Nonpublicly Accountable Entities

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MAY 2005 - In my last two columns, I made fundamental points about financial accounting’s conceptual framework. The March column contained a plea for rational discourse rather than posturing about beliefs. The April column laid the groundwork for a rational discourse. Firmly grounded in who uses financial reports for what general purposes, it presented two ancient general purposes, accountability and interim settling-up, and a modern general purpose, valuation of the equity of public companies.

A Change in Approach at the IASB

In February, the International Accounting Standards Board (IASB) announced its decision to rename its project on accounting standards for small and medium-sized entities (SME) to accounting standards for nonpublicly accountable entities (NPAE). The IASB has increasingly focused its deliberation of general-use financial statements on external users of NPAEs, defined as owners not involved in management; existing and potential creditors; and credit-rating agencies. In other words, the IASB has recognized that the general use of NPAEs’ financial reports does not involve equity valuation, as it does with public companies. The IASB’s approach is a positive development because it explicitly recognizes that financial reporting standards depend on their use rather than on the size of the entity.

Operation, Sale, or Liquidation

To understand the general uses that different parties might have for financial statements, it sometimes helps to consider users’ fundamental decisions. For example, proprietors must decide periodically whether to stay in business, sell their equity in the business, or liquidate the business. Economically rational individuals would choose the action that maximizes their value. Consequently, they might want to compare estimates of the future net cash flows from the business, of the liquidation value of the business’ assets and liabilities, and of what another party might pay them for the equity of the business.

Traditional accounting measurements provide indirect insights into future net cash flows, but no information about the liquidation or market values of the business. On the other hand, fair value measurements could approximate liquidation values for some assets and liabilities, but not others (e.g., any probabilistically weighted estimate). Neither measurement directly addresses equity valuation, although when valuing equity, most business valuation specialists start from an understanding of general-use financial statements.

General-use financial statements, however, are not intended for insiders, but for external users without the power to seriously ponder liquidation or to operate the business. An external owner’s decision consists of either selling currently owned equity or holding it to collect future dividends and appreciation. While noncontrolling owners of both public and nonpublic businesses would be routinely interested in estimates of future cash flows, only owners of public company equities have access to an active market where ownership interests can be readily sold or purchased.

Fair Value

Fair value measurement of assets and liabilities focuses accounting on currently unrealized changes in asset and liability values that are likely to either increase or decrease as time passes; moreover, the actual value reported at any given time will likely never be realized. It’s not easy to see the relevance of such measurements in a going concern unless the company plans to liquidate the asset or liability close to the reporting date. Bitter experience, however, has demonstrated that rigorous application of the lower of cost or market principle to investment portfolios of financial institutions and inventories of manufacturing and trading companies generates useful information for many external users of businesses, both public and private, primarily as an indicator of going-concern risks.

On the other hand, all external parties, whether owners or creditors, public or private, recognize that insiders control the business’ accounting records. A fundamental demand for basic standards flows from such external users’ desire to limit insiders’ ability to manipulate financial records for their own benefit. One paradox of the asset and liability recognition approach to accounting with fair value measurement is its reliance on insiders’ current estimates of future events.

At some point, one must consider whether this approach is related to any of the general purposes for external financial reporting. Does it provide equity analysts with information they desire, or do the analysts still clamor for additional disclosures to draw their own conclusions about future cash flows? Does it provide noncontrolling owners and creditors with useful safeguards, or must they write extensive side contracts to protect their interests in the future cash flows? Does it provide not-for-profit boards with assurance that expenditures have been in accordance with their missions, or do they have to create alternative, non-GAAP accounting systems to fulfill their fiduciary duties?

Several years of innumerable discussions with preparers, auditors, analysts, creditors, standards setters, and regulators have convinced me that the scope of the conceptual framework project should include a more sophisticated and broader consideration of the general purposes of financial reports; a deeper analysis of the interdependencies among recognition, measurement, and disclosure for different general purposes; and an authoritative guide for differentiating the application of financial accounting standards for different general purposes. A unified GAAP is much preferable to multiple GAAPs from different sources.

Robert H. Colson, PhD, CPA





















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