insiders. The cash basis and tax basis frameworks are generally less expensive to use while requiring fewer disclosures and complex measurements.
Excess Complexity
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One example of how GAAP results in greater complexity for private companies is the employee stock-option reporting requirement. FASB’s shift toward fair value-based accounting led to requirements that companies report employee stock options, also known as warrants, at fair value. A major component in calculating the fair value of a warrant is its intrinsic value, the difference between a stock's strike price and its market price. However, private companies typically don't have that information as there is no market for their stock. Those with outstanding warrants must therefore value them using complex pricing models or hire valuation experts to do so.
